Welcome to the next edition of Bookworm, my column that seeks to share insights from investing and business writing that can make you a better investor.

Going forward, this column will be published every second Tuesday. Each insight will fall under one of three key themes that I think can lead to better long-term investment results.

These three themes are:

  • Seek high quality assets
  • Keep building a long-term mindset
  • Process trumps emotion

Today’s insight

As the title suggests, today’s insight falls under the own high quality assets theme. We are going to look at five tenants of a great business according to one of the world’s most famous ‘quality-style’ investors, Terry Smith.

Smith’s firm is UK based but invests globally. The performance of his flagship Fundsmith fund (14% annualised from inception in late 2010 to March 2025) has seen it grow to around GBP 20 billion under management.

Reasonable minds can disagree or have a slightly different take on what makes an asset or business ‘good’. For some of the five tenants, I will share some thoughts of my own. I will also highlight an ASX company that exhibits some of these quality hallmarks. Let’s get started.

Businesses that can sustain a high return on operating capital employed

If there is one hallmark that defines a quality asset or business more than anything, it is an ability to generate consistently high returns on capital.

Smith suggests that shareholders should prioritise this measure of business performance over the likes of earnings per share growth. Why? Because he says that earnings per share growth “takes no account of the capital employed to generate those earnings, or the return that is generated on it”.

Smith continues: “If all you want from your investments is earnings per share growth, we can provide as much as you need providing you supply us with unlimited capital and turn a blind eye to the returns we are able to generate.”

This is the difference between needing to stump up $15 for every dollar in extra profit and only needing to invest three dollars to get the same dollar payback. It is this ability to generate high returns on capital – and just as importantly, a solid reason why this can continue – that our Moat framework looks for.

It is important to note that Smith isn’t looking for one or two years of high returns in isolation. He wants companies with the rare ability to chug out high returns on capital year after year, with no regression to the mean. This is why he famously avoids cyclical companies and prefers companies that sell essential products and services that are in demand every single day.

The returns on capital enjoyed by a company are only one half of the ‘compounding equation’ offered up by Conor Leonard and discussed in an earlier Bookworm. Let’s move onto the other half of that equation now.

Businesses with growth potential

The other half of Leonard’s compounding equation is how much capital can be reinvested back into the business at high rates of return.

This is why Smith says that he is looking for companies that have ample growth opportunities ahead of them to reinvest a decent chunk of the cash they throw off.

Smith stresses that growth should not be pursued for the sake of it, and that it shouldn’t come at the expense of returns on capital.

As for sources of growth, Smith highlights a preference for companies that can continue to grow the amount of products and services being sold (the volume) as opposed to simply flexing their pricing power.

If the latter is overdone, he hints, it can open the door for competition. Nonetheless, I’d underline that having elements of pricing power (even if some of it is untapped) is a clear sign that you have a quality business on your hands.

You can read more about where to hunt for companies with pricing power here.

Businesses with assets that are intangible and difficult to replicate

For a long time, Smith was associated primarily with investing in consumer staple products with well-known brands. But he is also big on what you could call a new breed of modern day ‘staples’ like the Microsoft (NAS: MSFT) software packages we all rely on every day.

Smith’s affinity for brand titans hasn’t gone away, though, and it stems from his quest to identify in businesses that, in his words, “do something very unusual”.

Smith says this unusual ability is often underpinned by assets that are intangible and hard or impossible to replicate by wannabe competitors. With an unlimited budget, a champagne start-up might be able to buy a vineyard in the right region. But you can’t simply pay to create a brand like Cristal from scratch.

This reminds me of Buffett’s advice to seek businesses that you would feel hopeless starting a new competitor against, even if your chequebook was essentially blank. I would point out, though, that some tangible assets are also incredibly hard to replicate.

Pipelines might be an example here, as replicating the assets might attach such great expense relative to the winnable business that no rational firm would make the investment. This is what we call efficient scale. If a pipeline company ends up in Smith’s portfolio, however, I would eat my hat.

Companies that are resilient

Smith’s search for companies that can deliver high and sustainable returns on capital for a long-time entails an obvious need for companies to stay in business for that long.

A key part of this, according to Smith’s Owner’s Manual, is selling products resistant to technological disruption. But I would say that resilience can mean a lot of things.

I would lump Smith’s preference for companies selling essential products in here too. These companies are more likely to make it through tough economic times than the average company. Pricing power can also increase a company’s ability to deal with cost inflation.

Companies that don’t need leverage to achieve high returns

Smith expresses preference for companies that don’t rely on debt to juice their returns on equity. Thus his avoidance of bank and real estate shares.

I’d say this links into a broader theme, alluded to by Buffett, of preferring companies that are able to self-fund their growth as opposed to relying on capital markets.

After all, relying on external capital comes with costs – interest for borrowed funds and dilution for raised equity. It is also riskier as these sources of capital have a tendency to dry up when they are needed most.

Example Fundsmith holdings

Fundsmith’s latest factsheet covering March 2025 lists the following companies as its five biggest positions: Meta Platforms (NAS: META), Microsoft, Stryker (NYS: SYK), Philip Morris (NYSE: PM) and Novo Nordisk (NYSE: NVO).

