Adaptation or Capitulation?

Fundsmith's H1 Letter

The talk of the value investor community last week was the H1 letter from Fundsmith, a U.K.-based manager with $30 billion in assets. They lost 2.9%, but what was notable wasn’t the return but founder Terry Smith’s announcement of a major strategy shift. They would no longer practice strict buy-fundamental-value-and-hold-it, but would now “take more account of momentum — both fundamental and share price — in … investment decisions. In particular, we will be much less willing to deploy the time-honoured technique of buying quality companies when they hit a glitch.”

Smith’s letter starts with a lengthy explanation of why the shift was necessary, citing the rise of index funds, which now own 60% of the stock market. These have vastly outperformed active managers over the last five years, with the U.K. index trackers up 66% vs. the active managers’ 32%. As the trackers’ lower fees would only explain a few percent of underperformance, not 34%, Smith addresses what else it could be.

Noting that active managers now represent only 10% of trading volume, he writes that what drives prices is “the momentum feedback loop of funds moving from active to passive and reweighting within passive funds.” Smith is right that this has become a momentum market, but in attributing that to the passive funds, he seems to be pointing at the tail rather than the dog. As my partner Steve Gorelik has observed, the “dog” would be retail investors, who have become extremely active, including via mobile apps like Robinhood, which have “gamified” investing.

It seems that the retail traders, not the active fund managers, are now determining market weights and, as in a kindergarten soccer game, clustering around a small group of stocks. Moreover, many juice their positions with options and leverage freely available to them, and with 3x ETFs on stocks like Nvidia and SpaceX. The passive funds quickly follow, becoming more concentrated in the hottest names, while the active managers lag way behind.

Whatever the actual reason for the shift to momentum, there’s no doubt that it has outperformed in recent years and no sign it’s letting up. In such an environment, Smith’s traditional strategy of “buying shares in companies which have hit a glitch is like trying to catch the proverbial falling knife. All we are getting is cut fingers as their downward share price spiral is exacerbated by the index momentum enhancement effect.”

Fundsmith might even try to tough it out until the trend reversed, but they “run open-ended funds, and you can and increasingly have been taking money out, we suspect mostly to join the exodus from active to passive ….” (A bit “passive” aggressive there.) Having already referenced the falling knife that gave this Substack its name, Smith drops another truism: “Sticking to our current approach may well fall foul of the adage that the market can remain illogical longer than we can remain in business.”

Dragging Smith

On X, What’s App, and whatever other corners value investors lurk, Smith has been accused of “throwing in the towel” or “style drift.” Comparisons are made to the dotcom bubble, when foolish managers chased the trend while Buffett remained steadfast, reaping the rewards when value rose again post-crash. Indeed, with the valuation gap between “growth” and “value” among the widest ever, it may be just the wrong time to bail on the latter. Some mock Smith’s fear of “going out of business” when he still runs $30 billion, even if that’s half his peak. (I’d ask the mockers, have you ever had to sell $30 billion of stocks? How do you think it would feel?) Also, at Smith’s fund size, sales can impact even very liquid stocks, as the market knows what he has to unload and avoids it, while traders short it, driving the stocks ever lower.

In an appendix, Smith gives examples of companies he’s sold and bought since the strategy shift. At first glance, the sight of Otis Elevator replaced with Applovin may induce nausea in value people, but Smith assures investors that he’s buying only stocks with solid free cash flow (FCF), and that the FCF yield on his new portfolio still exceeds the S&P’s. Plus, a momentum cherry on top. What he writes makes sense, but unlike the quality stocks with a temporary glitch, where he presumably had a differentiated view, nothing he says about his new stocks indicates any analytical edge. Therefore, if he retains any hope of outperforming those relentless indices, it rests mainly on his portfolio’s higher FCF yield — a rather thin reed.¹

That said, Smith did what he thought he had to do and I credit him for saying it as opposed to changing stealthily, stock by stock, as many managers do. I’ve written about my investment in Clarium, Peter Thiel’s hedge fund, which without notice changed from a global macro strategy to venture with one 90% holding. I called to see what was going on and the IR lady said Thiel had decided that global macro wouldn’t work in an era of central bank intervention. I asked what if investors wanted their money back and she said, “Oh, Peter will buy them out.” I wound up adding to the fund, not redeeming, which was smart because the big private holding was Palantir.²

Changing and Evolving

Sometimes it’s right to quickly throw in the towel on a strategy, as Thiel did; whether Terry Smith will be vindicated remains to be seen. Other times, a shift happens but it looks more like evolution. When I was ten years into managing money, in the mid-00s, I found myself adapting to big changes in my target markets.

My basic ideas about investing came from Benjamin Graham, but my first experience managing money was in Russian voucher privatizations, where we knew little about the companies beyond the size of their oil reserves or the kilometers of their power lines. Revenues? Earnings? Forget it. We were making a top-down bet that the future blue chips in a bull market would no longer trade at a 99% discount to foreign comps. From 1994-2004 we deployed mainly this top-down approach across a series of markets, including in the Baltic States, Central Asia, Romania, and Georgia. They didn’t all work, though we learned as much from the failures as the successes.

In the mid-00s things changed, as some of our markets began to look less “frontier” and more “emerging.” While among the former Soviet republics only the Baltics had IFRS financials, companies seeking higher valuations or listing GDRs began hiring Western-trained CFOs who knew what real financials looked like and how to speak to foreign investors. I was finally able to revert to my original Ben Graham value principles, and to make the shift properly my partner and I brought in three younger people who were better at the bottom-up analysis than us.

Since then, our investing has been fundamentals-based, with the macro overlay necessary in emerging markets, but frontier is still in our DNA. If a new country in transition from a mess to a market economy were to come along and we envisioned a bull market, we could still put on our top-down hats and invest based on franchises or assets, with little in the way of reliable financials. Our OTC purchases of Nebius in Q3 2024, when it was still called Yandex, looked like a frontier trade, based as it was mainly on the assets’ cheapness relative to comps. When I mention a winner, my CCO likes me to balance it with a loser, so I’ll say that one time we bought a gold mining stock that was in reality a hole in the ground with a liar standing at the top.

Besides the adaptation from frontier to emerging (and back again), there’s another kind that we haven’t been as good at. I’ve often said that in emerging markets sometimes you have to be Warren Buffett and sometimes you have to be George Soros. Being a Buffett-esque buy-and-hold investor from 2003-07 worked very well, but in 2008 what you needed to be was a Soros-like trader, able to cold-bloodedly take your favorite stocks out back and shoot them. A similar predicament arose with Russia in 2022, and in neither case did I rise to the challenge. Maybe next time.

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1. Even there, Steve Gorelik notes that Smith is being generous with the FCF calculations on the momentum stocks. For example, he credits Applovin with a 3.7% FCF yield, but this ignores the dilution from stock compensation, which can run 1-2% annually, making the real FCF yield closer to 1%, lower than the S&P’s.

2. My Palantir story and an investment lesson I learned from it is recounted in this post: