William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

At Smead Capital Management (SCM), we have made it part of our work to take the psychological pulse of the stock and bond markets. When we can identify behavior and sentiment statistics which indicate an extreme crowd has been formed, we choose to be the contrarians and invest appropriately. We call these crowd extremes a “Well-Known Fact”. A “Well-Known Fact” is a body of economic information which is known to all market participants and has been acted upon by almost anyone who could care to do so. As we have watched, read and participated in the debate about the economy recently, it struck us that today’s psychology surrounding investing is similar to the psychology associated with the AIDS disease (Acquired Immune Deficiency Syndrome) back in the late 1980’s and early 1990’s.

In the early 1980’s, young men in Metropolitan areas like New York City were beginning to get hit by a deadly disease. It ultimately was understood to be a virus which was passed through body fluids. The most common way these fluids were passed from person to person was either sexual contact or the sharing of hypodermic needles in drug use. The public became very aware of the disease in 1987 when actor Rock Hudson declared publicly that he suffered from the disease. The awareness reached a very high level when basketball great, Magic Johnson, announced in 1991 that he was HIV positive stemming from heterosexual contact he had with numerous women. Suddenly, you were worried about whether you had been exposed to AIDS, how you get exposed and a huge number of other unknowable issues. The psychology of the subject was incredibly creepy as projections and anecdotal evidence around us was horrific. A fraternity brother of mine and another good friend from college died because of contracting AIDS. Waiting to find out from a blood test whether you were HIV positive was scary for everyone regardless if you were an altar boy or an atheist.

I was very fortunate during that time. While others, out of rational fears, were avoiding interaction with folks who were HIV positive, I had a conversation with another fraternity brother. He had worked in the emergency room at the University of Connecticut Hospital during his residency and was well informed about AIDS. He explained to me that the disease is highly unusual. It needs almost perfect circumstances to be transmitted, but if it gets the perfect setting and body fluid exchange, it is also successful almost 100% of the time. Therefore, you were free to be interactive with other human beings who potentially carried the virus as long as contact with them fell short of providing the perfect circumstances my doctor friend described. By the early 1990’s, Americans had modified their behavior and incorporated the risk they would run in this part of their life. Safe Sex (quite an oxymoron) became the nation’s most popular mantra. In the late 1980’s, we were all afraid of whether we had AIDS or whether our kids would someday get exposed to the virus.

Fast forward to today. The US economy became infected with a disease between 1995 and 2005. We will call it Financial AIDS. Bankers became comfortable having customers borrow against their homes to buy boats and cars so that they could tax deduct the interest. Homes appreciated and everyone involved began to believe that homes never fell in value or if they did that the decline and length of time would be short. It all cascaded into a bubble in the early 2000’s in the aftermath of the attacks on September 11th of 2001. Our government felt that the recession triggered by the Tech bubble bursting would be exacerbated by the attacks and used monetary and fiscal policy to pull us out of the recession. Most of the stimulus was translated into the residential real estate markets and a bubble in prices with correspondingly higher and higher loan balances occurred. The perfect circumstances for a financial comeuppance were in place and it was 100% successful. It all ended up in the sub-prime lending fiasco, the derivatives debacle, the deep recession of 2008-09 and the stock market meltdown of 2007-09.

We have all learned a great deal about the causes and the side effects of Financial AIDS. We pretty much know what caused it and who carries the disease. We know that millions of Americans have changed their behavior voluntarily through budgeting and better choices. Others have had their behavior changed involuntarily through foreclosure, short sales and bankruptcy. What we don’t know is how long the economy will take to cleanse itself. Is this episode of the disease as bad as the one Japan caught in the late 1980’s or as bad as the whole world got it in the Great Depression? The psychology of economists, business owner/leaders and government policy makers is completely dominated by trying to figure the timing of this disease out. THE EXTREMELY NEGATIVE PSYCHOLOGY BORN BY NOT KNOWING HOW LONG THE EFFECTS OF FINANCIAL AIDS WILL LAST APPEARS TO US AT SCM TO BE VERY SIMILAR TO THE PSYCHOLOGY WHICH SURROUNDED HIV/AIDS DISEASE BACK IN 1991!

