Fundsmith 2024 annual letter
Temporary vs. Structural
Dear friends,
Sources: Fundsmith annual letters
Terry Smith’s fifteenth annual letter is out, marking his fourth consecutive year of underperformance relative to the market. While many have jumped at the opportunity to critique his performance, it’s essential to take a more nuanced and thoughtful approach.
Being a fund manager is no small feat, especially when every decision and outcome is laid bare for public scrutiny. Smith has built his reputation on a disciplined, long-term investment philosophy. This kind of approach can sometimes lag during periods of rapid market shifts or in environments that disproportionately reward risk-taking.
I still remember during the peak of dotcom bubble, Barron wrote a piece of article called what’s wrong, Warren? The article detailed out as follow:
“After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch. Shares in Buffett's Berkshire Hathaway are set to experience their first annual decline since 1990 and their second-worst year of performance, relative to the Standard & Poor's 500 Index, since Buffett took control of what had been a struggling New England textile maker in 1965.”
So, does Terry Smith lost his magic? I don’t think I am fit to comment on this but I do think that his letters offer good insights and it will always within my priority reading lists. However, in this article, I wanted to focus on this topic: Temporary vs structural challenges and I will use some of the companies within his portfolio to discuss about it.
Temporary vs. Structural
The problem for buying a high quality business is always price. When a business that has consistently outperformed the market, it is hard for most high quality investors to miss them. (I don’t deny that it does happened but only on rare occasion) As a result, they are usually trading at rich valuation. Some good examples are Cintas, Costco, Rollins, etc.
However, occasionally, Mr. Market would offer an opportunity to us but always with a catch. There is usually an event that alter the narrative about the company. (I will discuss company specific challenges rather than macro) This is where the challenges: Whether is the company facing a temporary or structural problems.
A temporary challenge is typically a short-term obstacle that does not fundamentally alter a company’s long-term prospects. For instance, in his letter, he discussed about Nike and he thinks that the challenge is temporary and I quote:
“Nike is a stock we bought after the share price fall during the pandemic when investors seemed convinced there would be many fewer buyers of trainers. In fact, Nike had made great strides in online marketing and fulfilment.
What we hadn’t realised was that the then management would parlay this success into a problem by ignoring the traditional bricks & mortar retail channel, which has recovered as the pandemic passed, and in so doing open the door literally to competition.
To be fair there have been other issues such as an increasing dependence on fashion and less on traditional exercise uses. However, the good news is that there has been a change of CEO this year. We see many commentators musing about the reasons why the US economy is so successful. Perhaps one reason is a quicker finger on the trigger when top executives do not deliver.
In which context we note that Unilever’s shares were up 20% in 2024. We await developments from Nike’s new management who have after all inherited what is still the dominant market share in the sector.”
By looking at Nike share performance, it is almost trading at around pandemic level. Investors are inclined to conclude that Nike demise is near given that their sales are decreasing at double digit, margin shrink, competitions are coming left and right for their market share, etc.
So, with the change of narrative, do you dare to conclude that Nike is still a high quality business? This has always been the dilemma for high quality investors. It is easy to say in hindsight and this is how a critique will always say:
See, i told you. Nike will rebound! (when the stock price went up) or;
See, i told you, Nike is losing its edge! (when the stock price went down)
Unless you did your work (understanding its moat and whether is it expanding or shrinking), it is hard to conclude that the issue is temporary or structural. In this case, my verdict is I don’t know. (Sorry for those who think I got the golden answer, I don’t!) Clothing/sport attire has always been a tough industry and I would deemed myself incompetent to predict the outcome.
However, if you could, this might be a very good opportunity to research or even invest in them. That is why doing your works matter and margin of safety will help to cushion our blind spot.
On the other hand, structural challenges imply a fundamental shift that threatens a company’s competitive position or business model. He seems to think that Diageo, facing potential disruption from the introduction of Ozempic (a weight loss drug), is an example. He said and I quote:
“Diageo, which we had owned since inception, has exhibited problems with its new management, shown by a lack of information about its Latin American business which produced results far worse than the sector in this area.
Moreover, we suspect the entire drinks sector is in the early stages of being impacted negatively by weight loss drugs. Indeed, it seems likely that the drugs will eventually be used to treat alcoholism such is their effect on consumption.”
Of course, some reader might be puzzle with his choice of keeping Brown Forman, another spirit producer when he thinks that the alcohol sector is in the early stages of declined which I quote below:
“We sold our Diageo stake during the year which I will cover later but retaining Brown-Forman keeps a foothold in what has long been a sector with good business characteristics and which has the potential benefits of family control, which can promote good long-term decision making, and a larger bias towards premium spirits than Diageo which may help obviate the impact of weight loss drugs (‘drink less but better quality’).
It is a company which survived Prohibition so we hope there is literally something in the DNA to help with these adverse circumstances.”
His rationale is that it is a more premium product and thus less susceptible to disruption, as most of it is consumed during social events. It might serve a different purpose beyond fulfilling a basic need, such as enhancing social experiences or celebrating special occasions.
This positioning aligns with a "drink less but better quality" mindset, making it potentially more resilient to challenges like weight-loss drugs or shifting consumer habits.
