William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Morningstar did some neat fund flow analysis recently which was picked up by a column written by Mark Hulbert on MarketWatch called, “Active vs. Passive”. In it he described how fund flows had moved toward passive or index investing among US equity funds and away from active managers in the last ten years. The amount of US equity assets which are indexed grew from 12% to 22% of the total pie. Theoretically the more that investors or their advisors index, the more likely active managers would be to gain the upper hand over passive investments in the S&P 500 Index (scarcity creates value). Unfortunately for the active managers, this was not the case as only 20% of active managers beat the market over the ten years. In the article, Hulbert concluded that all the added advantage that active managers might have received from greater passive participation was dissipated or offset by the increased portfolio activity (turnover) of stock mutual fund managers. At Smead Capital Management, we think these results and information are important to contemplate because it sheds light on what it means to be a wise contrarian investor in early 2010 and in the future.

The S&P 500 Index has obvious built in advantages over active funds. As a benchmark it has no management fee. Therefore, throughout the year the index will gain the advantage of not paying a management fee of .50%-1.00%. The active managers automatically have to overcome this difference through better performance. Second, there are no operational costs associated with the index. In the actively managed US equity fund universe this adds up to an average of 1.31% per year including the management fee. Third, the index has very low turnover historically. This means that trading costs and bid and asked spreads do little to reduce the returns of the index. Lastly, the S&P 500 Index is a market-capitalization weighted index. It means that the S&P 500 Index holds its winners to a fault while allowing the duds (like General Motors) to run their stock price into the ground. At SCM, we believe this is one of the index’s biggest built in advantages over active managers. The math is that you can make 10 times your money on a big winner, but you can never lose more than 100% of your money on a stock going bankrupt.

Academic research has shown repeatedly that long time periods allow value to get recognized in the marketplace. Eugene Fama’s work on efficient markets at the University of Chicago focused on low price to book value. Others like Bauman, Conover and Miller as well as David Dreman have shown clearly that buying the lowest P/E ratio stocks has soundly beaten the market averages if measured over a ten year or longer time frame. This shows that long durations produce better results for both passive and active investors.

Ben Inker, research director at Grantham, Mayo and Van Otterloo (GMO), exposed what is wrong with the high level of activity and portfolio turnover at the average actively managed fund. His work shows that 75 per cent of the current intrinsic value of a stock comes from cash flows earned more than 11 years from now. Why are short term business prospects receiving most of the professional investor attention when company durational success should be their focus? Ironically, in 2009 the average holding period for a stock on the New York Stock Exchange dropped below a year for the first time in 70 plus years. Not only have fund managers been more impatient, but individual and institutional investors have been as well! On top of all this is the fact that dividends and dividend increases make up a substantial part of long-term returns produced by participating in US equity investments. The average investor doesn’t stay around long enough to collect an entire year of dividend payments.

Let’s put this wonderful band of players together and see what we come up with. When stocks do poorly for a decade, investors are motivated to try to compact duration or holdings periods on stocks to gain an advantage. In the process they cede success to the S&P 500 Index. And by being impatient and too active they fail to take advantage of the kinds of under valuations provided by cheap stocks. We believe these advantages include dividends, dividend growth and companies with long duration business characteristics (wide moats and strong balance sheets).

It appears that good stock selection, with an eye on low PE’s and long duration business characteristics could be very successful for the patient US equity fund manager. It also appears to be quite contrary to the popular view and methodology of active managers in 2010.

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:

As value investors and proponents of low turnover portfolios, we at Smead Capital Management are concerned about becoming New Age Visionaries. Fortunately, we are in tune with investing great Warren Buffett, who came out with his annual letter over the weekend. As veteran Buffett watchers, we can see that he is out “New Aging” the “New Agers” and identifying Oil as the “New Salt”.

Once upon a time, people packed their meats in salt to preserve them. For this reason, salt was a very precious commodity. My cousins (Schmied’s and Krutz’s) moved to Hutchinson, Kansas in about 1875, because Jay Gould bought a salt plant there and one of my cousins had a management position with Gould’s company. Gould was the Carl Icahn/Ron Burkle of his day and ironically, his core business was the railroad business. He owned peripheral businesses which could somehow contribute to rail line activity. However, instead of putting a high price on salt at the time (which folks did), they should have been preparing for the emergence of ice boxes and refrigeration. When those “New Age” technologies came along, salt lost a great deal of importance and prices reflected the loss of demand.

