Terry Smith's Investing Approach

Terry Smith’s investing approach rests on three rules: buy good companies, don’t overpay, and do nothing. He focuses on a small number of high-quality businesses with high returns on capital, resists trading, and judges performance over years rather than quarters. He founded the fund manager Fundsmith in 2010.

Where this fits: Smith’s approach is a clean expression of Criterion 1 (a great business) and Criterion 5 (a reasonable price) in the Five Criteria, anchored on return on invested capital. This article is part of our Learning from the Masters series.

Who Is Terry Smith?

Terry Smith is a British fund manager who founded Fundsmith in 2010 and runs its flagship global equity fund. The firm became one of the better-known quality-focused managers in the United Kingdom.

Before Fundsmith, Smith spent years as a City analyst and executive. He wrote Accounting for Growth, a book exposing the accounting tricks companies use to flatter their numbers, which gave him an early and lasting scepticism about reported profits.

That background shapes everything he does now. He treats accounts as something to interrogate, not accept, and he has written extensively in his own annual letters and essays, some collected in Investing for Growth.

The Three-Part Philosophy

Smith is unusual among fund managers for compressing his whole method into three short rules. Their power is in how hard they are to follow, not how hard they are to understand.

1. Buy good companies.
2. Don’t overpay.
3. Do nothing.

Each rule resists a different temptation. The first resists the lure of cheap but mediocre businesses. The second resists paying any price for a wonderful story. The third resists the constant itch to trade. Taken together they describe a patient owner of excellent businesses, which is exactly what the Five Criteria aim to produce.

Rule One: Buy Good Companies

For Smith, a “good company” is defined mainly by its return on capital. A business that earns a high return on the capital it employs, year after year, is creating real value rather than just getting bigger.

Why returns on capital matter so much

A company that reinvests profits at a high rate of return compounds shareholders’ money far faster than one that reinvests at a low rate. Over a decade or two, the gap becomes enormous.

Smith looks for businesses that can not only earn high returns but also reinvest a good portion of their profits at those same high rates. That combination, high returns plus the ability to redeploy cash, is the engine of long-term compounding. Our guide to return on invested capital explains how to measure it.

The kinds of business he favours

Smith tends to prefer:

• Companies selling many small, repeatable items rather than a few large, lumpy ones.
• Businesses whose products are consumed and repurchased often, giving predictable demand.
• Firms with strong brands, habits or switching costs, so they can hold their prices.
• Asset-light, cash-generative models that do not need constant heavy investment to stand still.

He tends to avoid cyclicals, heavily indebted companies, and businesses whose fortunes depend on factors they cannot control. The preference for predictable, cash-generative firms overlaps closely with our case for boring businesses.

Beware accounting flattery

Smith’s analyst background makes him suspicious of reported earnings. He pays close attention to whether profits turn into actual cash and whether the numbers have been massaged. This is the discipline behind our guides to quality of earnings and free cash flow.

Rule Two: Don’t Overpay

Smith is sometimes caricatured as an investor who ignores valuation because he is willing to pay up for quality. That is a misreading.

His actual position is more careful. A genuinely high-return, long-compounding business is worth more than an average one, so it deserves a higher multiple. But “worth more” is not the same as “worth any price”. Pay too much even for a wonderful company and your returns will suffer for years.

The practical balance he strikes is to focus on free cash flow yield rather than headline earnings multiples. A business can look expensive on a P/E ratio and still offer a reasonable free cash flow yield once you account for its quality and cash generation.

This is where Smith and value purists meet. Both agree that overpaying is a real risk. They differ only on how much extra a top-quality business is worth, not on whether price matters.

Rule Three: Do Nothing

The third rule is the one most investors find hardest. Once you own excellent companies bought at sensible prices, Smith’s advice is to leave them alone.

