Performance measurement for pros

Investors tend to judge their portfolios by how much they go up or down in value, typically compared to a benchmark index like the FTSE All-Share, over perhaps a year. Taking a leaf out of Fundsmith Equity’s playbook, Richard thinks he has found a better way.

In my last article, I questioned Fundsmith Equity, a high profile fund racking up an impressive track record, for presenting a distorted view of history by using the wrong kind of charts. But I have a more fundamental criticism of watching prices and indexes, especially over shorter time periods. I do not think it tells us much. On this, I agree with Fundsmith.

Prices versus fundamentals

In Fundsmith’s ‘Owner’s Manual’, the fund’s semi-eponymous manager Terry Smith warns fundholders off the annual performance measurement merry go round:

In our view, even a year is a short period to measure things by. Moreover, a year does not have its foundations in the business or investment cycle. It is, in fact, the time it takes the earth to go around the sun and is therefore of more use in studying astronomy than investment.

Even though it has done well, the fund’s annual letter tends to skate over how much its price has gone up during the year. It dwells longer on a set of statistics that show whether it is doing what it set out to do, which is own shares in high-quality businesses, businesses it believes will deliver big share price gains over long periods of time.

It does this by averaging certain financial statistics for the companies it owns, basically if it were one big company – how profitable it would be and how indebted it would be.

All funds should do this so their clients can abide by rule number one in investing, which is to know what we own. Sadly, few, if any, others do.

This is the table from Fundsmith’s latest letter, sent to fundholders in January. It shows the ratios for every year the fund has existed and how it compares with the averages for two major indices at the end of 2018.

If Fundsmith were a company, it would be a good one, at least judging by the stats.

Return on Capital Employed

ROCE is profit as a percentage of investment in factories, equipment, stock and so on. For investors that hold shares for the long-term like Fundsmith, this internal rate of return will also be the most important driver of their portfolio returns. Rising ROCE since 2011 suggests Fundsmith invests in businesses capable of sustaining high levels of profitability.

Gross profit margin and operating profit margin

Profit margins measure the proportion of revenue earned as profit. If a company earns high profit margins, it is probably doing something special because it can sell its product or service for a lot more than it costs to supply. Rising profit margins auger well for future profitability too.

Cash conversion

Cash conversion is a check on the quality of the profit figures used in the return and margin calculations. Accounting has developed to give a more accurate presentation of company performance but it is reassuring to know that a substantial proportion of profit is earned in cold hard cash. Consistently high cash conversion implies Fundsmith’s profits are real.

Leverage and interest cover

Otherwise known as gearing, leverage shows how much a company’s capital is funded by debt. As both terms imply, debt is a double-edged sword. When things are going well and a company is very profitable, leverage boosts returns to shareholders, but the more highly leveraged a company the more interest will eat into profit when things go badly.

Fundsmith’s leverage is rising. The fund says the statistic is skewed by companies that have deliberately reduced their capital by buying back shares and it would prefer us to focus on interest cover, the ratio of interest to profit, which is stable and high.

So, Fundsmith is much more profitable and no less indebted than average, and the fund also tells us we can buy the returns on this high-quality portfolio at a valuation that is at least not indecent. The weighted average free cash flow yield is 4%, compared to slightly more generous 4.7% for the humdrum S&P 500 index.

How do we measure up?

SharePad can tell us the average statistics for a list of shares. Here, I have created a new list setting, added the columns for each of the ratios in Fundsmith’s table (plus free cash flow yield), and applied my base filter to all of the shares listed in London. The base filter simply excludes shares in sectors I am not currently interested in. It is my market, and it contains 623 shares.

(Richard’s base filter criteria can be found in the library of filters within SharePad. Simply go to: Filter -> Apply filter -> Library -> “Richard Beddard 30/08/18: Building a base filter”)

Do not be put off by the long complicated column headings. I have chosen to use the latest “TTM” (trailing twelve month) data, and to adjust for leases, to compensate for inconsistencies in when companies report and how they finance their operations.

To find the average for any of the seven statistics in the table, we just need to click on the column heading, click on “Options”, and then click on “Column statistics”:

Abracadabra, we get the averages, in this case for operating margin:

I want to compare my portfolio to my market, to see if the shares I have picked are superior. But there is a problem. Which average to use? Fundsmith’s table uses weighted averages for some statistics and median values for others.

The average or mean is the sum of all the values in a list divided by the number of values. The advantage of using the mean is the values can be weighted so the biggest companies in a list (this is how SharePad weights the average), or the biggest holdings in a portfolio, contribute most. But the mean can be skewed by very large values, and give us the wrong impression.

The median is the middle value of an ordered list. It is not weighted, but it reduces the impact of abnormal values and it’s very easy to produce a table of medians from SharePad. We just need to note them down from the statistics table for each ratio.

This is how Share Sleuth, a model portfolio I run for Money Observer stacks up:

Share Sleuth portfolio averages (24 shares) Portfolio median Market median*
ROCE (%) 18 11
Gross margin (%) 47 44
Operating margin (%) 14 9
Free cash conversion (%) 73 69
Net debt/capital (%) 5 23
Fixed charge cover (x) 8 4
Free cash flow yield (%) 5 4

*Market is all LSE shares excluding various sectors defined in my Base Filter

Yay! Typically, my portfolio beats the market on every statistic. It is more profitable in every way, it is less leveraged, and it can more easily afford interest and lease payments. It also promises a higher return so it is better value.

We cannot compare these statistics directly to the ones in Fundsmith’s table because the data is from different sources and the ratios have been calculated in different ways. Generally, I think, my versions of the Fundsmith ratios are more strict. Fixed charge cover includes the cost of lease payments as well as interest payments, for example.

To weight the average by the size of portfolio holdings requires a bit of work in a spreadsheet. When I did it, I got a bit of a shock:

Share Sleuth portfolio averages (24 shares) Portfolio weighted average Market weighted average*
ROCE (%) 22 24
Gross margin (%) 43 40
Operating margin (%) 15 16
Free cash conversion (%) 82 9
Net debt/capital (%) 7 44
Fixed charge cover (x) 23 17
Free Cash Flow yield (%) 6 5

*Market is all LSE shares excluding various sectors defined in my Base Filter

As you can see the portfolio is decidedly average in terms of profitability when you view it as a company. But it wins handsomely on all the other factors.

On reflection, I am chilled about the average profitability of the Share Sleuth portfolio because I am confident it is real and will be sustained, and I doubt the same is true of the market weighted average.

When I look at the figures for my portfolio, I feel calm because I would definitely be interested in a company with these financial characteristics. Regardless of the gyrations of the stockmarket, I reckon I am doing OK.

If you are comfortable with spreadsheets and want to put your data in mine, it is here. You will need to export the value of your holdings from SharePad and create and export a list table of ratios for your portfolio too.

Company analysis

Having been waylaid by Fundsmith’s letter, I have been neglecting my company analysis duties lately. Normal service will resume in a fortnight, but in addition to Maynard’s articles, private investors are publishing insights using SharePad. This investigation of fast growing Fevertree’s financials by Damian Cannon is thought-provoking.

Richard Beddard

Contact Richard Beddard by email: or on Twitter: @RichardBeddard