In the early 1900’s, horses and oats were highly valued commodities because humans and goods were transported in those days by horse drawn wagons. In a wonderful paper called, “From Horse Power to Horsepower”, author Eric Morris shared how horses and oats became the “New Salt”. In the year 1900, four thousand automobiles were sold in the US. Instead of putting high prices on oats and horses, folks should have been prepared for their prices to drop as auto sales in the US hit 3.5 million in 1925. To be a New Age thinker back then you had to be thinking of gas stations, convenience stores and motels for newly mobile Americans.

This brings us to Buffett’s Annual Letter. Berkshire Hathaway is taking a large and capital intensive position in the Electric/Natural Gas Utility Industry via Mid-American Energy and the US Railroad Industry via its purchase of the Burlington Northern/Santa Fe Railroad. Berkshire also owns a company, BYD, which makes electric auto engines in China. And Berkshire is selling shares of oil company, Conoco Phillips, to buy the railroad. Buffett obviously thinks that Oil is the “New Salt”. He has already stated publicly that we will all be driving electric cars in twenty years. Railroads transport coal and much of our electricity is made out of coal. Therefore, his company is now one of the largest companies providing fuel and engines to electric cars.

Buffett reminded everyone in his letter that you should be concerned about the profitability of your companies over the next ten to twenty years, not the next 10 to 20 weeks. Short holding periods for industries with bright near-term futures are very popular just like they were in 1999 for tech stocks. Poor longer-term fundamentals could put investors into a Cinderella position, where you run out of time and everything turns into pumpkins and mice. Wayne Gretzky was once asked why he was such a great hockey player and he answered, “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” At SCM, we believe that Oil is the “New Salt” for this very reason.

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:

For a long-term multi-year bull market to exist in stocks in the US, a number of things need to fall into place. Since we at Smead Capital Management enjoy owning high quality large cap US equities for long holding periods and seek to find “Hall of Fame Companies”, we would like to see a long bull run play out over the next 3-5 years. We thought it would be helpful to line up the current “ducks” to see if the markets have done what they need to do for this bull market to last for a long time.

Duck No. 1—Negative Sentiment

When this market sneezes, investors get a cold. A recent 7.5% pullback in the S&P 500 Index caused individual investor sentiment and professional investor sentiment to plunge. Mark Hulbert covered this in a column called “A mid-winter night’s gloom” in which he showed that short-term professional market timer’s had reduced their equity exposure in a short time by 45%. Both the Investor’s Intelligence and American Association of Individual Investor’s (AAII) surveys saw the number of bulls plummet and the number of bears or people looking for a correction soar.

Duck No. 2—Insider’s Positive

The recent pullback in the market saw a big drop off in insider selling (Officers and Directors and Substantial Stockholders of public companies). When the Insider’s are big sellers of dips, beware.

Duck No. 3—Favorable Supply and Demand for Shares

Every week another major acquisition announcement is made. Most are all cash (Terra Industries $4.1 billion) or mostly cash purchases (Berkshire Hathaway’s buy of Burlington Northern). When shares of stock are bought out for cash, the supply of shares outstanding decline. Major stock buyback announcements have been fairly constant (Merck and Amgen in our stable are recent examples) and are being executed, wiping out more supply. In more normal times this supply elimination would be offset by Initial Public Offerings (IPO’s) and Secondary Common Stock offerings. Ask any investment banker, IPO issuance is almost non-existent.

Duck No. 4—Massive Cash on the Sidelines

US households ($7 Trillion), Banks ($1.2 Trillion) And Non-Financial Corporations ($1.8 Trillion ) are holding record levels of cash on their balance sheets. When confidence comes back a significant piece of this amount will either participate in business growth or stock purchases.

Duck No. 5—Negative “Nabobs” have Credibility

Any two-bit economist or market strategist who foresaw the sub-prime meltdown is treated like a god/guru and like they have a crystal ball. They all say the same thing about the US economy in one way or another. The US has seen its best days and we are in for a long deleveraging phase. In their mind commodities and emerging markets are a better place to invest than the best companies in the world domiciled in the USA.