At the height of concern in the US about AIDS and being HIV positive, Magic Johnson made a comeback and returned to playing for the Los Angeles Lakers. One of the most outstanding players in the league, Karl Malone, refused to take the risk of playing against Magic. It forced him (Magic) to re-retire. Our economic future is almost completely tied up in the extreme psychology tied to Financial AIDS and the media spends most of its time analyzing the opinions of the Karl Malone-like economists, money managers and investors. Everyone from individual investors to the biggest institutional investors approach their investment choices and asset allocation like Karl did back in the early 1990’s. If there is any chance of getting Financial AIDS disease, they don’t want to participate. To be sure to avoid the disease, avoid risk. Massive amounts of money are being poured into bonds and bond funds under the assumption it somehow “protects” folks like some financial prophylactic. The public is a large net liquidator of common stocks and US equity mutual funds. Here is what the American Association of Individual Investors reported on the sentiment of their dues-paying members:

“The number of individual investors who have a bullish outlook on the stock market for the next six months plunged to 21 percent, from 30 percent last week, according to a widely followed sentiment survey. What’s more, this is the lowest weekly reading from the American Association of Individual Investors since a March 2009 level of 19 percent, which occurred just before the S&P 500 collapsed to a 12-year low of 676.

Source: CNBC

So effectively, individual investors feel as good about stocks as they did at the very depths of the credit crisis, even though the S&P 500 is still more than 50 percent higher than that low.”

We believe there are few humans and investors that aren’t aware of Financial AIDS. Financial AIDS is incorporated into gold prices, Treasury bond prices and common stock share prices. It has caused depressed PE multiples among the kinds of companies which fit our eight criteria for stock selection. It looks to us like a “well known fact” and that means we must avoid what the crowd is doing and invest under the belief that the best money will be made betting against the crowd. We are a nation of Karl Malones at the moment, but we believe that if you embrace some of America’s finest companies and/or take some financial risks in your business you will get well rewarded no matter how long it takes our economy to recover.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

The information contained in this tv appearance represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this tv appearance do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

In discussions with clients and prospective clients recently, we at Smead Capital Management (SCM) have argued that the US Treasury Bond market today is the antithesis of 1984. In 1984, 10-year Treasury bonds peaked at 14% with a 4% trailing inflation rate. Back in 1981 the interest rate was higher at over 15%, but it took massive courage to believe that inflation would get tamed. It took wisdom to see in 1984 that the back of the demand-pull and cost-push inflation of the 1970’s was broken. In an editorial in the Wall Street Journal dated August 18th, 2010, Wharton Professor Jeremy Siegel reiterates our argument about why today’s 2.7% interest rate on 10-year Treasuries could be as dumb an investment as the 1984 rates were smart.

In his article titled, “Great American Bond Bubble”, Siegel points out that the fear of deflation and the lack of trust in eventual economic recovery have caused an avalanche of money to flow into bond funds and individual bond purchases.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.

He focused on comparing this bond bubble to the tech stock bubble of 2000. Many tech stocks were trading at 100 times earnings back then and Siegel correctly points out that if you’re buying a bond instrument paying 1%, you are effectively paying 100 times pre-tax profits to buy the bond. Are IBM, Johnson and Johnson, and McDonald’s, which sold billions of dollars of debt recently, not performing a bit of genius by borrowing money that they really don’t need. IBM paid a 1.1% interest rate for three-year bonds, while JNJ and McDonald’s issued 10-year bonds at 3.1 and 3.5%, respectively.

