Fundsmith’s Terry Smith would buy stocks like this to beat inflation

When Fundsmith Equity‘s Terry Smith has a view on something going on in the markets, many investors — including myself — make a point of listening. After all, Smith’s track record over the 11 years or so speaks for itself. Based on its latest factsheet, Fundsmith has achieved an annualised return of 18.7% since inception. 

His most recent comment that captures my attention relates to something that’s caused a lot of hand-wringing recently. Rising inflation. 

Why Smith isn’t worried

Smith doesn’t dismiss concerns about inflation from investors. However, he does think that the impact of prices increasing really depends on what sort of company we’re talking about. 

For Smith, knowing a firm’s gross profit is vital. The less money a company spends producing something relative to the price it sells it for, the better. So, although rising inflation will increase the cost of what it takes to produce something, a company with a larger gross profit can take this on the chin.

These firms have “better insulation” from inflation, according to Smith. He offers French cosmetics company L’Oreal as an example in a recent presentation. Understandably, the company features in the Fundsmith Equity portfolio.

Quality + value

To further back up his argument, he looked at how quality stocks have performed over eight separate periods of rising inflation between 1933 and 2008. In 75% of these intervals, the sort of companies Smith is interested in owning outperformed the US S&P 500 index. Just in case you weren’t aware, this has proven to be one of the hardest indexes for fund managers to beat.

What’s even more interesting is that there was only one period where stocks offering both quality and value underperformed. In other words, buying great stocks but also not overpaying for them works even better.

That might seem patently obvious to even the most fresh-faced Foolish investor, but it’s exactly the strategy Smith adopts with Fundsmith Equity. And it’s clearly worked out well for him (and Fundsmith holders such as myself). 

What I should be looking for?

Taking Smith’s conclusions on board, it seems logical I should continue directing my cash towards companies that show characteristics of quality. This is the case even in the event of rising inflation.

Among the things he looks for are companies that have strong brands, are resilient to change and, yes, those with big gross margins. On a more technical note, Smith is looking for businesses that can generate high returns on capital employed. In other words, they make a lot of money back from the money fed into the business.  

One problem with this is that firms with the above tend to be fairly popular already. Even so, I think there are a few stocks on the London Market that are attractively valued right now. This FTSE 100 stock could be one example. 

Volatility ahead

Whether the recent rise in inflation continues remains to be seen. Some, like the US Federal Reserve, think it will prove transitory. Others think it may last a lot longer. Regardless of who’s right, the market hates uncertainty and this debate may cause share prices to remain volatile for now. 

However, based on Smith’s argument, quality-focused investors like me can simply sit on our hands and be ready to pounce if an opportunity presents itself.