The presence of Meta may surprise some readers. But don’t you use at least one of their products most days? And how easy do you think it would be to attract users to a new version of WhatsApp, Instagram or Facebook at this point?

Two other holdings I’d refer to as ‘vintage Smith’ are Unilever (LON: ULVR) and OTIS (NYS: OTIS).

Unilever owns several billion-dollar brands in the low-ticket consumer goods space. Dove, Rexona, and Magnum to name just three. OTIS sells a very different kind of everyday essential: it is one of the most trusted brands when it comes to elevators and escalators.

Both companies exude the types of competitive advantage sought by Smith. Many of Unilever’s brands benefit from over a century of customer familiarity and are ‘sure sellers’ for any store stocking them.

As for OTIS, how likely are we to invent a radically different way of getting people up buildings? And how attractive is a slightly cheaper lift system without the decades-long record of safety and quality? This is especially true when OTIS often provides the systems at cost or the next best thing. It makes most of its money from service contracts once the systems are in place.

An ASX company that ticks the boxes

As a reminder, the ‘quality hallmarks’ from Fundsmith’s Owner’s Manual we’ve talked about today were:

  • A high and sustainable return on capital
  • Assets that are difficult to replicate
  • Growth opportunities
  • Resilient products and services
  • A lack of leverage

I think that Cochlear (ASX: COH) fits a lot of these criteria, although I am cognizant that they raised equity and diluted shareholders during the pandemic.

Cochlear sells implants that improve a patient’s hearing. The company’s shares currently trade well above their fair value according to our analyst Shane Ponraj, but I think this Wide Moat company exemplifies several of the qualities we have looked at today.

A high and sustainable return on capital?

Cochlear has delivered exceptional returns on invested capital for a long-time. We’re talking consistently 30% and above before Covid-19. Even the lower, high-teen levels achieved in recent years are very impressive compared to your average company. Especially when you consider its net cash position.

Most of Cochlear’s demand comes down to necessity rather than choice, with the alternative to a cochlear implant or other hearing device being an inability to hear. Once installed, patients generally need a replacement sound processor every five to ten years. This is essentially an annuity stream because only Cochlear’s own components will work.

It’s important to question why returns have fallen from a phenomenal 30% plus to a still good level in the high-teens. Shane said this has mostly been down to slowing growth as the market for child implants in developed countries becomes saturated. Cochlear is increasingly putting resources towards adult markets, which are more challenging.

Assets that are difficult to replicate?

Cochlear gets a big portion of its revenue and profits from an asset that new competitors can’t match: its installed base of over 600,000 devices. Patients wanting to switch to a new implant would face considerable inconvenience (i.e. surgery) to do so. In the vast majority of cases, this is highly unlikely.

As for maintaining market share for new implants, Cochlear benefits from the trust and familiarity that surgeons have with its products. Shane’s analysis, for example, notes that even a product recall in 2012 didn’t leave a long-term dent in surgeon loyalty. Cochlear undoubtedly has a strong brand in its niche.

Growth opportunities?

As I mentioned earlier, the market for infant implants in most developed countries is largely saturated and birth rates in many of those markets are weak. However, Cochlear still has opportunities to grow by selling implants to the growing senior population and continuing to service its installed base.

Developing markets are less of a focus but there is a lot more white space for Cochlear’s high-end products here and many of these countries have more attractive birth rates. Shane expects that this part of the business can grow at a healthy double-digit clip.

Products and services that are resilient?

As for the resilience of Cochlear’s products to disruption, advances in the hearing space are generally evolutionary rather than revolutionary. As a result, an incumbent with Cochlear’s resources can often replicate any improvements before market share is lost.

Shane thinks that potentially disruptive stem-cell and gene therapies are a long way off. What’s more, they could be too expensive for the vast majority of patients to use anyway. He does not see them taking meaningful share from Cochlear, which is actively researching in this area too.

Overall, I think Cochlear ticks a lot of Smith’s boxes for a high quality business. As I said earlier, though, it is materially overvalued according to our analyst. Valuation matters, so this might be one for the watchlist rather than one to consider buying just yet.

Some closing thoughts

Today we’ve covered some of the ways that Fundsmith define a quality business. Even more famous, perhaps, is the three-step approach that they recommend to investors: “1) invest in good companies 2) don’t overpay and 3) do nothing”.

In addition to the excellent performance of the underlying companies, Fundsmith and its investors benefitted from Smith’s preferred style of company attracting much higher valuation multiples during the ultra-low-interest rate era.

As rates have risen to more moderate levels, the fund has copped flak for struggling against global benchmarks. I see things differently. It is not Smith’s fault that his style of investing became so popular that valuations reached eye-watering levels. And if he were suddenly to sell everything that had performed well, this would go against his ethos of holding quality companies for the long-term.

I admire that Smith has a clear investing philosophy, knows the exactly the kind of company he wants to own, and has stuck to his guns despite tough conditions. For some pointers of crafting your own investing strategy, follow this five-step guide by my colleague Mark LaMonica.

Today’s edition of Bookworm fell under our ‘Own high quality assets’ theme. For a primer on moats, which in our view are the biggest market of quality in a business, see this article by Mark on the different sources of moat and how to find them.