“Do nothing” is not laziness. It rests on several observations:

• Trading costs money. Commissions, spreads and taxes quietly erode returns every time you deal.
• Trading invites mistakes. Every sale is a decision that can be wrong, and every purchase replaces something you understood with something you may not.
• Compounding needs time. Interrupting a compounding machine to chase a slightly cheaper one usually costs more than it saves.

Fundsmith is known for very low portfolio turnover, holding its businesses for many years. The idea is that the hard work is in the buying; after that, patience does the rest. This is the same logic behind our view that a long time horizon is your biggest advantage.

“Do nothing” has one important exception. If a business deteriorates, if the quality erodes or the original reason for owning it breaks, then doing nothing becomes a mistake. The rule is about resisting needless activity, not about ignoring real change. For that judgement, see when to sell a stock.

A Hypothetical Comparison

To see why returns on capital matter, imagine two companies, both reinvesting all their profits for ten years.

	Company A	Company B
Return on reinvested capital	20% a year	8% a year
Starting value (illustrative)	100	100
Rough value after 10 years	about 620	about 216

With round, illustrative numbers, Company A ends up worth far more, simply because each pound it reinvests earns a much higher return. This example is hypothetical and ignores tax, dividends and the price you paid; real outcomes vary widely. But it captures Smith’s central insight: over long periods, the rate at which a business reinvests its cash matters enormously.

It also shows why rule two still binds. If you paid a wild price for Company A, much of that advantage would be handed to the seller rather than kept by you.

Where the Approach Needs Care

Smith’s method is elegant, but it is not risk-free.

• Quality can get crowded. When many investors chase the same high-quality names, their prices can rise to levels that stretch even Smith’s definition of “don’t overpay”.
• Great businesses can stumble. A durable moat is never guaranteed. “Do nothing” must not become “never re-examine”.
• Concentration raises the stakes. A focused portfolio of a few dozen names means each decision carries real weight, which demands careful position sizing.
• Patience is tested in cheap markets. When unloved, low-quality stocks surge, a quality portfolio can lag for a while. Sticking with the approach then is the whole challenge.

How Smith Fits the Five Criteria

Smith’s three rules map almost directly onto our framework, which is one reason his approach is so useful for individual investors.

Smith rule	Five Criteria link	House test
Buy good companies	1. Great business	ROIC of 15% or more for 5+ years
Buy good companies	2. Durable moat	Name a clear moat and show returns holding up
(implicit in quality)	3. Aligned management	Sensible capital allocation; flat or falling share count
Avoid heavy borrowers	4. Sound balance sheet	Net debt/EBITDA of 2.0x or less; interest coverage 5x or more
Don’t overpay	5. Reasonable price	FCF yield of 5% or more, or 25%+ below intrinsic value
Do nothing	Temperament	Hold while the business stays great; sell only on real change

The overlap is close enough that Smith can almost be read as a worked example of the Five Criteria applied with unusual discipline and patience.

Frequently Asked Questions

Is Terry Smith a value investor or a growth investor?

He sits in the quality tradition that blurs the line. He buys growing businesses but insists on paying a sensible price, so he is neither a pure value investor hunting cheap stocks nor a growth investor indifferent to valuation.

Does “don’t overpay” mean Terry Smith buys only cheap stocks?

No. He will pay a higher multiple for a genuinely superior business, because it is worth more. The discipline is that there is still a limit; quality justifies a premium, not an infinite price.

How long does Terry Smith hold a stock?

Typically many years. Fundsmith is known for very low turnover. The holding period is governed by the business, not the share price, so a holding stays until its quality erodes or its reason for ownership breaks.

Can an individual investor copy this approach?

The principles translate well. Own a handful of high-return businesses you understand, refuse to overpay, and resist trading. The hardest part is not the analysis but the patience, which is exactly where most investors fall short.

Your Next Step

Smith shows how far three simple rules can take a patient investor. Build them into a full process with the Five Criteria framework, learn to measure quality with the return on invested capital guide, and see how his ideas sit alongside others in lessons from the greatest investors of all time. To judge price the way he does, read price to free cash flow.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.