1 00:00:00,000 --> 00:00:03,800 Your mind has been conditioned to search for cheap stocks in 2 00:00:03,800 --> 00:00:07,100 expensive, stocks stocks that are called undervalue. 3 00:00:07,100 --> 00:00:10,500 And this word undervalued has been used for so long and 4 00:00:10,500 --> 00:00:13,500 investing that is basically synonymous with investing. 5 00:00:13,800 --> 00:00:16,600 The goal of investing is to Simply scan through companies 6 00:00:16,600 --> 00:00:19,600 and figure out which ones are the most undervalued, which ones 7 00:00:19,600 --> 00:00:22,300 are selling cheapest. This has been the often quoted 8 00:00:22,300 --> 00:00:25,300 strategy of Warren Buffett. Buffett is quoted saying, price 9 00:00:25,300 --> 00:00:28,300 is what you pay value is what you get and in terms of 10 00:00:28,300 --> 00:00:31,900 valuation when we're looking at. Individual companies, there's no 11 00:00:31,900 --> 00:00:35,400 easier way to assign whether or not a company is undervalued or 12 00:00:35,400 --> 00:00:39,200 overvalued then by the PE Ratio the price of the company 13 00:00:39,200 --> 00:00:41,200 compared to its forward earnings. 14 00:00:41,500 --> 00:00:44,600 This is a price to earnings multiple of the company and too 15 00:00:44,600 --> 00:00:47,000 many investors whether or not a company's overvalued or 16 00:00:47,000 --> 00:00:50,800 undervalued relies heavily on this PE ratio the bright line, 17 00:00:50,800 --> 00:00:54,200 typically being a 20 PE companies, like apple that are 18 00:00:54,200 --> 00:00:57,700 above a 20 PE, well, they can be looked at as overvalued 19 00:00:57,700 --> 00:01:01,000 companies like Intel with a lower than Any PE currently 20 00:01:01,000 --> 00:01:04,300 sitting at 14? This company is undervalued a 21 00:01:04,300 --> 00:01:06,700 company. Like, Microsoft, 28 PE 22 00:01:06,900 --> 00:01:10,800 overvalued a company. Like Paramount, Global a 94 PE 23 00:01:11,100 --> 00:01:13,000 undervalued. Now, this may seem like an over 24 00:01:13,000 --> 00:01:15,600 simplification, but this is how a lot of value investors are 25 00:01:15,600 --> 00:01:18,200 doing analysis today. And why wouldn't they buying 26 00:01:18,200 --> 00:01:20,700 cheap companies companies with a low price to earnings? 27 00:01:20,700 --> 00:01:23,800 Ratios is what responsible investors do? 28 00:01:23,800 --> 00:01:25,800 It's what intelligent investors do? 29 00:01:26,100 --> 00:01:28,700 It gives you a feeling of superiority you're buying 30 00:01:28,700 --> 00:01:31,300 inexpensive? These value stocks you're not 31 00:01:31,300 --> 00:01:34,600 like one of those hype investors riding into the high, multiple 32 00:01:34,600 --> 00:01:37,500 companies, you're responsible investors, putting your money to 33 00:01:37,500 --> 00:01:40,500 work at the best value possible. Well, that all sounds great, but 34 00:01:40,500 --> 00:01:43,500 there's one big problem to this thought process and it's this 35 00:01:43,500 --> 00:01:45,700 guy right here, his name is Terry Smith. 36 00:01:45,700 --> 00:01:48,600 One of the things that some value fund managers say is the 37 00:01:48,600 --> 00:01:51,900 way their their help to make returns for you as by buying 38 00:01:51,900 --> 00:01:55,900 significantly cheaper stocks and waiting for that re-rating. 39 00:01:56,200 --> 00:01:58,900 Is there a risk then with your strategy that you're paying over 40 00:01:58,900 --> 00:02:01,600 the odds at these? So expensive, the strategy that 41 00:02:01,600 --> 00:02:05,000 this interviewer just described is exactly what I'm outlining 42 00:02:05,000 --> 00:02:07,200 here. Value investors looking to buy 43 00:02:07,200 --> 00:02:10,300 cheap stocks and waiting for them to be re-rated at a higher 44 00:02:10,300 --> 00:02:12,700 multiple. This is the traditional 45 00:02:12,700 --> 00:02:16,500 definition of value investing buying cheap companies and 46 00:02:16,500 --> 00:02:19,400 waiting for them to re-rate. And this is Terry Smith's 47 00:02:19,400 --> 00:02:21,100 response to this. Yeah, you're right. 48 00:02:21,100 --> 00:02:23,300 That's how some value for managers seek to do it. 49 00:02:23,600 --> 00:02:25,800 I have to say, looking at the average results that you just re 50 00:02:25,900 --> 00:02:28,200 not very many of them seem to manage to achieve our 51 00:02:28,200 --> 00:02:30,600 performance with that. Now, that's a little bit of a 52 00:02:30,600 --> 00:02:32,600 burn right there. Terry, you don't have to go that 53 00:02:32,600 --> 00:02:36,300 hard on the entire industry. But what he says is true, the 54 00:02:36,300 --> 00:02:38,900 so-called value investors in the investment industry. 55 00:02:39,100 --> 00:02:42,700 In most cases do not generate Alpha, they don't beat the 56 00:02:42,700 --> 00:02:44,700 market over any consistent basis. 57 00:02:44,900 --> 00:02:47,700 They have high volatility and they charge expense ratios. 58 00:02:47,700 --> 00:02:50,100 On top of that that don't justify their performance 59 00:02:50,400 --> 00:02:53,600 overall value. Investing in the professional 60 00:02:53,600 --> 00:02:56,400 industry has been an absolute joke. 61 00:02:56,600 --> 00:02:59,800 Most investors have not performed better than the index. 62 00:03:00,200 --> 00:03:04,500 And Terry Smith stands alone in this category, he is one of the 63 00:03:04,500 --> 00:03:08,200 very few that has consistently outperform the index across 64 00:03:08,200 --> 00:03:10,800 multiple benchmarks. Terry, Smith's Equity Fund 65 00:03:10,800 --> 00:03:14,100 called Fun Smith has had Stellar performance even at its large 66 00:03:14,100 --> 00:03:16,200 size of now. Twenty nine billion dollars 67 00:03:16,200 --> 00:03:19,400 approximately and assets under management is continue to 68 00:03:19,400 --> 00:03:22,300 outperform its Benchmark, indexes its outperform, the 69 00:03:22,300 --> 00:03:25,700 equity markets, the UK bonds and of course cash and it's done it 70 00:03:25,700 --> 00:03:29,800 by a huge amount. It's had 16 percent annualized 71 00:03:29,900 --> 00:03:33,400 Earns since Inception compared to the equity Market, which is a 72 00:03:33,400 --> 00:03:36,700 total stock market's 11.8 percent return, to give you an 73 00:03:36,700 --> 00:03:39,400 idea of how much that means over this time. 74 00:03:39,400 --> 00:03:41,500 Period fun Smith, has total returns. 75 00:03:41,500 --> 00:03:43,500 Since Inception of four hundred and ninety. 76 00:03:43,500 --> 00:03:46,900 One point nine percent, the equity markets, the comparable 77 00:03:46,900 --> 00:03:51,100 Benchmark has returned. 269 point, seven percent. 78 00:03:51,300 --> 00:03:54,100 The out performance has been nearly double over this time 79 00:03:54,100 --> 00:03:56,300 period and then even more impressive with that 80 00:03:56,300 --> 00:03:59,800 outperformance is he hasn't accomplished it by taking on 81 00:04:00,100 --> 00:04:04,000 Excessive risk, concentrated positions and results that are 82 00:04:04,000 --> 00:04:06,800 unlikely to repeat. He's done it by consistent 83 00:04:06,800 --> 00:04:09,800 investing in high quality companies, he's had very low 84 00:04:09,800 --> 00:04:11,900 variance month-to-month performance. 