Terry Smith explains: the free cash flow yield

Summary

The speaker addresses investors' concerns about the high valuation of successful companies, acknowledging the uncertainty of future share prices. They emphasize the importance of free cash flow yield as a key metric for evaluating investment value, comparing it to long-term bond yields. The speaker believes in investing in companies with a free cash flow yield higher than the expected bond yields, ensuring long-term value creation. They also discuss the concept of mean reversion in valuation and the behavioral finance aspect of investors' attraction to high-risk, high-reward investments, which allows for the purchase of quality companies at reasonable prices.

Takeaways

• 😌 The speaker acknowledges that investors might be right about the high valuation of companies in their fund, but admits uncertainty about future share prices.
• 💼 The fund tracks the free cash flow yield of companies as a key measure to determine if there's still value in investing, which is the cash generated after expenditures divided by market value.
• 📉 The speaker compares the free cash flow yield of companies to the long-term bond yields, suggesting a minimum yield of 1% over expected inflation for bonds.
• 💹 The speaker believes in investing in companies with a free cash flow yield of at least 5%, higher than what bonds should be yielding, to ensure long-term value creation.
• 🚫 The fund maintains discipline to not overpay for companies, aiming to hold onto them for the long term and benefit from their cash flows.
• 📈 Despite the fund's success, the speaker finds value in a significant portion of the investable universe, suggesting opportunities still exist.
• 🏆 The speaker discusses the concept of 'mean reversion' in company valuation, suggesting that some companies with superior margins and returns don't mean revert due to intangible advantages.
• 🎰 There's a behavioral finance aspect where investors are attracted to high-risk, high-reward investments, which the speaker believes is misguided and creates opportunities for their fund.
• 🗣️ The speaker addresses the irony of being criticized for both poor and good timing, highlighting the challenges of market sentiment and investor behavior.
• 🍔 A humorous anecdote is shared about the modern equivalent of an ideal investment being a whole sweet burger wrapped in a gold ETF certificate, a commentary on the trust in currencies and investments.

Q & A

What is the primary concern of investors regarding the fund's investment strategy?

Investors are concerned that since the fund has performed well, all the companies they invest in might be overvalued, making it unwise to invest more money in them.

What is the speaker's stance on the future performance of the companies in their portfolio?

The speaker acknowledges that they cannot predict future share prices and admits that investors might be right about the companies being expensive, but they are certain they own a portfolio of very good companies.

What key financial metric does the speaker use to evaluate the value of companies for investment?

The speaker uses the free cash flow yield of companies, which is the amount of cash generated after all expenditures divided by their market value, as a key measure to evaluate investment value.

How does the speaker compare the free cash flow yield of companies to long-term bond yields?

The speaker compares the free cash flow yield of companies to what they believe long-term bond yields should be, not what they currently are, considering the impact of government bond buying and inflation.

What is the minimum free cash flow yield the speaker looks for in a company before investing?

The speaker looks for a free cash flow yield of at least 5% in the companies they invest in, as this provides a higher yield than what they believe long-term bonds should be yielding.

Why does the speaker believe they can invest in good companies at a relatively cheap price?

The speaker believes they can invest in good companies at a relatively cheap price due to economic concepts like mean reversion and behavioral reasons such as investors' attraction to high-risk, high-reward investments.

What is the concept of 'mean reversion' as it relates to company valuation?

Mean reversion is the concept that companies with high returns on capital will attract competition and investment, driving down returns towards the market average, while companies with low returns will see capital exit, driving up returns over time.

How does the speaker describe the economic reason for the strategy's viability?

The speaker suggests that there are a small group of companies with superior margins and returns that do not mean revert due to intangible advantages like brand names, patents, and distribution networks, which protect them from competition.

What behavioral finance concept does the speaker mention that influences investor behavior?

The speaker mentions the 'lottery ticket effect' as a behavioral finance concept, where investors are attracted to high-risk investments with the potential for large returns, similar to the allure of lottery tickets.

What is the speaker's view on investors' ability to time the market?

The speaker expresses skepticism about investors' ability to time the market, pointing out the inconsistency in investors' advice regarding market timing and the difficulty of predicting market movements.

What modern investment analogy does the speaker give in relation to Jim Slater's 'can of corned beef' investment strategy?

The speaker's modern equivalent to Jim Slater's strategy is a 'whole sweet burger wrapped in a gold ETF certificate,' suggesting that the focus should be on tangible assets rather than financial instruments during times of high inflation.