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William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

Benjamin Graham wrote the most important book on the analysis of common stocks (Security Analysis), as well as the most important book for stock market investing and portfolio management (The Intelligent Investor). His pupil, Warren Buffett, has repeated one of his main concepts many times for us and it has probably never been more valuable than today.

Graham compared the stock market to a partner you have in the ownership of a business. This partner would voluntarily set a price everyday at which you could buy his half of the business or sell him your half. You never asked him to establish this practice. He did it on his own volition. When business conditions were poor, he would set the price very low because he was concerned that you would stick him with the other half of the business. At the time the business is booming, his price is very high because he is afraid you will take his bright future away by buying his share of the company.

Mr. Market is on barbiturates (downers) right now because we are in a once in sixty year business coma which includes a deep, long recession and credit crisis. He is setting a very low price on the greatest businesses that have ever graced this planet because the business climate has contracted, households are pulling back and companies are reducing expenses. The most effective tool for reducing expenses is to reduce staffing. We now have a negative feedback loop and we wonder whether we are going to do business with each other anymore. He is setting the price very low.

Let me help you understand Mr. Market by looking at his behavior ten years ago on a couple of companies which he reduced his price on last week. In 1999, Microsoft traded at 60 times profits and Mr. Market envisioned back then that they would grow their profits immensely in the next ten years. A deep recession was nowhere in sight back in 1999. He was afraid that his partner would buy it away from him, so he set a price over $50 per share. Last week the stock dropped to $17 and the price to earnings ratio dropped to 9. The earnings did grow immensely the last ten years. He is afraid you are going to stick him with the other half of the business even though they have $20 billion in cash on their balance sheet and gush $12-15 billion each year in free-cash flow. He is afraid that our economy won’t make a comeback like it did from the other deep, long economic contractions of the last 233 years.

Mr. Market is even more depressed about his Ebay ownership. Back in 1999, he thought that by 2009 this small but profitable auction website business could dominate its category and produce massive free cash flow from facilitating the movement of pre-owned goods from buyer to seller at auction prices. The stock traded at $80 per share and well over 100 times profits. He was very concerned his business partner would buy it away from him, so he set a very dear price. All of his belief in the company was justified as they produced free-cash flow of $2 billion in 2008. However, the current business coma has caused sales activity to contract at even the bargain counter for items like pre-owned golf clubs. Mr. Market is afraid things won’t ever improve and he has set a price for the stock around $12. This gives them a price to earnings multiple of around 8 and a free-cash flow multiple around 7.5.

They own PayPal, the most successful payment system on the internet and five of the six largest online classified ad businesses in the world. In their spare time they own Skype and 25% of Craigslist. Did I forget to mention that have $3 billion in cash, no debt, no inventory, no pension liability, zero stores and own Bill-Me-Later? Mr. Market needs to go to Joel Osteen’s Church (the author of “Your Best Life Now”) for awhile and get his attitude rearranged. So what if business is crummy for a year or two? When my kids are my age, everyone will be tech savvy and PayPal could rule the world as the ultimate toll bridge.

At Smead Capital Management, we want investors to understand the enormous opportunity this market is offering participants to buy him out of his half, and implore those on the sidelines to hit the low bid of Mr. Market!

Best Wishes,

William Smead

The securities identified and described in this missive 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

Dear Clients and Prospective Clients:

We know that we have been in an “economic coma” for the last three to four months and almost every business and individual household is retrenching. Since we are raising our savings rate and reducing our consumption, most businesses are reducing employment. Simultaneously, investors are hoarding low interest rate vehicles like T-bills, CDs and money market funds. They are also not being enticed by depressed stock prices and high corporate bond rates to make the investments they would normally make. Warren Buffett describes it as a “negative feedback loop”.

At Smead Capital Management, we have done a great deal of analysis on past major market declines coinciding with deep economic contractions. We believe that corporate survival and brand perpetuation are the most important issues. For that reason, we are focusing on owning three kinds of large capitalization companies:

1. We own companies with no debt and billions in cash sitting on their balance sheet. Their earnings might be disappointingly lower than the previous year (Microsoft, Ebay, Starbucks), but since they are still very profitable, gush massive free-cash flow and have billions in cash on their balance sheets, the survival of the company is not a part of the discussion. For us this also includes companies like Accenture and Amgen.
2. We own companies which have debt, but have massive amounts of cash on their balance sheet. They also have the ability through free-cash flow to retire their debt over a short number of years. This group includes Merck, Pfizer and Abbott Laboratories. Some of them will have impressive earnings, but most will be disappointing compared to last year at the same time.
3. We own companies which have less cash than debt, but have such reliable businesses and customer bases that we feel their survival is not in any way threatened by the current circumstances. Disney, WalMart, AT&T and Verizon would be good examples. Let’s consider Disney for just a moment. They will definitely be hurt by attendance at theme parks in 2009. What could be easily neglected is that we are going to be staying home more and watching High School Musical or ESPN. Disney (which owns ABC and 80% of ESPN) rakes in a greater and greater share of advertising dollars as it dominates wholesome family entertainment through cable, movies and network television. For companies like AT&T and Verizon, cell phone service is probably the last expense cut in an unemployed person’s home.