85 00:04:12,100 --> 00:04:15,100 You can look at it and there's not many draw Downs in as fund. 86 00:04:15,200 --> 00:04:18,200 He has a better Sorrentino rating than the overall indices. 87 00:04:18,200 --> 00:04:21,899 Meaning that immeasurable risk. Terry Smith is outperforming, 88 00:04:21,899 --> 00:04:24,200 while taking on less risk overall. 89 00:04:24,200 --> 00:04:26,800 This performance has been accompanied by less draw Downs, 90 00:04:26,800 --> 00:04:29,700 less volatility and less severe of bear markets. 91 00:04:29,900 --> 00:04:32,300 Terry Smith isn't shy about What's led to this out 92 00:04:32,300 --> 00:04:34,500 performance and what he believes will lead to continued out 93 00:04:34,500 --> 00:04:38,300 performance in the fullness of time, his strategy is simple, 94 00:04:38,600 --> 00:04:40,900 avoid bad companies and invest in. 95 00:04:40,900 --> 00:04:43,100 Good companies one of the problems of owning the bag 96 00:04:43,100 --> 00:04:45,900 companies in life is while you're waiting for. 97 00:04:45,900 --> 00:04:48,000 Those companies are sort of steel companies in the chemical 98 00:04:48,000 --> 00:04:50,700 companies in the airline's of the banks of this world to have 99 00:04:50,700 --> 00:04:53,500 an event, which is what people are really waiting for a change 100 00:04:53,500 --> 00:04:57,100 of management, a take over the business cycle to turn up. 101 00:04:57,300 --> 00:04:59,800 They basically destroy value just the same as it would just 102 00:04:59,900 --> 00:05:02,000 Value for you. Personally, if you took in money 103 00:05:02,000 --> 00:05:05,600 at a cost of 10 percent and you invested at five bad companies 104 00:05:05,600 --> 00:05:08,300 are companies that earn low Returns on their invested 105 00:05:08,300 --> 00:05:10,300 Capital. Their companies that take money 106 00:05:10,300 --> 00:05:14,300 in at 10% in the, invest it at 5%, that destroys shareholder 107 00:05:14,300 --> 00:05:16,400 wealth and Terry doesn't invest in those companies. 108 00:05:16,400 --> 00:05:19,400 No matter how seemingly cheaper inexpensive, they are the invest 109 00:05:19,400 --> 00:05:21,400 in what he calls. Good companies companies we own 110 00:05:21,400 --> 00:05:24,200 taking money out, cost of let's call it ten percent and that 111 00:05:24,200 --> 00:05:27,200 makes 30%, you can rely on the fact that we may get the share 112 00:05:27,200 --> 00:05:30,200 price right or wrong where we buy them but whilst Sitting 113 00:05:30,200 --> 00:05:33,000 there in that portfolio, they consistently create value. 114 00:05:33,100 --> 00:05:34,600 So that's what our screening process is about. 115 00:05:34,600 --> 00:05:37,200 It's about looking for companies that right across the business 116 00:05:37,200 --> 00:05:40,200 and economic cycle have fundamentals that actually 117 00:05:40,200 --> 00:05:43,300 create value by making a high return on Capital in cash. 118 00:05:43,300 --> 00:05:45,900 This is a dramatic difference than the traditional way of 119 00:05:45,900 --> 00:05:48,100 looking at Value. Investing traditionally value 120 00:05:48,100 --> 00:05:49,900 investing has looked something like this. 121 00:05:49,900 --> 00:05:53,200 You screen for companies that are on the surface cheap, we can 122 00:05:53,200 --> 00:05:56,500 take the example of Citigroup. This is a cheap stock, 123 00:05:56,500 --> 00:05:58,400 fundamentally speaking. When you look at some of the 124 00:05:58,400 --> 00:06:02,100 basic valuation metrics, We look at an eight forward, P/E ratio, 125 00:06:02,200 --> 00:06:06,000 that's a very low P/E ratio, half of what the S&P 500 is The 126 00:06:06,000 --> 00:06:10,000 Price to Book value is 0.5. So on paper, this company looks 127 00:06:10,000 --> 00:06:13,600 very cheap, maybe we could invest in this company and wait 128 00:06:13,600 --> 00:06:17,400 for it to be rated by investors back to, it's appropriate. 129 00:06:17,400 --> 00:06:22,400 Fair value of a let's say 12 forward P/E ratio, or a One 130 00:06:22,400 --> 00:06:25,000 Price to Book value. And as it gets re-rated, the 131 00:06:25,000 --> 00:06:28,700 price goes up, we make money and then we can search for the next 132 00:06:28,700 --> 00:06:30,700 cheap stock to Make more money on. 133 00:06:31,000 --> 00:06:34,200 That is a traditional definition of value investing and that is 134 00:06:34,200 --> 00:06:36,700 not what Carrie Smith does. Instead of investing in 135 00:06:36,700 --> 00:06:40,300 companies that are cheap and may become Fair valued Terry Smith 136 00:06:40,300 --> 00:06:44,100 invest in companies that create value, they generate value every 137 00:06:44,100 --> 00:06:46,700 single year that they do business and whether or not 138 00:06:46,700 --> 00:06:49,400 they're cheaper expensive. They have a high probability of 139 00:06:49,400 --> 00:06:52,100 continuing to create a lot of value for shareholders have 140 00:06:52,100 --> 00:06:55,000 fundamentals, that actually create value by making a high 141 00:06:55,000 --> 00:06:58,200 return on Capital in cash companies that have fundamentals 142 00:06:58,200 --> 00:06:59,800 in creating High Returns on invested. 143 00:06:59,900 --> 00:07:02,900 Capital in cash. Now luckily for us we can take a 144 00:07:02,907 --> 00:07:05,500 look at the specific Holdings that Terry Smith has in his 145 00:07:05,500 --> 00:07:07,300 portfolio. Let's go ahead and look at the 146 00:07:07,300 --> 00:07:11,100 very top one here, Microsoft with a 10 point 6, 1 percent 147 00:07:11,100 --> 00:07:14,700 waiting this is by far the largest holding in his portfolio 148 00:07:15,000 --> 00:07:18,000 and it's almost a 4% waiting greater than the second place 149 00:07:18,000 --> 00:07:19,800 one. So he has a lot of money 150 00:07:19,800 --> 00:07:23,200 invested in Microsoft, Microsoft trades that a 28 forward P/E 151 00:07:23,200 --> 00:07:25,100 ratio. This looks like an expensive 152 00:07:25,100 --> 00:07:30,000 company a28 pe1, lots of companies are selling for 50 18 153 00:07:30,000 --> 00:07:33,600 and 17 and 18 40. He's Microsoft sitting here at a 154 00:07:33,600 --> 00:07:36,600 28 yet this is the biggest holding and fun Smith's 155 00:07:36,600 --> 00:07:38,400 portfolio. Most investors believe that 156 00:07:38,400 --> 00:07:41,500 Microsoft's expensive, Carrie Smith does not the next 157 00:07:41,500 --> 00:07:45,000 companies one that's less known called ID, e XX Laboratories. 158 00:07:45,000 --> 00:07:46,900 It's a Healthcare company. This one trades at an 159 00:07:46,900 --> 00:07:51,600 astounding, 46 Ford, P/E ratio. Now, most of us would assume 160 00:07:51,600 --> 00:07:54,200 that this company is overpriced because of the very high 161 00:07:54,200 --> 00:07:57,000 multiple of price to earnings, but Terry Smith and fun Smith 162 00:07:57,000 --> 00:07:59,200 May disagree. The company is at a six point 163 00:07:59,200 --> 00:08:01,200 eight waiting. In their portfolio. 