“Buy good companies. Don't overpay. Do nothing."

That's Terry Smith's mantra, and it's one of the main inspirations behind how we invest at RatedA. Which is why his latest letter to shareholders stopped me in my tracks: Fundsmith is officially changing its strategy to incorporate momentum. The high priest of buy-and-hold quality investing just admitted that in this market, doing nothing no longer works… at least not for him. Let's unpack what he actually said, and whether he's right.

Terry Smith starts by pointing the finger at passive investing.

In the 1990s, active funds accounted for around 80% of trading volume. Today, that figure is down to 10%. Passive is now the force that sets prices, which kind of breaks the original logic of indexing. The whole pitch for passive was this: the market return is, by definition, the average of all active managers before fees. So you buy the whole market cheaply, skip the fees, and beat the average manager by a percentage point or so. In other words, “settle for average at a discount.”

That's not what's happening anymore. Smith cites the example of Vanguard's UK All Share tracker returning 66% over five years while the average UK active fund returned 32%. A tracker isn't supposed to beat the average manager by 34 points, it's supposed to beat them by roughly the fees saved. Something else is driving returns, and that something is momentum: money flows into index funds, index funds buy the largest stocks regardless of price, those stocks go up, which attracts more money into index funds. The loop feeds itself.

For active managers like Smith, spotting mispricings in the market is not the hard part. Mispricings only pay off when they correct, and corrections require someone on the other side of the trade with the capital and the mandate to act on fundamentals. But those investors are leaving en masse. Every active manager who underperforms and capitulates to passive removes another correcting force from the market and strengthens the loop that made her underperform in the first place.

Which brings us to Smith's conclusion. Buy good companies, don't overpay, do nothing… the third leg only works if you can actually hold through the illogic. Smith can't. He runs an open-ended fund, and his investors have been pulling money out, mostly to join the passive exodus. The market can stay illogical longer than he can stay in business. As he puts it, there will be little point in being proved right about the dangers of momentum investing after his fund has closed.

When I read this, the first thing that jumps out at me is the dilemma every investor faces the moment they start managing outside capital. Terry Smith can have all the conviction in the world about the right way to invest. But the moment he took outside money into an open-ended fund, he entered a different business: the AUM business. And assets under management are a function of investor patience, which in practice runs out after a few quarters of underperformance.

A buy-and-hold philosophy requires exactly the thing an open-ended fund structure cannot guarantee: time. You can be completely correct about a company's fundamentals and still be forced to sell it, because your investors redeemed and you need to raise cash.

This is where it gets interesting for the rest of us. The current market, which is dominated by passive momentum, is a machine for manufacturing inefficiencies. Smith points to the example of Snowflake, which on the 27th of May this year closed at a $60 billion company and opened on Thursday at $82 billion. Or Dell Technologies, which grew its market cap from $205 billion to $273 billion in just a day. Those are massive moves on large cap companies which prove the inefficiencies of market we currently live in. How can such a large business with so many people looking at it increase its value by 33% in a single day?

These inefficiencies in pricing aren't going away. The people paid to exploit them just can't afford to. This leaves one group perfectly positioned: investors who answer to no one. No redemptions, no career risk, no quarterly performance reviews. If you're managing your own money with a long horizon and the stomach for volatility, you're now playing a game most professionals have been forced to abandon.

But passive flows don't fully explain why Fundsmith hasn't meaningfully outperformed its benchmark since 2018. That's eight long years. Warren Buffett, one of Smith's idols (and mine), went through his own stretches in the wilderness, most famously during the dot-com era. But Buffett always bounced back with a vengeance, proving he'd been right to stick to his guns. He didn't change the strategy. He waited for the market to come back to it. (Of course, it helped that Buffett didn’t manage an open-ended fund.)

Truth is, maybe Terry Smith lost his way a little, and this shift is partly a fresh start dressed up as an adaptation. Smith is a very intelligent man; he could find ten compelling arguments for any sale he wants to make. Passive investing is a real excuse. But it's also a partial one.

Because look at what he's actually selling. Coloplast: no growth, weak moat. LVMH: the China growth story may be dead. IDEXX: too expensive for its growth. EssilorLuxottica: moat under attack. Nike: no moat. Otis: no growth. Novo Nordisk and Zoetis: pharma facing adverse competitive dynamics. Intuit: a bad acquisition it won't admit to.

These aren't bad companies. But they expose a blind spot in Smith's favourite metric. Return on capital tells you how much a business earns on every dollar invested, which is a great measure to follow over time. What it doesn't tell you is how much capital can actually be deployed at that return. A business earning 50% on capital with nowhere left to invest generates impressive ratios and mediocre returns for shareholders. That's arguably the story across much of his sell list.

Now look at the buys. Five of them are companies we cover at RatedA, and four of those five are currently signalling great value on our framework, which combines moat, profitability, and risk. In other words, this letter could be summarised in one line: "I'm selling lower-quality businesses and buying better ones." Which means the mantra, “buy good companies, don't overpay, do nothing,” might not be dead after all.

Upgrade to unlock full access to the RatedA Portfolio (with weekly updates on every buy/sell and rationale), and the complete database of companies + ratings.