Terry Smith: The mistake Woodford made that I will not make

Terry Smith, manager of Fundsmith Equity fund, shares his thoughts on the Neil Woodford debacle. 

Terry Smith has vowed to not commit the cardinal sin that ultimately led to the downfall of Neil Woodford – changing the way he invests.

When a fund manager underperforms, the one thing fund analysts want to see more than anything is the manager ‘sticking to their knitting’. Woodford, though, “changed his game”, Smith notes, and this ultimately led to his spectacular fall from grace.

In his annual letter to shareholders, Smith gave his thoughts on the debacle, first pointing out that it has raised important issues about the fund management industry.

According to Smith, the most obvious problem was the “lethal combination of a daily-dealing open-ended fund with significant holdings in unquoted companies and large percentage stakes in small quoted companies which had very limited liquidity”.

He adds that “an open-ended daily-dealing fund is clearly not an appropriate vehicle through which to hold such assets”. Moreover, he points out:

“The daily dealing and open-ended structure give investors the illusion of liquidity, but when a large number of them try to exercise it at once, the effect is similar to shouting ‘Fire!’ in a crowded theatre.”

But, ultimately, Smith adds, the biggest problem that led to Woodford’s demise and has resulted in investors in the LF Woodford Income Focus receiving large capital losses, was that Woodford changed his investment strategy – by investing higher stakes in small illiquid companies and unquoted firms.

“In the technical jargon of the industry, he engaged in ‘style drift’. The problem wasn’t that he was regarded as a star but that he changed his game,” says Smith.

Smith adds that the ‘star manager’ reputation Woodford had is the “wrong issue” to focus on, further remarking: “I think it makes no more sense to avoid funds run by ‘star’ fund managers any more than it does to avoid supporting sporting teams because they have star players.

“The trouble arises not because teams have star players but if the star tries to play a different game to the one which delivered their stellar performance. Would Juventus do as well if Cristiano Ronaldo played as goalkeeper? How is Usain Bolt’s second career as a soccer player going?”

Smith vowed not to make the same mistake, insisting he will continue to stick to his guns and that there will be “no style drift” – meaning his Fundsmith Equity will continue its approach of backing high-quality businesses and will not, for example, rotate into value stocks.

He adds: “We have no desire to change our strategy. We are convinced that it can deliver superior returns over the long term.

“If you expect such a ‘rotation’ (from growth to value) to occur at some point and for value stocks to enjoy a period in the sun, would you rather we tried to anticipate that and switched into a value investment approach of buying stocks based mainly or solely on the basis of their valuation, or would you rather we stuck to our existing approach of buying and holding high-quality businesses? I would suggest the latter approach might be better, and it is what we are doing. There will be no style drift at Fundsmith.”

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