164 00:08:01,500 --> 00:08:03,500 The next one after that is Estee Lauder. 165 00:08:03,800 --> 00:08:06,600 This is also at a very high waiting in their portfolio of 166 00:08:06,600 --> 00:08:10,100 5.4%, Estee lauder's. A makeup company that owns a lot 167 00:08:10,100 --> 00:08:14,200 of Premium makeup brands but the company currently trades at a 32 168 00:08:14,200 --> 00:08:17,600 PE ratio. So far, his top waited companies 169 00:08:17,800 --> 00:08:20,800 are all way more expensive on a price to earnings than the rest 170 00:08:20,800 --> 00:08:26,400 of the market 2846. 32, these are high multiple companies, we 171 00:08:26,400 --> 00:08:28,600 can continue on with this list, we have another health care 172 00:08:28,600 --> 00:08:31,600 company s YK Okay, this one's finally a little bit more 173 00:08:31,600 --> 00:08:34,000 reasonable. It's only out of 23 forward, P/E 174 00:08:34,000 --> 00:08:37,100 ratio, not quite as expensive, as the rest of the companies in 175 00:08:37,100 --> 00:08:39,400 his portfolio. After that, we have a real Value 176 00:08:39,400 --> 00:08:42,500 stock here, Philip Morris. This one trades only at a 17 177 00:08:42,500 --> 00:08:45,000 forward P/E ratio but then we get back to more expensive 178 00:08:45,000 --> 00:08:46,100 companies. Right underneath. 179 00:08:46,100 --> 00:08:49,900 Philip Morris is McCormick out of 5.3% waiting McCormick, is 180 00:08:49,900 --> 00:08:52,500 that flavor company? It makes lots of spices and it 181 00:08:52,500 --> 00:08:55,100 has flavor signs for different companies and this one is 182 00:08:55,100 --> 00:08:57,900 another premium High, multiple valuation. 183 00:08:58,000 --> 00:09:02,100 It trades at a Then forward. P/E ratio, we can continue on 184 00:09:02,100 --> 00:09:04,800 looking at, basically all of his top Holdings that compiled his 185 00:09:04,800 --> 00:09:07,200 entire portfolio. The next one, after that at a 186 00:09:07,208 --> 00:09:11,700 four point nine seven waiting is into it into it trades at a 33 187 00:09:11,700 --> 00:09:14,800 price to earnings multiple. This is another so-called 188 00:09:14,800 --> 00:09:18,400 expensive company in Terry Smith's portfolio after that, we 189 00:09:18,400 --> 00:09:20,700 have Pepsi, everyone knows this company. 190 00:09:20,700 --> 00:09:23,700 It's at a four point four, nine percent waiting Pepsi trades at 191 00:09:23,700 --> 00:09:28,500 a 26, four turnings. These are all overvalued, every 192 00:09:28,500 --> 00:09:31,300 single one of them, how Can Terry Smith, outperform the 193 00:09:31,300 --> 00:09:34,700 market by investing in a basket of seemingly overvalued 194 00:09:34,700 --> 00:09:37,000 companies? And after Pepsi the same Trend 195 00:09:37,000 --> 00:09:39,400 continues, all of these companies create a high 196 00:09:39,400 --> 00:09:42,000 multiples relative to the rest of the market leading many 197 00:09:42,000 --> 00:09:44,700 investors to believe that these companies are overvalued. 198 00:09:44,700 --> 00:09:47,200 Now this is the part that's confusing looking over his 199 00:09:47,200 --> 00:09:49,300 portfolio. It appears that every single 200 00:09:49,300 --> 00:09:52,700 company is overvalued based on the price to earnings multiple, 201 00:09:52,700 --> 00:09:55,400 but then we look again at his historical performance and since 202 00:09:55,400 --> 00:09:58,900 2011, he's dramatically out performed, all the major 203 00:09:58,900 --> 00:10:01,500 benchmarks. Nearly doubling the world market 204 00:10:01,500 --> 00:10:04,500 index and even we slice up different timelines and zoom 205 00:10:04,500 --> 00:10:07,700 into different periods. For instance, from 2017, to 206 00:10:07,700 --> 00:10:11,100 current day, fund Smith has continued to outperform The 207 00:10:11,100 --> 00:10:15,000 Benchmark index. It hasn't had any type of Arc 208 00:10:15,000 --> 00:10:19,800 like, sell off any 70% drawdown. Even in the most recent draw 209 00:10:19,800 --> 00:10:24,000 down there, still outperforming the broader market indices even 210 00:10:24,000 --> 00:10:27,400 when companies outside of their portfolio are doing particularly 211 00:10:27,400 --> 00:10:30,500 well, like oil companies, for example, And Smith is still 212 00:10:30,500 --> 00:10:32,200 prevailing. If the purpose of a value 213 00:10:32,200 --> 00:10:35,200 investor is to determine the value of a company. 214 00:10:35,300 --> 00:10:39,000 This is a perplexing problem. If we can't use Simple metrics, 215 00:10:39,100 --> 00:10:42,400 like the PE Ratio to accurately determine the value of a 216 00:10:42,408 --> 00:10:44,700 company, then what metrics can we use? 217 00:10:44,900 --> 00:10:46,800 When I started investing to begin with? 218 00:10:46,800 --> 00:10:50,200 I had many of the same simple views at a lot of new investors. 219 00:10:50,200 --> 00:10:54,600 Have the company has a low P/E ratio that company is cheap. 220 00:10:54,700 --> 00:10:58,400 There is more value there. The company has a high P/E ratio 221 00:10:58,500 --> 00:11:02,200 that company's expense If it's overvalued but Terry Smith and 222 00:11:02,200 --> 00:11:04,600 other investors have called into question this way of doing 223 00:11:04,600 --> 00:11:08,600 valuation, this simple metrics like this don't accurately lead 224 00:11:08,600 --> 00:11:12,900 to the true value of a company and he offers a different method 225 00:11:12,900 --> 00:11:16,700 in determining the real value of companies like Pepsi like Estee 226 00:11:16,700 --> 00:11:19,700 Lauder or like Microsoft. So with how quote-unquote 227 00:11:19,700 --> 00:11:22,900 expensive all these companies are that Terry Smith owns in his 228 00:11:22,900 --> 00:11:25,000 portfolio. You can imagine how he's 229 00:11:25,000 --> 00:11:29,700 constantly bombarded with concerns and questions about. 230 00:11:29,800 --> 00:11:32,100 None of these companies investors are looking at these 231 00:11:32,100 --> 00:11:35,000 companies and saying, Terry, these companies seem very 232 00:11:35,000 --> 00:11:37,500 expensive, compared to the Alternatives in the rest of the 233 00:11:37,500 --> 00:11:39,200 market. Aren't you concerned about 234 00:11:39,200 --> 00:11:42,200 valuation? Well, yes, Terry Smith is don't 235 00:11:42,200 --> 00:11:44,400 over Pi. Second leg of our strategy. 236 00:11:44,800 --> 00:11:47,800 This is probably the most Vex part of our strategy over the 237 00:11:47,800 --> 00:11:48,900 years. People always worried about 238 00:11:48,900 --> 00:11:51,200 whether we are overpaying, we were about whether overpaying. 239 00:11:51,400 --> 00:11:53,900 You see last year, we finished the year with a free cash flow 240 00:11:53,900 --> 00:11:57,100 yield of to point subset. So take the free cash flow that 241 00:11:57,100 --> 00:11:59,100 our companies have generated after paying for everything 242 00:11:59,100 --> 00:12:01,600 except that. Then which is a distribution 243 00:12:01,600 --> 00:12:05,200 from the cash flow that we own and you'll see that it was two 244 00:12:05,200 --> 00:12:08,200 point seven percent when that is divided by their market value. 