The negative nabobs of double-dip recession and Japanese style deflation have been jumping up and down lately as local, state and federal governments have been shedding staff to cover up the beginnings of private sector employment growth. Temporary staffing firms like Manpower are booming, which has historically been a predecessor of permanent job openings to follow. We believe the current economic consternation stems from having stared into the abyss back in late 2008, when we seriously considered a total breakdown of our economic system. We also believe that it is human nature to want the source of our prior problems (in this case excessive household debt) to get eliminated before we can feel comfortable about the future. Here is how Professor Siegel explains these attitudes.

Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar.

This suggests that if the household sector owes what the market believes that debt is worth, then effective debt ratios are much lower. On the other hand, if households do repay most of that debt, then the financial sector will be able to write-up hundreds of billions of dollars in loans and mortgages that were marked down, resulting in extraordinary returns. In either scenario, we believe U.S. economic growth is likely to accelerate.

We argue that the 2% interest rate on 10-year Treasury bonds in late 2008 was a function of not knowing whether we’d have a 1930’s style depression. We know that the TARP plan and the work the Treasury and Federal Reserve Board did back then successfully avoided the worst case scenarios. However, there is a large crowd out there that believes there are years of penance to pay for the financial sins of the last 15 years. These purveyors of painful futures don’t think the 50% decline in the stock market in 2007-2009 and the changed household behavior (some forced and much unforced) are doing the trick to cleanse the system and prepare us for long-term economic growth. The future agony they self righteously predict assumes that we can’t have a long-lasting economic recovery unless Americans borrow money like drunken sailors on leave.

We disagree and can see it in the sales and profit figures from companies we own like Starbucks, Disney, EBAY and Nordstrom. As US Households postpone car purchases, put off trading up on homes and maintain rather than remodel their homes, they keep fixed monthly payments from being added to their income statements. They are saving a good part of these outlays, paying off debt and have money left over to spend on things they want. Those things they want include coffee, movie and TV entertainment, online purchases and clothing/shoes to upgrade their appearance. None of these purchases require installment or mortgage debt.

Therefore, in our eyes, the 2.7% 10-years Treasury Bonds are foolishness. We believe everyone out there avoiding the premier US companies to own those bonds will be looking back at today in the future and asking themselves, “What was I thinking about when I could have bought those stocks back in 2010?” With huge amounts of cash earning nearly nothing in money market funds, savings accounts and a massive amount of money tied up in historically low interest rates in the bond market, we could have a market melt up if the nabobs end up being wrong. We could have a pretty good US stock market even if we avoid their worst case scenarios. We saw an 80% move up in the S&P 500 Index coming off of the 2009 lows, but the best could be yet to come.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

I love to watch the biographies on CNBC and on the A&E Channel. Rodney Dangerfield’s biography was on last week. Born Jacob Cohen, Rodney worked as a comedian for years as Jack Roy. He floundered a long time, but he worked hard perfecting his jokes. He ultimately broke through nationally by appearing on the “Tonight Show” and on “The Ed Sullivan Show”. His agent gave him the name, Rodney Dangerfield, after a character in one of Jack Benny’s old shows. His career exploded when he came up with his trademark introduction, “I get no respect”. Most of his jokes were attached to less than great things which went on in his life whether real or fiction.

At Smead Capital Management (SCM), we go through phases when we feel a little like Rodney. We are a large cap value firm with a series of eight criteria. These criteria seek to guide us to companies which have demonstrated: 1) success in the past, 2) have strong balance sheets, 3) have wide moats to protect the duration of their profitability, 4) generate high levels of free cash flow and, 5) are available at below market PE multiples or are available for purchase at 30 to 50% below intrinsic value.

When we go for an extended period of time with markets not recognizing the merits of our portfolio we can feel a little sick. Rodney went to the doctor because he felt a little sick. The doctor told him, “Rodney you are sick.” He says, “Can I get a second opinion?” The doctor replies, “Yes, you are ugly too.” We believe to make above-average returns in an expense minimizing and tax efficient way, you need long duration investments. Low turnover promotes low trading costs and lays the groundwork for the kind of wealth creation that only comes from having a significant part of a portfolio invested in stocks which garner long-term dividend growth and trade at many times original investment ten to twenty years later. Can we at SCM pursue anything more contrary to the conventional wisdom and popular investment approaches of today? Holding periods on the New York Stock Exchange are the shortest ever recorded in recent years and portfolio turnover among large cap equity mutual fund managers is close to all-time highs.

