Terry Smith: The keys to equity investing in 2012

Most investors would be better off using index funds than active managers, but high quality corporates can still prosper in 2012, according to Terry Smith.

His Fundsmith Equity fund returned 7.5% in the year to 30 December 2011, according to Morningstar, versus an IMA Global sector average fall of 9.5%.

Smith said the fund's performance had been driven by holdings in Domino's Pizza, Philip Morris, Imperial Tobacco, Colgate Palmolive, and Unilever.

Principal detractors were Serco, Kone, Becton Dickinson and Intercontinental Hotels.

The manager has sold out of Domino's, however, after a steep climb in its share price and concerns over its ability to refinance debt, due to take place in 2014, given the market environment.

Smith said he views the year ahead with "some trepidation", but is taking heart from the potential strength of high quality corporates. He pointed to credit default swaps on Nestlé, which the market is pricing more cheaply than those on European governments and the US Treasury.

The fund held 24 stocks as at the end of 2011, and turnover stood at 15%, but Smith said this was a result of bid approaches, one successful and one aborted, for two of his companies.

"Excluding dealing in Del Monte and Clorox, the turnover was 4% which is much closer to the level we seek (zero ideally)."

The manager echoed the comments of those who have said income will play an increasingly important part of equity investing in future.

"There is only one stock in the fund that does not pay a dividend. This is significant: it is becoming clear that dividends are likely to provide a more significant portion of the total return on equities in the future than they did in the equity bull markets of 1982-2000 and 2003-2007," Smith said.

He also reiterated his concerns over ETFs, saying investors should instead look at index funds.

"Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds.

"The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don't want active management, and mostly you should not, buy an index fund."