245 00:12:08,700 --> 00:12:10,000 How does that compare with the index? 246 00:12:10,000 --> 00:12:12,900 While you can see their 5.4% for the ftse? 247 00:12:12,900 --> 00:12:15,800 The companies we own are about twice as highly rated at half 248 00:12:15,800 --> 00:12:18,000 the yield of the ftse. There's something that Terry 249 00:12:18,000 --> 00:12:20,400 Smith does interesting there. That I don't see a lot of 250 00:12:20,400 --> 00:12:22,600 investors doing. You looks at the Historical free 251 00:12:22,600 --> 00:12:25,600 cash flow, yield of his fund compared to the rest of the 252 00:12:25,608 --> 00:12:27,300 market. And this is something that we 253 00:12:27,300 --> 00:12:29,600 have in qualtrics. The free cash flow yield like 254 00:12:29,700 --> 00:12:34,200 You described is basically the trailing 12-month yield of the 255 00:12:34,200 --> 00:12:37,400 free cash flow of the company. So it gives you a multiple or a 256 00:12:37,400 --> 00:12:38,900 reference of how much free cash flow. 257 00:12:38,900 --> 00:12:41,600 Your company's generating based on its last 12 months. 258 00:12:41,600 --> 00:12:45,500 Now, fun Smith's Equity Fund has a free cash flow yield of 2.7% 259 00:12:45,700 --> 00:12:48,600 which compared to the ftse 100 on financials. 260 00:12:48,900 --> 00:12:52,500 It's roughly half as much. Another way of stating that is 261 00:12:52,500 --> 00:12:55,800 his companies are trading at roughly double the free cash 262 00:12:55,800 --> 00:12:58,100 flow multiple as the rest of the market. 263 00:12:58,100 --> 00:13:00,800 But the verbiage that Terry Smith This here, the actual 264 00:13:00,800 --> 00:13:03,300 words he uses are not cheap inexpensive. 265 00:13:03,300 --> 00:13:06,500 In this case uses highly rated and lowly rated. 266 00:13:06,600 --> 00:13:10,100 Notice how he calls his fund more highly rated, how does that 267 00:13:10,100 --> 00:13:13,300 compare with the index? While you can see their 5.4% for 268 00:13:13,300 --> 00:13:15,000 the ftse? The companies we own are about 269 00:13:15,000 --> 00:13:17,900 twice as highly rated at half the yield of the ftse. 270 00:13:18,000 --> 00:13:20,900 He says they're about twice as highly rated as a words he uses 271 00:13:21,100 --> 00:13:23,900 and this is almost interchangeable from cheap too 272 00:13:23,900 --> 00:13:26,700 expensive. Highly rated meaning expensive, 273 00:13:26,700 --> 00:13:29,600 lowly rated meaning cheap and he goes on to immediately. 274 00:13:29,700 --> 00:13:32,600 He explained why he doesn't think it's a problem. 275 00:13:32,600 --> 00:13:35,500 He doesn't really consider a concern that his company's have 276 00:13:35,500 --> 00:13:37,600 twice the rating of the rest of the market. 277 00:13:37,700 --> 00:13:40,400 I personally wouldn't worry about a lot because I think an 278 00:13:40,400 --> 00:13:44,000 awful lot of the stuff in the ftse is very poor quality stuff. 279 00:13:44,000 --> 00:13:46,400 That's not going to produce great long-term returns for you. 280 00:13:46,400 --> 00:13:49,200 Terry Smith takes a long-term View and he sees that even 281 00:13:49,200 --> 00:13:51,700 though these companies have a higher, current free, casual 282 00:13:51,700 --> 00:13:53,800 yield in terms of their long-term future. 283 00:13:53,800 --> 00:13:55,900 They're not going to generate as much cash because they're lower 284 00:13:55,900 --> 00:13:58,100 Quality Companies. Now, he goes on to compare his 285 00:13:58,100 --> 00:14:01,600 valuation of his fund. The S&P 500, which still a bit 286 00:14:01,600 --> 00:14:06,300 more expensive than the S&P you can see their 3.6% now. 287 00:14:06,800 --> 00:14:09,300 Yeah, we are more expensive. Probably about 25 percent more 288 00:14:09,300 --> 00:14:11,300 than the S&P. Now in this case, Terry Smith 289 00:14:11,300 --> 00:14:14,200 used the words expensive and cheap and this is the common 290 00:14:14,200 --> 00:14:16,600 terms, these are the common verbiage that value investors. 291 00:14:16,600 --> 00:14:20,600 Use low P/E, ratio companies are cheap and high P/E ratio 292 00:14:20,600 --> 00:14:23,200 companies are expensive. But notice how when Carrie Smith 293 00:14:23,200 --> 00:14:26,000 talks through this, he's very intentional about the words that 294 00:14:26,000 --> 00:14:29,600 he uses and he tries to substitute cheap for lowly. 295 00:14:29,700 --> 00:14:32,900 Rated and expensive for highly rated because that more 296 00:14:32,900 --> 00:14:36,000 accurately describes his investing Theory and how he 297 00:14:36,000 --> 00:14:40,000 views valuation, what you've got to ask yourself is yes, we all 298 00:14:40,000 --> 00:14:43,100 more highly rated but does that that's not expensive. 299 00:14:43,100 --> 00:14:46,000 If the quality of our companies is even more significantly 300 00:14:46,000 --> 00:14:49,300 higher than the index than the the rating on the shares would 301 00:14:49,300 --> 00:14:52,800 suggest and so he considers his company's more highly rated on 302 00:14:52,800 --> 00:14:54,900 the surface. They look more expensive, but 303 00:14:54,900 --> 00:14:56,900 when you look at their comparative qualities, he 304 00:14:56,900 --> 00:14:58,400 believes, they're actually cheaper. 305 00:14:58,600 --> 00:15:02,000 So even though they're Rated companies still an aggregate, he 306 00:15:02,000 --> 00:15:05,400 thinks he's buying the best value, the cheapest companies in 307 00:15:05,400 --> 00:15:09,700 the market, all these companies, 25% better than the index. 50%. 308 00:15:09,700 --> 00:15:12,100 Yeah, when you look at the range of those figures whereabouts to 309 00:15:12,100 --> 00:15:14,000 get you and there's a clue at the bottom of this table, you 310 00:15:14,000 --> 00:15:17,600 can see the free cash flows on our companies, grew 20% last 311 00:15:17,600 --> 00:15:22,100 year or as we call it in the analytical team, as a technical 312 00:15:22,100 --> 00:15:24,700 term quite a lot. Terry Smith's companies are more 313 00:15:24,700 --> 00:15:27,500 expensive on a free cash flow basis but the truth of the 314 00:15:27,500 --> 00:15:30,100 matter is they grow free cash flow much, Faster than the 315 00:15:30,108 --> 00:15:32,800 average of the index and they have less likelihood of being 316 00:15:32,800 --> 00:15:36,600 disrupted and they have longer life lines than most companies. 317 00:15:36,800 --> 00:15:39,500 So even though they're more highly rated on the surface, 318 00:15:39,500 --> 00:15:42,400 they look more expensive in aggregate, they're cheaper, 319 00:15:42,400 --> 00:15:44,100 that's basically telling you that. 320 00:15:44,100 --> 00:15:47,200 Yeah, we all, we have got slightly more highly rated 321 00:15:47,200 --> 00:15:49,900 companies but they're growing faster than the market and 322 00:15:49,900 --> 00:15:51,700 they've got better operating ratios. 