Even if you have a reason to believe that you own superior companies and are patient enough to hold many of them for years to receive the long term benefits, you can temporarily feel ugly too. One day you come in and the market is down because of the fear of our economy collapsing. The next day investors are chasing the hot commodity or ETF of the day. Rodney would say, “It’s tough out there.” Based on trailing and consensus estimates of non-GAAP earnings, our companies trade at sizable PE discounts to the S&P 500 Index. This is despite having superior ten-year records of revenue and earnings growth in comparison to the S&P 500 Index. Rodney said, “I get no respect. I play hide-and-seek, and they wouldn’t even look for me.” Individual and institutional investors rarely seek out a portfolio when its style is out of favor and the most future success is available near the lowest prices.

We believe difficult markets are a great time to hone your craft and patiently wait for the benefits of buying and holding well-chosen common stocks. They were many times when Rodney felt like giving up, but ultimately he attained wealth and fame at the highest levels of the entertainment industry. His on-stage persona and trademark lines differentiated him from other comedians and caused him to bond with a large group of fans covering three generations. We believe that many of our portfolio holdings could have very bright long-term futures, even though at the moment, they are a little short on respect.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

A number of naïve investors have a mental picture of some great buying interest entering the stock market at major low points. The same folks also think a massive number of shares controlled by smart people are sold in huge quantities at the top of the market. In the view of Smead Capital Management (SCM) nothing could be further from the truth. Thanks to a recent article in Investment News and some simple research at the Wall Street Journal’s website, you can see at major market low points the seller is someone who prefers to buy, but is forced to sell.

In the article entitled, “American Funds Losing Luster in Eyes of Reps”, writer Jessica Toonkel shared the statistics provided to her by Morningstar on which equity mutual funds had seen the biggest outflows since the beginning of the year 2010. The second largest fund family, American Funds, had seven of the top ten funds on the outflow list. Toonkel theorized that the American Funds family, which had been incredibly popular over the last ten years among registered reps and financial advisors, were “losing their luster”. We have observed the American Funds over the years and after a ten-year stretch of poor performance in the S&P 500 index and an orgy of bond fund buying the last two years, we are not surprised by their large equity funds getting hit by net redemptions.

A natural outcropping of the liquidation of these popular large cap funds is the making of an especially large seller of the top ten holdings in each of these funds. Therefore, the portfolio manager is forced to sell a large number of shares of the companies which they are the most enthusiastic to buy. The seller is someone who prefers to buy, but their behavior is being dictated to them by the necessity of meeting the mutual fund redemptions. We believe this is true at all major market low points including the May-June 2010 swoon in the US stock market.

The Wall Street Journal website gives you a picture of the top ten institutional holders and top ten mutual fund holders of a stock. We own shares of Merck (MRK) in our portfolios. Seven of the top ten mutual fund holders of MRK as of March 31, 2010 were large funds managed by American Funds and was nearly the same list as the top ten liquidation list that Morningstar and Investment News highlighted. Merck was heavily liquidated in the first half of the year because someone who thinks very positively about the future of the company is selling to meet redemptions. We believe these redemptions are most likely being forced upon the registered reps and financial advisors by the will of clients who prefer to own bonds.

A number of highly respected portfolio managers and asset allocators have pointed out how undervalued large cap US quality is currently compared to other asset classes. The bottom usually comes right after someone who prefers to buy them is forced to sell. At SCM, we think the exodus out of stocks into bonds hasn’t ended yet, but since the seller is someone who prefers to buy, maybe the turn is not too far off.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.