The Terry Smith Ratios
6 investing ratios that legendary investor Terry Smith uses to pick quality firm
In this edition of ZappChai, we are taking a break from everyday financial happenings and sectoral coverage. Today, we will cover something more theoretical - financial ratios and how to use them to pick quality firms and understand a company’s underlying business drivers. Rather than bore you with details on how to calculate financial ratios and how you can interpret them, we will defer to the wisdom of legendary investor Terry Smith.
Terry Smith, who?
He is often called Britain’s answer to Warren Buffet. Mr Smith has won over legions of private investors and wealth managers since setting up Fundsmith in late 2010 by generating stellar returns year after year. An initial investment of £1,000 in Fundsmith would now stand at £3,448 compared with £1,184 for an investment in MSCI ACWI Growth index.
Although, unlike Buffet, Terry Smith does not dish out sage-like advice and is not one to mince words. A former stock trader who enjoys boxing on the side, he became infamous for publishing ‘Accounting for Growth’, which critiqued accounting practices at companies, including those that were direct clients of his then employer UBS. He was later terminated.
Despite the current economic scenario, he is very confident of his fund’s performance. He said he is ‘not worried one iota’ about a sustained recession caused by the pandemic.
In a letter to shareholders last month, he said that if two of his holdings — airline booking technology provider Amadeus and hotel chain InterContinental Hotels — went bankrupt as a result of the lockdown, Fundsmith Equity would lose about 5 percent of its portfolio. “Whilst I would not be pleased with that, if that’s the worst thing that happens, I would suggest we can live with it,” he wrote.
So what’s his investment style? He believes no one can consistently predict macro events, and it is more worthwhile to identify good companies.
Fundsmith invests in mature companies with strong balance sheets and established brands, which are capable of reinvesting their profits and compounding value for investors over time, while excluding cyclical sectors, such as mining and financials.
He advocates using these six ratios as a starting point.
Gross Margin: Simply put, gross margin is the part of sales revenue a company retains after incurring direct costs associated with producing the goods and services it sells. It tells us whether the core of a business is profitable, and also indicates the company’s ability to weather shocks. The key is to look for trends – stable gross margins are always better!
Operating Margin: Essentially it tells us how much profit a company makes on a rupee of sales, after paying variable costs of production (such as wages) but before paying interest or tax. It tells us how well the firm is able to manage costs and gives us an indication of the profitability of the firm.
Return on Capital Employed: It connects the Profit and Loss statement with the balance sheet by comparing profitability to the level of assets. The idea remains the same, look for consistent trends. In an Indian context, Saurabh Mukherjee, CIO at Marcellus Investment Management and author of ‘Coffee Can Investing’ recommends investing in companies which have consistently shown 15% ROCE for each of the past 10 years.
Cash Generation and Conversion: Terry also likes to monitor the relationship between operating cash flow and operating profit. Operating cash flow indicates if a business can generate sufficient positive cash flow to maintain and grow its operations, otherwise it may require external financing.
Debt-to-Equity: Too much debt (relative to equity) can signal trouble for the company. The debt-to-equity ratio is a measure of financial risk. Too much debt may also lead to inflexibility in raising funds when required.
Interest Coverage Ratio: This ratio determines how comfortably a company can pay interest on its outstanding debt. The interest coverage ratio can be calculated by dividing a company's earnings before interest and taxes (EBIT) during a given period by the company's interest payments due within the same period.
All these ratios are quite simple. Yet investors are more easily swayed by trends and emotions than by numbers. There are several tools available online that can help build an initial ‘screen’ to filter for these ratios - one example is screener.in which has some standard stock screens.
A stock might have a good story, and a lot of people may buy the stock because of the story. But stories being subjective need to be weighed by numbers.
About the author: This post is written by Aman Jain with edits from our editorial team. Aman recently graduated from IIM Kozhikode and will be joining Boston Consulting Group.