323 00:15:52,200 --> 00:15:54,600 Because I think what we're trying to get away from him in 324 00:15:54,600 --> 00:15:58,100 representing this to you, is the idea that lowly rated equals 325 00:15:58,100 --> 00:16:00,500 cheap and highly rated. It was expensive. 326 00:16:00,500 --> 00:16:03,200 It depends what you're getting. It's like anything else in life 327 00:16:03,200 --> 00:16:05,000 that you buy. The thing, we're trying to get 328 00:16:05,000 --> 00:16:08,900 away from is the idea that lowly rated equals cheap and highly 329 00:16:08,900 --> 00:16:11,900 rated equals expensive. It's like everything else in 330 00:16:11,900 --> 00:16:13,500 life. It depends on what you're 331 00:16:13,500 --> 00:16:15,600 getting. One of the interesting things is 332 00:16:15,600 --> 00:16:18,800 when you look at different things to buy in any aspect of 333 00:16:18,800 --> 00:16:22,200 life, most people are very diligent and thoughtful and the 334 00:16:22,208 --> 00:16:25,000 way that they do analysis on their purchase, you can take a 335 00:16:25,000 --> 00:16:27,100 home. For example, when people are 336 00:16:27,100 --> 00:16:30,700 buying a home Peter Lynch always noted that They asked all the 337 00:16:30,700 --> 00:16:33,500 right questions, they do the right research when they're 338 00:16:33,500 --> 00:16:36,000 buying a home. They look at the location of it. 339 00:16:36,100 --> 00:16:39,900 They look at the price, which is the price per square foot or the 340 00:16:39,900 --> 00:16:42,200 total price of the house compared to the lot size. 341 00:16:42,400 --> 00:16:44,600 There's different metrics, you can look at for the price of a 342 00:16:44,608 --> 00:16:46,300 home. They go through and look at the 343 00:16:46,300 --> 00:16:50,000 style of the home, the fixtures, they look at the kitchen counter 344 00:16:50,000 --> 00:16:52,000 and if it's Marble they look at the flooring. 345 00:16:52,200 --> 00:16:55,100 They look at the foundation. They look at the amenities and 346 00:16:55,100 --> 00:16:58,000 then they'll also do an analysis on the quality of the nearby 347 00:16:58,000 --> 00:17:00,600 schools. The location of The proximity to 348 00:17:00,600 --> 00:17:03,400 different things in the city, they look at the taxes and the 349 00:17:03,400 --> 00:17:06,700 cost of living there, the size of the property, if it's part of 350 00:17:06,700 --> 00:17:09,500 a homeowner's association. When people look at buying a 351 00:17:09,508 --> 00:17:12,800 home in most cases, they do some thoughtful and diligent 352 00:17:12,800 --> 00:17:14,700 research. They know that it's an important 353 00:17:14,700 --> 00:17:17,700 purchase that they should put time and energy behind but when 354 00:17:17,700 --> 00:17:20,700 people look at buying a stock and many cases it's the exact 355 00:17:20,700 --> 00:17:24,200 opposite, they look at one metric like the PE Ratio and 356 00:17:24,200 --> 00:17:27,300 immediately come to conclusions of whether or not that companies 357 00:17:27,400 --> 00:17:29,500 cheaper expensive. This would be similar. 358 00:17:29,700 --> 00:17:32,700 To buying a home and only looking at the price per square 359 00:17:32,700 --> 00:17:35,700 feet. Whether it's $100 150 or 200 360 00:17:35,700 --> 00:17:38,900 dollars, not concern yourself about the location, the home 361 00:17:38,900 --> 00:17:41,700 exists in a high crime area or that it's across the street, 362 00:17:41,700 --> 00:17:45,200 from a railroad, or the style, or the size of the house. 363 00:17:45,300 --> 00:17:48,600 That's not really important. As long as the price is cheap, 364 00:17:48,600 --> 00:17:50,900 none of this other stuff matters, it doesn't matter, the 365 00:17:50,900 --> 00:17:53,400 quality of the schools, the taxes or cost of living. 366 00:17:53,600 --> 00:17:56,600 If there's a homeowner's association or any of this other 367 00:17:56,600 --> 00:17:59,200 qualitative stuff. The big thing that investors 368 00:17:59,200 --> 00:18:02,700 Focus And when it comes to stocks is the price and what 369 00:18:02,700 --> 00:18:06,500 Terry Smith is wanting people to do is to take a more holistic 370 00:18:06,500 --> 00:18:10,000 approach to evaluation instead of just looking at the price, 371 00:18:10,200 --> 00:18:13,600 consider the other attributes, the same way you would, if 372 00:18:13,600 --> 00:18:16,300 you're shopping for a home. Now, I use the example of a home 373 00:18:16,300 --> 00:18:18,800 but Carrie Smith uses, the example of a car. 374 00:18:18,900 --> 00:18:21,500 It depends what you're getting is like anything else in life 375 00:18:21,500 --> 00:18:24,900 that you buy Foods, don't cost the same as Ferraris, right? 376 00:18:25,400 --> 00:18:27,200 And, therefore, the fact that one is priced lower than the 377 00:18:27,200 --> 00:18:29,500 other doesn't in itself. Tell you anything about the bar? 378 00:18:29,600 --> 00:18:31,600 Sure, that you're getting now, if for a supposed to have 379 00:18:31,600 --> 00:18:34,700 in-depth research that considers more than just the price, then 380 00:18:34,700 --> 00:18:37,500 what other type of things are we supposed to look at for a home, 381 00:18:37,500 --> 00:18:39,800 we know intuitively what to look at. 382 00:18:40,000 --> 00:18:42,100 We know to look at the schools, we know to look at the home 383 00:18:42,100 --> 00:18:45,400 style and location. We know to look at the taxes or 384 00:18:45,400 --> 00:18:47,300 the crime rates of the place we're living in. 385 00:18:47,400 --> 00:18:50,000 We know all of this stuff intuitively to keep in mind, but 386 00:18:50,000 --> 00:18:52,600 with stocks we don't know. Intuitively what to look at is a 387 00:18:52,608 --> 00:18:54,600 little bit more confusing in some cases. 388 00:18:54,600 --> 00:18:58,200 Terry Smith's approach resembles that of finding Compounders and 389 00:18:58,200 --> 00:19:01,200 I talked about Compounders As a term, I used to describe 390 00:19:01,200 --> 00:19:04,400 companies that have lots of characteristics that most 391 00:19:04,400 --> 00:19:06,900 companies in the market do not have. 392 00:19:07,100 --> 00:19:09,400 It's not just stocks where the price goes up. 393 00:19:09,500 --> 00:19:11,300 That's not what defines a compounder. 394 00:19:11,600 --> 00:19:15,100 The best definition I've ever found of a compounder is in this 395 00:19:15,100 --> 00:19:19,300 Morgan Stanley study from 2013. They say we defined Compounders 396 00:19:19,300 --> 00:19:23,400 as companies with high quality franchise businesses, ideally 397 00:19:23,400 --> 00:19:26,700 with recurring revenues built-in dominant and durable intangible 398 00:19:26,700 --> 00:19:29,700 assets which possess pricing power low capital Well 399 00:19:29,700 --> 00:19:31,800 intensity. When evaluating these companies 400 00:19:31,800 --> 00:19:35,100 we focus on franchise quality and durability of financial 401 00:19:35,100 --> 00:19:38,200 strength industry position and management quality. 