Terry Smith’s top six investing ratios

By: Tim Bennett
Award-winning retail fund manager Terry Smith likes to keep investing simple. Tim Bennett sums up six of his preferred analytical tools.

Terry Smith’s top six investing ratios

One of the most successful retail investors of recent times, Terry Smith is a believer in keeping investing simple. Here is a short summary of six of his favourite “magic numbers” when it comes to understanding companies and unearthing winners.

Terry Smith

Through his Fundsmith vehicle, Terry Smith has built a reputation as a no-nonsense investor. Earlier in his career he uncovered plenty of accounting nonsense in his controversial best-seller Accounting for Growth and has since espoused the virtues of keeping investing simple.

His basic aims

For someone who has consistently topped the performance charts over the past five years, his approach can seem, at first glance, very straightforward. However, whilst it is indeed easy to summarise, it is much harder to execute. Here are his three basic tenets;

What makes for a good business?

Arguably the key challenge within this approach is finding good companies in the first place, something all investors are seeking to do one way or another. Smith likes to distil his more detailed analysis down to three questions, each of which generates some key numbers for further investigation;

Gross profit margin

In some ways this is the king of ratios for Terry Smith as it reveals whether the heart of a business is profitable and also its ability to weather shocks in the future. For Smith, the higher the number, the better in this regard but he is also looking for stability over time to avoid any “one trick wonder” stocks.

Operating profit margin

Once you have a firm picture on the strength and consistency of the gross margin, this next number factors in operating overheads to get a snapshot on core profitability and cost control.

Return on capital employed

Now to a number that connects the profit and loss account to the balance sheet – or, that equates profitability to the level of assets needed to generate it. ROCE (as it is known) is a great measure of management’s ability to convert assets into returns. Again, the overall trend is important here, combined with the picture given by this ratio alongside other key ones.

Cash generation and conversion

Whilst profitability is key to Terry Smith’s approach, firms also need to be able to turn it into cash regularly and effectively. He therefore likes to monitor the relationship between operating profit and operating cash flow – the closer the two numbers, the better. And both need to be positive in Terry Smith’s world.

Financial stability – leverage

Now for financial risk, measured as leverage or “gearing”. Again, Smith is looking here for the ability of a firm to ride out a rough patch. Too much debt, relative to equity, funding can signal trouble and a lack of flexibility when it comes to raising further funds.

Financial stability – interest cover

A bit like a homebuyer needing to cover their mortgage interest, Smith requires his target investments to be able to cover their interest bills. Enter interest cover, which equates the profit available to pay interest to the annual interest charge, as a multiple. The higher the better and this can also be tested using numbers from the cash flow statement as backup.
So, there it is – a brief window into the investing world of Terry Smith. To find out more, please email me at the usual place (below) or contact an Investment Manager.