Duck No. 6—The Public Can’t See the Ducks

We believe US household investors and many institutional investors are looking in the rearview mirror at the horrid decline of October 2007-March 2009 and can’t see the ducks lined up. Remember, US households were net liquidators of US common stock last year.

We are very excited to own the companies which fit our eight criteria and look to enjoy the ride as we believe investors will slowly recognize that the “ducks are lined up”.

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:

Last week those of us at Smead Capital Management got to listen to the wisdom of Warren Buffett and Hank Paulson. We also read some terrific economic history from Joel Kotkin in a column called “America on the Rise”. I’d like to share some of their thoughts and connect them. In this way we can help folks understand why we think this is one of the best times to own US high quality common stocks by looking for Hall of Fame Companies and use long-term holding periods.

Mr. Buffett interviewed Hank Paulson in Omaha at a big Chamber of Commerce gathering. They spent most of their time talking about the tough decisions which Paulson spearheaded in the fall of 2008 as US Treasury Secretary in the Bush administration to avert an economic catastrophe. In the second half of the talk, Hank shared some thoughts which really solidified our feelings about the “group think” which has a tendency to dominate investment decisions in the short run. He said, “Every other economy, including China, has more significant problems than we do.” You might need to read what he said again. Paulson was Treasury Secretary from June of 2006 to January of 2009 and had been the leader of Goldman Sachs in the years just prior. We have just spent the last two years hearing from a wide variety of economic pundits. Almost all of them have told us that the cleansing of 2007 through 2009 and the overhanging debt of the past 15 years is ushering in the decline of American economic glory. Whether it is “seven lean years” or the “new normal”, we’ve heard it and seen most of the people who manage money adopt it as the foundation of what drives their investments and asset allocation.

Kotkin piggybacks Paulson by demystifying China’s future and rebuts George Will’s recent writing about American “declinism”. He does this by sharing some economic history and by sharing key attributes of long-term economic growth.

“Rarely mentioned in such analyses is China’s own aging problem. The population of the People’s Republic will be considerably older than the U.S. by 2050. It also has far more boys than girls–a rather insidious problem. Among the younger generation there are already an estimated 24 million more men of marrying age than women. This is not going to end well–except perhaps for investors in prostitution and pornography.”

“In the longer term demographic trends actually place the U.S. in a relatively strong position. By the end of the first half of the 21st century, the American population aged 15 to 64–essentially your economically active cohort–are projected to grow by 42%; China’s will shrink by 10%. Comparisons with other competitors are even larger, with the E.U. shrinking by 25%, Korea by 30% and Japan by a remarkable 44%.”

Kotkin goes on to remind us how wrong the punditry has been in past cycles. Remember when Japan was eating our lunch in the 1980’s?

“The Japanese experience best illustrates how wrong punditry can be. Back in the 1970s and 1980s it was commonplace for pundits–particularly on the left–to predict Japan’s ascendance into world leadership. At the time distinguished commentators like George Lodge, Lester Thurow and Robert Reich all pointed to Europe and Japan as the nations slated to beat the U.S. on the economic battlefield. “Japan is replacing America as the world’s strongest economic power,” one prominent scholar told a Joint Economic Committee of Congress in 1986. “It is in everyone’s interest that the transition goes smoothly.”

He (Kotkin) then reminded all of us what could go wrong with China’s economic miracle and then shared his opinion of the future.

“China’s social problems will be further exacerbated by a huge, largely ill-educated restive peasant class still living in poverty. Of course America too has many problems–with stunted upward mobility, the skill levels of its workforce, its fiscal situation. But the U.S., as the Japanese scholar Fuji Kamiya once noted, possesses sokojikara, a self-renewing capacity unmatched by any country.”

“As we enter the next few decades of the new millennium, I would bet on a more youthful, still resource-rich and democratic America to maintain its preeminence even in a world where economic power continues to shift from its historic home in Europe to Asia.”

Are the pessimistic and dour pundits of today right this time? Should we be congregating our investments in the BRIC countries (Brazil, Russia, India and China) or dialing down our expectations for investment returns in the US investment markets because the inevitable “declinism” of the US economy has set in? This “group think” robs investors of the urge to concentrate on the strong balance sheet, wide moat and powerful brand companies which weather recessions and have more potential to be “Hall of Fame companies”. We believe anything that stops us from owning some of the best companies in the world this close to the aftermath of a terrible consumer-led recession is robbing us of future success.

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.