402 00:19:38,300 --> 00:19:41,800 The key financial characteristic of Compounders is that they 403 00:19:41,800 --> 00:19:46,800 enjoy sustainable High Returns on invested Capital roic. 404 00:19:46,800 --> 00:19:49,800 They say that it's generated by a combination of recurring 405 00:19:49,800 --> 00:19:52,300 revenues recurring, meaning that they're getting money, 406 00:19:52,300 --> 00:19:55,600 continually, high gross margins and low Capital, intensity. 407 00:19:55,700 --> 00:19:58,300 This combination helps support strong, free cash flow 408 00:19:58,300 --> 00:20:00,900 generation. Surely that must either be 409 00:20:00,900 --> 00:20:03,300 reinvested or distributed to shareholders. 410 00:20:03,400 --> 00:20:06,500 Compounders also tend to be relatively robust and economic 411 00:20:06,500 --> 00:20:09,000 downturns. With steady operational, cash 412 00:20:09,000 --> 00:20:12,100 flow and no excess. Leverage, profits are typically 413 00:20:12,100 --> 00:20:15,400 less sensitive to economic conditions given the repeat 414 00:20:15,400 --> 00:20:17,400 purchases at high-growth margins. 415 00:20:17,400 --> 00:20:20,300 This combined, with the low cyclicality of top-line demand, 416 00:20:20,400 --> 00:20:23,000 because these companies typically sell non-discretionary 417 00:20:23,000 --> 00:20:25,500 items. Help insulate, Compounders from 418 00:20:25,500 --> 00:20:28,400 the - cyclical impacts of operating cash flow. 419 00:20:28,700 --> 00:20:31,000 These characteristics This coupled with modest top-line 420 00:20:31,000 --> 00:20:34,500 growth have helped ensure that intrinsic value of Compounders 421 00:20:34,800 --> 00:20:37,000 continues to grow over time. Now, this definition of 422 00:20:37,000 --> 00:20:39,300 Compounders, I think, is obviously thorough, but it's 423 00:20:39,300 --> 00:20:41,600 also difficult to wrap our heads around. 424 00:20:41,700 --> 00:20:43,400 They have a lot of characteristics. 425 00:20:43,400 --> 00:20:46,800 And how do you boil this down to a realistically investable 426 00:20:46,800 --> 00:20:48,900 thesis? Well, Terry Smith has actually 427 00:20:48,900 --> 00:20:51,700 done this. He's taken the definition of a 428 00:20:51,700 --> 00:20:54,800 compounder. The one that we just read and he 429 00:20:54,800 --> 00:20:57,400 boils it down to five different ratios, five. 430 00:20:57,400 --> 00:20:59,500 Different things that he tracks for his portfolio. 431 00:21:00,000 --> 00:21:01,900 The try to determine whether or not the companies. 432 00:21:01,900 --> 00:21:05,000 He owns our long-term Compounders and this is an 433 00:21:05,000 --> 00:21:07,900 objective scientific way of looking at solving this problem. 434 00:21:08,100 --> 00:21:11,200 The first thing that he highlights is our oce. 435 00:21:11,400 --> 00:21:15,100 The return on Capital employed is very similar to Returns on 436 00:21:15,100 --> 00:21:17,100 invested Capital. If you look at it the return on 437 00:21:17,100 --> 00:21:20,600 Capital at companies last year, Roc and the table return on 438 00:21:20,600 --> 00:21:24,300 Capital employed was 28%, a recovery from the prior year. 439 00:21:24,300 --> 00:21:26,500 When there was a bit of a downturn caused by the pandemic, 440 00:21:26,700 --> 00:21:30,400 This is highly satisfactory insofar as It's back to where it 441 00:21:30,400 --> 00:21:32,800 has been in the long term and you'll see that it's 442 00:21:32,800 --> 00:21:34,900 significantly ahead of where the index are. 443 00:21:34,900 --> 00:21:37,600 Whether it's the SP or the ftse smile has companies are more 444 00:21:37,600 --> 00:21:39,700 highly rated. They have much better Returns on 445 00:21:39,700 --> 00:21:42,500 Capital employed, then the rest of the index and this makes it. 446 00:21:42,500 --> 00:21:44,800 So, they create more long-term wealth than the rest of the 447 00:21:44,800 --> 00:21:47,500 index to put it in English for every pound on dollar of 448 00:21:47,500 --> 00:21:49,400 capital, we own in these companies. 449 00:21:49,400 --> 00:21:54,000 In our portfolio, we're getting 28 pencil sense of profit 450 00:21:54,000 --> 00:21:55,800 return. Whereas, if you're in the index, 451 00:21:55,800 --> 00:21:57,800 you're getting about 15 pounds. Our companies have been 452 00:21:57,800 --> 00:22:00,700 delivering, Twice as much return. 453 00:22:00,700 --> 00:22:04,000 And I think that's the single most important metric to look 454 00:22:04,000 --> 00:22:05,200 at. When you look at our company's 455 00:22:05,200 --> 00:22:07,300 performing when I've gone through and done analysis, on 456 00:22:07,300 --> 00:22:09,800 the companies that I'm investing in one of the metrics that I 457 00:22:09,808 --> 00:22:13,000 started to look at is this return on Capital employed and 458 00:22:13,000 --> 00:22:16,300 the companies that I've targeted have a particularly High return 459 00:22:16,300 --> 00:22:18,400 on Capital employed. And I've come to believe that 460 00:22:18,400 --> 00:22:21,500 this is such an important metric that I'm leaving out of my 461 00:22:21,500 --> 00:22:24,400 analysis that I'm actually going to be adding this metric into 462 00:22:24,400 --> 00:22:26,300 qual trim. I'm going to make it really easy 463 00:22:26,300 --> 00:22:29,400 to look at the long-term historical return on Capital. 464 00:22:29,600 --> 00:22:32,500 Employed for every single company my portfolio because 465 00:22:32,500 --> 00:22:35,000 without this you don't know how effectively your company's 466 00:22:35,000 --> 00:22:38,400 reinvesting, its profits. So in comparison to doing home 467 00:22:38,400 --> 00:22:41,500 shopping the return on Capital employed is like, looking at the 468 00:22:41,500 --> 00:22:43,300 location. If you buy a stock without 469 00:22:43,300 --> 00:22:45,500 looking at how effectively the company can reinvest its 470 00:22:45,500 --> 00:22:48,100 capital, it's kind of, like, buying a home without looking at 471 00:22:48,100 --> 00:22:50,100 what location it is. You don't even know whether or 472 00:22:50,108 --> 00:22:53,000 not you're buying a home in a high crime area or a low-crime 473 00:22:53,000 --> 00:22:55,500 area after that. The next metric that he looks at 474 00:22:55,500 --> 00:22:57,700 is gross margin. This is one that I think most 475 00:22:57,700 --> 00:22:59,400 people are familiar with gross margin. 476 00:22:59,700 --> 00:23:02,600 These are the difference between revenues and costs of goods. 477 00:23:02,600 --> 00:23:06,500 Sold companies take in stuff, they take in ingredients or 478 00:23:06,500 --> 00:23:09,700 components or services and do something with them and turn 479 00:23:09,700 --> 00:23:11,800 them into products and services that they sell. 480 00:23:11,900 --> 00:23:14,400 This is the mark up the difference between the two, our 481 00:23:14,400 --> 00:23:17,400 companies are at 64%, which you'll see is pretty rock-solid 482 00:23:17,400 --> 00:23:19,500 down the years. Basically, in English, they're 483 00:23:19,500 --> 00:23:23,300 making stuff for 36 and selling it for 100. 