Will he be right on this? Who knows? The role of an investor is to make informed decisions while carefully managing the risk of permanent loss. Great investors, however, distinguish themselves by consistently maintaining a much higher win rate, achieved through disciplined analysis, experience, and sound judgment.
Hindsight bias: The Difficulty of Real-Time Decision Making
Some investors are quick to criticize with the benefit of hindsight, pointing out perceived mistakes like Terry Smith selling Adobe or Intuit before their stock prices rose by a certain percentage. This kind of retrospective analysis oversimplifies the complexities of real-time decision-making and ignores the principles behind such choices.
Even worse are the so-called "finfluencers" (and I hope you don’t lump me in with them) who seem invincible, constantly boasting about outperforming the market over the past few years, as if they can do no wrong. It reminded me this quote by Buffett:
"Only when the tide goes out do you discover who’s been swimming naked."
While their recent success deserves credit, this overconfidence in short-term performance contrasts sharply with the reality of investing. True success requires long-term discipline and the ability to navigate uncertainty, which is why only a select few fund managers consistently outperform the market over time. (I mean more than 10 years)
It’s easy to assess decisions with the clarity of hindsight, but making the right call as events unfold requires a deep understanding of the business, the industry, and broader market forces. If you lose conviction in a stock, it’s best to sell, even if the stock’s performance defies your expectations afterward.
So far, both Adobe and Intuit are starting to show cracks in their investment thesis and underperformed the market last year. Lets see if people will bring this up and compliment Terry Smith for being right. (probably not because criticizing people attract more views)
Lesson for investors
The key lesson here is that mistakes are inevitable, but learning from them is what makes us better investors. Dwelling on past errors doesn’t help; what matters is refining our process and decision-making to avoid repeating them.
Terry Smith did openly discussed his mistakes, demonstrating a willingness to learn and adapt. When asked why he didn’t invest in Apple, he candidly called himself an idiot—a refreshing admission in an industry where ego often prevents self-reflection. This highlights an important truth: investing is a humbling job because Mr. Market will inevitably humble even the best investors.
No one has perfect foresight, and the market is a relentless teacher. Success comes not from avoiding mistakes entirely but from acknowledging them, learning, and improving. The ability to admit errors, as Terry Smith does, shows humility and a commitment to growth—qualities essential for long-term investing success.
It’s also important to avoid criticizing others. Pointing out flaws in someone else’s strategy may feel satisfying in the moment, but it won’t make you a better investor. The focus should always be on improving your own approach and learning from your own experiences.
Unfortunately, the investment industry often discourages patience, pushing managers to chase short-term results instead of sticking to their principles. This pressure can lead to poor decisions and undermine long-term success.
True success in investing comes from discipline and commitment to a solid strategy, not reacting to short-term challenges or finding fault in others. By staying focused, humble, and committed to learning, you can build the habits that separate great investors from the rest.
The Role of Investment Philosophy
Smith’s approach—investing in quality companies, avoiding overpayment, and doing nothing unless fundamentals change—is a cornerstone of navigating such dilemmas. This philosophy emphasizes patience and the importance of understanding the businesses in which one invests.
It aligns closely with Buffett’s idea that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Great companies often face temporary setbacks, but their structural advantages—strong brand recognition, scalable business models, or competitive moats—allow them to recover and thrive.
However, a critical part of this philosophy is the interplay between quality and valuation. While Smith avoids overpaying for businesses, it’s clear from Alex Morris’s chart on the declining FCF yield in his portfolio that valuation expansion has played a significant role in his performance over time.
This reflects the market’s increasing recognition of the quality of these businesses, driving up their multiples. That said, while valuation expansion can amplify returns in the short to medium term, it is not the foundation of long-term success.
Sustained outperformance ultimately depends on the underlying earnings growth and free cash flow generation of the portfolio companies, not on continually rising valuations. By staying true to his principles and focusing on business fundamentals, Smith ensures that his portfolio remains resilient, even as market conditions evolve.
Conclusion
The ability to differentiate temporary from structural challenges is a hallmark of great investors. It involves understanding whether a challenge is a short-term setback to endure or a fundamental issue requiring a change in course. This skill is critical for navigating the complexities of investing and making decisions that align with long-term goals.
Terry Smith’s disciplined approach exemplifies this principle. His ability to evaluate challenges within this framework has contributed to his impressive track record. (annualised 15% return)
By internalizing this mindset, investors can navigate uncertainty with greater confidence and clarity. Success in investing requires not just identifying challenges but understanding their nature and responding with patience, discipline, and a focus on the bigger picture.
Lastly, please do read his letter and it has always been a good learning materials that help me to grow overtime. In summary, Terry Smith elaborates on the evolving challenges posed by AI-driven hype, market volatility, and rising interest in passive index investing, cautioning against overexuberance in speculative trends.
Disclaimer: I might have positions in the above posts and receive no fees for writing the post. I am not affiliated or have any role with the company. This post is just for educational purpose and it is not an advice to buy or sell the stocks. Invest at your own discretion.
Thanks for sharing the annual letter, and your analysis. Interesting stuff.