We do not know when the bottom will ultimately be established in the stock market during this very difficult phase. We believe that those who focus on quarterly earnings reports and stock price declines will not enjoy the wealth creation that comes as the stock market leads us out of this “economic coma” . We believe this cleansing of epic proportion in both consumer and investor attitudes plants the seeds for a long and healthy bull market.

Best Wishes,

William Smead

Disclosure: The securities identified and described in this missive 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

Dear Clients and Prospective Clients:

At Smead Capital Management we are strong believers in owning high-quality recession-resistant common stocks and holding them for many years to create wealth and meet economic needs. Normally, the finest of the U.S. banks are a great way to make dividends and ultimately see capital appreciation. However, the current efforts on the part of the U.S. Treasury to stabilize our financial system seem to be having a detrimental affect on the common stocks of exactly those banks which the Treasury wants to build our financial system around. We are adjusting to this new reality and let me explain.

One of our eight criteria for selecting companies is shareholder friendliness. Is the company allocating capital, paying and/or raising dividends, buying back stock and making effective acquisitions in a way that is friendly to shareholders? In the case of a JP Morgan or a Wells Fargo, the answer to that question in the past has been absolutely. But in the new environment of Treasury intervention their past record appears to be breaking down. When the Treasury is giving you money to invest and wants you to loan it out, can you buy back stock when a lousy market environment drives your stock price lower? When a current negative feedback loop exists in the economy where one company’s layoffs lead to layoffs of others companies, doesn’t that put further loan write downs at the bank in position to make it hard to pay the dividends? When this all played out at Washington Federal Savings and Loan here in Seattle recently, it was a warning shot across the bow. Nobody has been more conservative about lending, credit quality and expense control than Washington Fed, but they were asked to take TARP money and cut their dividend soon after by 76%.

The problem is we are using for-profit institutions to produce goals for a non-profit institution and the companies are being run for the social good rather than for the shareholders. Investments in these great companies are being diluted and the rewards for their survival and future prosperity are being pushed out further into the future. This is because they aren’t being controlled by outstanding management people like CEO Jamie Dimon or John Stumpf, but rather have had control put in the hands of the U.S. Government. We are re-researching all of our financial companies to see if these dynamics are in force and could be detrimental to our capital over the next 12 months. With a plethora of great companies which meet our eight criteria available out there and unaffected by Treasury intervention, we think the opportunities could work in our favor until the time comes when we can understand the affect on shareholders and management friendliness of this new business model.

Best Wishes,

William Smead

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

As we start the year in the financial markets it appears that there are three distinct approaches being taken by those who normally invest. Since we believe the markets try to do whatever they have to do to frustrate the most people, let’s look at what would frustrate these three camps.

The smallest but most vociferous groups are those who think that this situation is most similar to 1930 through 1933. They believe that our economic difficulties will not allow a major improvement in the stock market for as long as two years. They think we will most likely retest the low in the stock market of November 20th of 2008 and very possibly go even lower. I think the strength of their argument is how cheap stocks got at the lows in 1974 and 1982 and their weakness is how much lower inflation and interest rates are today than back then and how much discounting a 50% peak to trough decline already did.

A large group today believes that sitting in cash or near-cash is the right thing to do. They kind of know in their hearts that things are cheap and attractive for purchase, but they are so traumatized by last year’s decline that they can’t bring themselves to stay in the saddle or jump back in. They also think they can’t take the psychological damage that an additional decline (predicted by the smallest group) in prices would do to their stock portfolio. The strength of their argument is that you can’t lose anything while they sit in the cash and the weakness is that nobody will ring a bell to get back in and they will likely miss the first two years of the next major U.S. bull market in stocks.

Nearly as large a group is the third one which includes us at Smead Capital Management. Folks like us want to own these common stocks for decades and enjoy what doing that normally brings. We are the traumatized optimists who wish we had received divine intervention one year ago (or listened to the divine intervention we got) and got out of the market. However, we don’t have too many regrets because we feel that long-term investors like us are going to get hit by one of these massive declines and cleansing processes every twenty years or so and it is a necessary part of admission to wealth creation. The strength of our argument is the history of investment markets and the economic history of the U.S. The weakness is we have no idea when the next great stock market will begin.

Therefore, what would frustrate the most people? A flat market or additional decline would make the first two groups happy and us sad. A huge move to the upside would make the buy-and-hold crowd like us very happy, but would frustrate everyone else. A grinding, slow and volatile recovery which takes three years and gains back everything lost last year would be similar to what happened after the 1987 crash in 1988 through 1990. It would frustrate the folks who are anxious to get their losses back quickly (like us) and leave the other two camps on the sidelines missing potentially double-digit returns. We believe this might be 2009’s most likely scenario.

In a 1995 interview in Forbes, Sir John Templeton explained his investment philosophy. He said, “People are always asking me where the outlook is good, but that’s the wrong question. The right question is: ‘Where is the outlook most miserable?” Put us with the traumatized optimists.

Best Wishes,

William Smead