484 00:23:23,300 --> 00:23:26,400 If you look over at the index you'll see around 45% companies 485 00:23:26,400 --> 00:23:29,400 in the index are making things for 55 and the seller. 486 00:23:29,500 --> 00:23:30,800 Get 400. The gross margins. 487 00:23:30,800 --> 00:23:33,100 Like you described are simply how much the company can make 488 00:23:33,100 --> 00:23:35,200 something for and then how much they can sell it for. 489 00:23:35,300 --> 00:23:37,700 That's their gross margin. And the companies that Terry 490 00:23:37,700 --> 00:23:41,600 owns have a much higher average, gross margin than the rest of 491 00:23:41,600 --> 00:23:43,200 the index. If you're looking at a stock and 492 00:23:43,200 --> 00:23:46,000 you don't consider the gross margins or operating margins of 493 00:23:46,000 --> 00:23:49,000 the business, it's like buying a home, but not even doing your 494 00:23:49,000 --> 00:23:52,100 due diligence, not even walking through the place and maybe the 495 00:23:52,100 --> 00:23:56,100 home has fractures, and it has breaks in the foundation that 496 00:23:56,100 --> 00:23:58,000 cheap home. Might end up being a lot more 497 00:23:58,000 --> 00:23:59,400 expensive than it originally looked. 498 00:23:59,600 --> 00:24:02,400 And Terry Smith. Also mentions that gross margins 499 00:24:02,400 --> 00:24:05,000 are possibly the best hedge against inflation. 500 00:24:05,300 --> 00:24:08,000 That is really what controls the pricing power of the company. 501 00:24:08,100 --> 00:24:10,900 Now after looking at the Returns on Capital employed and the 502 00:24:10,908 --> 00:24:13,900 margins of the business, the next big metric that Terry Smith 503 00:24:13,900 --> 00:24:16,400 looks over. His portfolio is called Cash 504 00:24:16,400 --> 00:24:18,900 conversion. It's amount of net profits. 505 00:24:18,900 --> 00:24:22,100 The company generates compared to the amount of free cash flow. 506 00:24:22,100 --> 00:24:24,100 We can take the example of Domino's Pizza. 507 00:24:24,100 --> 00:24:26,100 This is a company that I have in my portfolio. 508 00:24:26,300 --> 00:24:29,100 If we look at the 2021 net income of the company. 509 00:24:29,500 --> 00:24:33,500 Was 491 million dollars. So 491 net income. 510 00:24:33,500 --> 00:24:37,500 And 2021 if we compare this to the cash flow, they made 504 511 00:24:37,500 --> 00:24:39,000 million dollars in free cash flow. 512 00:24:39,300 --> 00:24:42,700 So Domino's actually made more money and free cash flow than a 513 00:24:42,708 --> 00:24:45,400 net income. That means they had above 100 514 00:24:45,400 --> 00:24:48,500 percent cash flow conversion. We can take a counter example 515 00:24:48,500 --> 00:24:52,200 here, Netflix, this is a company that has very low cash flow 516 00:24:52,200 --> 00:24:54,400 conversion. In fact it's extremely low. 517 00:24:54,600 --> 00:24:58,500 If we compare their net income in 2021 a 5.1 billion dollars 518 00:24:58,800 --> 00:25:02,900 with their freak, Ashlyn 2021, their free cash flow in 2021 was 519 00:25:02,900 --> 00:25:07,800 - 131 million dollars. So, net income of five billion 520 00:25:07,900 --> 00:25:11,100 free, cash flow of - 131 million right now. 521 00:25:11,100 --> 00:25:14,600 Netflix has a negative cash flow conversion and that's telling 522 00:25:14,600 --> 00:25:17,800 about the company Terry Smith likes to focus on companies that 523 00:25:17,800 --> 00:25:20,100 very high conversion rates of cash flow. 524 00:25:20,200 --> 00:25:23,200 But also companies have consistent conversion rates of 525 00:25:23,200 --> 00:25:25,000 cash flow in this period of time. 526 00:25:25,000 --> 00:25:27,600 In a rare instance. The actual indices are 527 00:25:27,600 --> 00:25:29,400 outperforming, Terry Smith's cash. 528 00:25:29,500 --> 00:25:32,200 A slow conversion but explains why this is the case and it's 529 00:25:32,200 --> 00:25:34,400 not likely to last cash conversion. 530 00:25:34,400 --> 00:25:37,100 Our company's converge at 95 percent of their profits into 531 00:25:37,100 --> 00:25:39,600 cash last year. The index had a particularly 532 00:25:39,600 --> 00:25:42,200 good performance. You'll see out there producing 533 00:25:42,400 --> 00:25:47,600 somewhere in the region of 100 and 108 to 124 percent of 534 00:25:47,600 --> 00:25:49,900 profits in cash. This is a, is a bit of an 535 00:25:49,900 --> 00:25:52,300 unusual feature. And the index is performing, 536 00:25:52,300 --> 00:25:55,200 particularly well at the moment for a couple of rather strange 537 00:25:55,200 --> 00:25:57,800 reasons bear in mind, this is a ratio and if you make your 538 00:25:57,800 --> 00:25:59,400 profits, go down, more than your cash. 539 00:25:59,600 --> 00:26:01,300 Throw your cash conversion, looks good. 540 00:26:01,300 --> 00:26:05,000 It's not a very good place to be but nonetheless that's how the 541 00:26:05,000 --> 00:26:06,700 ratio comes out. And the reason that's happening 542 00:26:06,700 --> 00:26:09,700 is companies in the index by and large had bigger Falls in 543 00:26:09,700 --> 00:26:11,500 profitability than our company's did. 544 00:26:11,700 --> 00:26:14,300 And at the same time because of supply chain difficulties, they 545 00:26:14,300 --> 00:26:16,700 had an awful lot of stock out so they're working capital went 546 00:26:16,700 --> 00:26:19,200 down invested in the business. So they didn't make as much 547 00:26:19,200 --> 00:26:21,900 profit but they converted more of the profit Into Cash. 548 00:26:21,900 --> 00:26:24,300 That's his explanation of why the index has a higher cash 549 00:26:24,300 --> 00:26:27,200 conversion than his portfolio. Now the final metric that Terry 550 00:26:27,200 --> 00:26:29,300 Smith looks at here is called interest cover. 551 00:26:29,600 --> 00:26:32,500 And this is a way of looking at the actual leverage of a company 552 00:26:32,600 --> 00:26:34,900 when you look at their profitability, compared with 553 00:26:34,900 --> 00:26:38,000 their obligations and interest payments and lost the interest 554 00:26:38,000 --> 00:26:39,700 cover. So is all this wonderful 555 00:26:39,700 --> 00:26:42,200 operating performance that we're getting from our companies being 556 00:26:42,200 --> 00:26:45,500 delivered with a lot of borrowed money and balance sheet 557 00:26:45,600 --> 00:26:49,100 trickery. No our company's last year 23 558 00:26:49,100 --> 00:26:51,700 times interest cover. So their profits comparable what 559 00:26:51,700 --> 00:26:55,100 they're paying out in interest and Lease rentals was 23 times. 560 00:26:55,100 --> 00:26:58,100 I mean there's he's a very strong balance sheet business is 561 00:26:58,100 --> 00:27:01,100 basically you can see they Leavitt last year 16 times a 562 00:27:01,100 --> 00:27:03,500 year before the index not in bad position. 