The 3 Rules of a Modern Master: Terry Smith's "Buy, Don't Overpay, Do Nothing" Strategy

The investment industry thrives on complexity. It bombards us with jargon, forecasts, and a dizzying array of strategies, wanting us to believe that success requires constant action and arcane knowledge.

But what if the most effective investment strategy in recent memory could be distilled down to just three simple rules?

Terry Smith, the outspoken and brilliantly clear-thinking founder of the UK-based Fundsmith Equity Fund, has built a phenomenal track record by doing just that. He doesn't try to time the market, he despises frequent trading, and he has condensed his entire philosophy into a simple, powerful, three-step mantra. For any investor feeling lost in the noise, Smith’s strategy is a lighthouse guiding you to a clear destination.

Step 1: Buy Good Companies

This is the foundation of the entire strategy and where the most rigorous work is done. So, what qualifies as a "good company" in Terry Smith's world? He has a very specific checklist:

1. A High Return on Capital Employed (ROCE): The company must be an efficient cash-generating machine, able to produce high cash profits from the capital it invests in its business.

2. Predictable, Recurring Revenue: The source of profits should be resilient, preferably coming from a vast number of small, repeatable, everyday transactions. This makes the business exceptionally durable.

3. Strong Intangible Assets: The company must have a competitive advantage that is difficult to replicate, such as powerful brands (e.g., L'Oréal), patents (e.g., a medical device maker), or network effects (e.g., Microsoft).

4. Resilience to Economic Cycles: He strongly prefers businesses that sell products or services people need or desire, regardless of the economic climate. This leads him to sectors like consumer staples, healthcare, and enterprise software.

In short, he looks for simple, capital-light, cash-generative industry leaders. He famously quips, "We don't invest in companies that need a bank," which neatly excludes highly leveraged and complex businesses like banking, real estate, and utilities.

Step 2: Don't Overpay

Buying the best company in the world can still be a terrible investment if you pay too high a price. This is Smith's second ironclad rule.

He is a "quality" investor, but he is also disciplined on "value." He doesn't hunt for "cigar butt" bargains in the way a deep value investor might, because those companies are rarely high quality. But nor is he a "growth at any price" investor who will chase a story to the moon.

He seeks a sensible balance: a fair price for a wonderful company.

His primary valuation tool is Free Cash Flow (FCF) Yield. He calculates a company's annual free cash flow as a percentage of its enterprise value and compares it to the yield on long-term government bonds. This helps him determine if the potential return from owning a piece of this excellent business is sufficiently attractive relative to a near-risk-free asset. He is willing to pay a premium for quality, but that premium has its limits.

Step 3: Do Nothing

This is perhaps the most counter-intuitive, and most difficult, part of the philosophy.

Once you have completed the hard work of the first two steps—identifying a small number of great companies and buying them at a reasonable price—your most important task is to fight the overwhelming urge to do something.

Smith calls portfolio turnover (how frequently you trade) "a weapon of mass financial destruction" because it:

• Increases Costs: Trading fees and taxes are a relentless drag on performance.

• Leads to Timing Errors: No one can consistently predict market tops and bottoms.

• Causes You to Sell Great Companies: You get scared by a market panic or bored by a period of flat performance and sell a "compounding machine" far too early.

The Fundsmith portfolio has an extremely low annual turnover rate. Smith's job, as he sees it, is to select a team of the world's best businesses and then sit on the sidelines and let their management and employees create value for him and his investors, year after year.

A Quiet Journey on a Supertanker

Terry Smith's investment philosophy is a masterclass in radical simplicity and discipline. It isn't "easy"—the upfront work to identify the right companies is immense. But its principles are clear, pure, and timeless.

He proves that successful long-term investing isn't about expertly navigating a speedboat through a stormy sea, chasing the next big wave. It's about finding a sturdy, reliable supertanker with a powerful engine, getting quietly on board, and trusting it to carry you through any weather, letting time and quality do all the heavy lifting to your destination of wealth.