Adapting to a Dynamic Market: Fundsmith's Commitment to Value
First Half 2026 Performance and Market Divergence
In the initial six months of 2026, the Fundsmith Equity Fund experienced a 2.9% downturn. This performance significantly lagged the MSCI World Index (£ net) by 14.1 percentage points, highlighting a stark divergence from broad market trends. The letter notes that while the Fund does not track a specific benchmark, these comparisons are provided for informational purposes.
The Rise of Passive Investing and Market Momentum
The current market landscape is increasingly shaped by the proliferation of passive investment vehicles, particularly ETFs, and the enthusiasm surrounding artificial intelligence. This combination has fostered a momentum-driven market where fundamental factors such as profitability, capital returns, and growth often take a backseat. This phenomenon has led to index funds demonstrating superior performance over active managers, a trend that paradoxically undermines the original rationale for passive investing and creates a self-reinforcing feedback loop.
Unpacking the Passive Investment Paradox
An interesting observation is that passive funds are beginning to exhibit characteristics traditionally associated with active management. For instance, Vanguard's FTSE 100 tracker holds half its assets in just ten stocks and shows significant sector concentration in banking, oil, and mining. This contradicts the perception of index funds as low-risk, diversified portfolios. Furthermore, the market's trading activity is now predominantly driven by passive fund rebalancing and the momentum effect, rather than the deliberate decisions of active managers, who now account for a mere 10% of trades, down from 80% in the 1990s.
Consequences of an Unchecked Momentum Market
The relentless pursuit of momentum has led to extreme market volatility, with large-cap stocks experiencing daily price swings of 33% or more. Such movements are largely unpredictable by traditional fundamental analysis and are exacerbated by the diminishing presence of active managers who might otherwise temper irrational exuberance. The letter warns that this unchecked momentum could lead to severe market corrections, potentially dwarfing historical downturns like the Dotcom bubble burst or the 2008 financial crisis.
Strategic Adaptations: Embracing Activity and Selectivity
Acknowledging the market's irrationality, Fundsmith is adjusting its investment process to become more dynamic. While maintaining its core principles of investing in good companies at reasonable valuations, the fund will increase its portfolio turnover, moving away from a rigid buy-and-hold strategy. This shift includes a greater consideration of both fundamental and share price momentum and a reduced willingness to acquire quality companies experiencing temporary setbacks, a strategy that has become akin to 'catching a falling knife' in the current environment.
Key Portfolio Changes and Rationale
During the first half of the year, Fundsmith undertook significant portfolio adjustments, initiating positions in twelve new companies and fully or partially exiting thirteen others. The new acquisitions span industrials, financials, healthcare, information technology, consumer discretionary, and communication services, chosen for their strong competitive advantages, predictable growth, and reasonable valuations. Conversely, sales were driven by factors such as stagnant organic growth, management missteps, increased competition, or unfavorable valuation metrics.
Reinforcing Fundamental Strength: The Evolved Portfolio
The revamped portfolio maintains robust fundamental characteristics, including a high Return on Capital Employed (ROCE) of 31%, a gross margin of 62%, and an operating margin of 29%. The weighted average Free Cash Flow (FCF) yield stands at 4.3%, significantly higher than the S&P 500's sub-2% FCF yield, which is impacted by the heavy AI investments of major tech companies. The fund projects an average annual cash flow growth of 14% over the next 3-5 years for its holdings, underscoring its belief in their long-term value creation. Despite the current market's irrationality, the fund remains committed to its strategy, confident that these fundamentally strong companies will eventually see their share prices reflect their intrinsic value.
Concluding Thoughts on Market Outlook
The letter concludes with an admission of uncertainty regarding the precise timing or cause of the current momentum market's eventual unraveling. However, it speculates on potential triggers such as the failure of AI investments to generate adequate returns, AI's destructive impact on other sectors, or a decline in passive fund inflows due to job losses. The core message remains: trees do not grow to the sky, and an eventual return to fundamental valuation is inevitable. Fundsmith reaffirms its dedication to its refined investment approach, expecting its investors to remain steadfast through market cycles.
Attribution of Performance: Detailed Analysis
Appendix 1 provides a breakdown of the key contributors and detractors to the Fund's performance. Positive contributors included Fortinet, Texas Instruments, Marriott, Alphabet, and Philip Morris. The largest detractors were LVMH, Zoetis, IDEXX, Microsoft, and Coloplast. These details offer transparency into the specific stock-level impacts on the overall fund performance.
Sales and Purchases: Strategic Rationale
Appendix 2 elaborates on the rationale behind each sale and purchase. Sales of companies like Atlas Copco, Coloplast, and EssilorLuxottica were primarily driven by factors such as decelerating growth, management issues, or competitive pressures. Conversely, new investments in GE Vernova, Legrand, Nextpower, Uber, Mastercard, Veeva Systems, AppLovin, Sage, TSMC, The TJX Companies, Netflix, and Yum! Brands were based on robust competitive advantages, significant growth opportunities, and attractive valuations within their respective sectors.