563 00:27:03,500 --> 00:27:05,700 If you look at eight to nine times, interest cover is pretty 564 00:27:05,700 --> 00:27:08,700 good but clearly these are very conservatively finance 565 00:27:08,700 --> 00:27:10,500 companies. They are not producing this 566 00:27:10,500 --> 00:27:12,600 performance out of financial engineering, that's simple 567 00:27:12,600 --> 00:27:14,100 enough. His companies in terms of the 568 00:27:14,100 --> 00:27:17,300 prophets they generate compared to their interest payments is a 569 00:27:17,300 --> 00:27:20,000 much higher multiple, which is a good thing compared to the rest 570 00:27:20,000 --> 00:27:21,700 of the index. So you can see in terms are 571 00:27:21,708 --> 00:27:25,000 doing valuation and Analysis, that Terry Smith looks at more 572 00:27:25,000 --> 00:27:26,600 than just the price of the company. 573 00:27:26,800 --> 00:27:29,300 If he's buying a home, he's looking at the Returns on 574 00:27:29,300 --> 00:27:30,500 Capital. Capital employed. 575 00:27:30,500 --> 00:27:33,100 He's looking at the location of the property, whether it's in a 576 00:27:33,108 --> 00:27:35,400 good location, he looks at the cash conversion. 577 00:27:35,400 --> 00:27:37,800 He's looking at the neighborhood and seeing if it's low crime 578 00:27:37,800 --> 00:27:40,000 area, it looks at the interest coverage. 579 00:27:40,000 --> 00:27:42,500 He makes sure the home has nice stainless steel appliances 580 00:27:42,500 --> 00:27:45,900 marble countertops and nice. Flooring Carrie Smith does 581 00:27:46,000 --> 00:27:49,300 holistic, research on a company. That's why he comes to the 582 00:27:49,300 --> 00:27:52,200 conclusion that many of the companies that appear to be more 583 00:27:52,200 --> 00:27:55,800 expensive in his portfolio are actually in aggregate, All 584 00:27:55,800 --> 00:27:58,400 Things Considered cheaper. Now, I hope you're enjoying the 585 00:27:58,400 --> 00:28:00,500 video so far. Before I move on to the next 586 00:28:00,500 --> 00:28:03,400 section, I have to give a quick shout-out to today's sponsor. 587 00:28:03,600 --> 00:28:07,100 Its FTX u.s. they have a brand-new brokerage account, you 588 00:28:07,100 --> 00:28:09,500 can sign up. Now, it's finally out of beta, 589 00:28:09,600 --> 00:28:12,900 it has a very slick interface. You can buy and sell any time 590 00:28:12,900 --> 00:28:15,000 stock markets, open using fractional shares. 591 00:28:15,300 --> 00:28:18,200 They don't do payment for order flow and they're part of finra 592 00:28:18,200 --> 00:28:20,700 and Si P c-- insured. So, if you want to sign up for 593 00:28:20,700 --> 00:28:25,300 this brokerage, make sure to use the refer code Carlson CA RL s 594 00:28:25,300 --> 00:28:29,300 0n, that'll give you $10. When you do your first $100 595 00:28:29,400 --> 00:28:32,300 Trade now, I know anytime I point out that there's other 596 00:28:32,300 --> 00:28:35,000 important fundamentals to take into consideration in terms of 597 00:28:35,000 --> 00:28:37,100 valuation than just the PE Ratio. 598 00:28:37,300 --> 00:28:41,200 It also brings up the problem that many cases, people swing, 599 00:28:41,200 --> 00:28:45,300 this pendulum way too far to the other side and use these type of 600 00:28:45,300 --> 00:28:49,200 videos in this type of content, to justify buying seemingly any 601 00:28:49,200 --> 00:28:52,500 company at any price. And in most cases, lots of 602 00:28:52,500 --> 00:28:56,700 companies that are higher prices are not worth the extra price. 603 00:28:57,100 --> 00:29:01,500 It takes a lot of convincing to If I paying a 28 forward P/E 604 00:29:01,500 --> 00:29:05,200 ratio, it takes even more to justify paying a 30-plus or a 605 00:29:05,208 --> 00:29:09,200 40-plus to justify paying a 30 plus PE ratio. 606 00:29:09,400 --> 00:29:11,700 A company would have to be completely phenomenal. 607 00:29:11,800 --> 00:29:15,400 With all of these other metrics have extremely high Returns on 608 00:29:15,400 --> 00:29:18,200 Capital. Employed have 70% plus gross 609 00:29:18,200 --> 00:29:21,500 margins have high operating profit margin, good cash 610 00:29:21,500 --> 00:29:25,100 conversion, incredible, interest coverage and beyond that have 611 00:29:25,100 --> 00:29:28,800 good brand, value franchise quality and long term durability 612 00:29:28,800 --> 00:29:33,100 with the Any it has to have these metrics to justify having 613 00:29:33,100 --> 00:29:36,200 a high P/E ratio. So I'm not suggesting to ignore 614 00:29:36,200 --> 00:29:40,300 the PE Ratio to not consider it or did just buy any company, at 615 00:29:40,300 --> 00:29:42,800 any valuation. That's not the purpose of this 616 00:29:42,800 --> 00:29:45,800 video, but it's when you do analysis, you're buying an 617 00:29:45,800 --> 00:29:48,500 actual company, there's lots of operating metrics to. 618 00:29:48,500 --> 00:29:51,900 Look at that lead different companies to have more long-term 619 00:29:51,900 --> 00:29:53,700 value creation than other companies. 620 00:29:53,700 --> 00:29:56,800 And lots of those metrics are very simple and easy to look at 621 00:29:57,000 --> 00:30:00,600 but they're routinely ignored in favor of Valuation metrics. 622 00:30:00,600 --> 00:30:03,500 And remember that, there's lots of ways to invest in the market, 623 00:30:03,500 --> 00:30:05,200 there's lots of ways of earning money. 624 00:30:05,400 --> 00:30:08,600 Many people are good at investing in low P/E companies, 625 00:30:08,800 --> 00:30:12,600 buying all the financials and cyclicals, and oil companies and 626 00:30:12,600 --> 00:30:14,100 timing the ups and downs of these. 627 00:30:14,100 --> 00:30:17,000 Highly volatile companies, at just the right times, they can 628 00:30:17,000 --> 00:30:19,000 make money doing that, but that's not the approach. 629 00:30:19,000 --> 00:30:21,400 I'm taking. I will always consider the price 630 00:30:21,400 --> 00:30:24,500 to earnings ratio, the free cash flow yield and other valuation 631 00:30:24,500 --> 00:30:26,800 metrics and every single company that I own. 632 00:30:26,800 --> 00:30:28,500 But I'm also going to be considering the franchise 633 00:30:28,500 --> 00:30:30,800 durability. The Returns on Capital employed, 634 00:30:30,800 --> 00:30:33,700 the margins of the company, the cash flow conversion, and The 635 00:30:33,700 --> 00:30:36,300 Leverage of the company. I'll have more than just one 636 00:30:36,300 --> 00:30:38,200 consideration when making a purchase. 637 00:30:38,200 --> 00:30:39,600 So I hope you enjoyed this video. 638 00:30:39,600 --> 00:30:41,700 It's a little bit different than usual but I thought this is an 639 00:30:41,700 --> 00:30:44,800 important subject to talk about. Having said that I'll have more 640 00:30:44,800 --> 00:30:47,600 content out in the future will be going over the news. 641 00:30:47,600 --> 00:30:49,600 Well, you going over earnings report and other important 642 00:30:49,600 --> 00:30:51,200 subjects. So make sure you subscribe to 643 00:30:51,200 --> 00:30:53,300 the channel and I'll see you in the next one.