Terry Smith: Underperformance In A Strategy Is A Feature Not A Failure

Terry Smith has long argued that the basic mathematics of return compounding is still the only serious anchor for long-term investors.

In his conversation on Behind the Balance Sheet, he explained that the starting free cash flow yield and the medium-term growth rate do most of the work.

“If our companies are capable of growing let’s call it 8% per anum. And there’s a 6% starting yield. Well, 14% might be the number… And if it’s now three and they’re capable of growing at 8% still, well, it’s probably 11, isn’t it?”

For investors who entered Fundsmith a decade ago, those arithmetic drivers created double-digit returns with surprisingly little drama.

More recently, however, the backdrop has been more difficult for quality-compounders. Smith noted that as rates adjusted upwards, growth equities behaved like long-dated bonds in their sensitivity.

This was compounded by the rise of large index flows and the runaway gains in the megacap cohort. “We had this whole magnificent 7 AI boom hype… we also had the flow of funds going into passives which were were giving it a momentum basically.”

As Smith pointed out, indexing is not genuinely passive in its pricing effect. “It’s a momentum strategy” and the consequence has been lopsided market leadership that has left many disciplined stock pickers trailing for a prolonged period.

Smith is not shy about acknowledging the psychological side of such phases. “Underperformance in a strategy is a feature not a failure. It is absolutely inevitable it will occur.”

Still, he made clear that changing strategy mid-cycle can be fatal: “If you decide to change strategy in the middle… you may be knocked off course forever.”

One of the more interesting current topics is whether valuations have simply pulled forward future returns.

Smith thinks that is likely: “If you’ve had that change in valuation you’ve absorbed some of the future return almost certainly.” That does not mean there are no bargains; only that the market offers them less often. When it does, investors must act without hesitation. As he put it, “If you buy at a 12% free cash flow yield… then you’re off to the races.”

Finally, Smith stressed the need for conviction even if criticism follows. “Don’t be the the timid soul who knows neither victory nor defeat… If you’re convinced that you should do something… do it and live with the consequences.” The arithmetic of return remains simple; the human element rarely is.

You can watch the entire interview here: