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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:

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

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

Before the next ten years of successful stock market investing gets away from us, we at Smead Capital Management would like to remind everyone that the purpose for investing is to build wealth to enhance future purchasing power. If you watch investment shows on T.V. or read investment magazines, newspapers or websites, you’d think that the object of the game is to be smart. However, let’s look at some of today’s key topics to see what is currently considered dumb and smart in the investment world. Then, let’s ask if they build wealth over long periods of time.

Ultra-Smart—Sitting in Cash, preferably U.S. Treasuries.
Those who were smart in 2008 held inordinate parts of their assets in cash or treasuries and missed some part of the stock market’s horrendous decline. They earned anywhere from 3% interest to as low as 0% toward the end of the year. It can be a very smart strategy in the short run, but has always been blown away as soon as everything returns to something more normal. We believe when normality returns those who sat in cash will have to stare longingly at the portfolios of their “dumb” friends who sat through abusive declines in the value of their blue chip stocks to get long-term returns averaging 10%.

Smart—Trading in and out of stocks.
Wade Cook hasn’t been out of business that long, but it is hard for you all to remember his advertisements which told people to “cash flow” their stocks. He said, “Buy a stock at $1 and sell it at $2, wait for it to go back down to $1 and do it again.” Wade spent time in jail for his misrepresentations, but the “Fast Money” people or Jim Cramer’s followers won’t. You’d have to be pretty “dumb” to sit through last year’s volatility when you could have been trading the enormous market swings (mostly down swings, they fail to mention). I think that if you add up the gains and losses, commissions taxes and you find that trading almost never builds wealth (unless your Charles Schwab).

Smart—Participating in highly sophisticated and esoteric asset classes.
Commodities, hedge funds, private equity, emerging international markets, short selling and the like always look and sound smart because of the exclusivity and complexity. The exclusivity and complexity contributes to dramatically higher participation costs (a leading cause of wealth destruction) and who knows if anyone ends up building wealth (see Bernard Madoff).

Smart—Gold.
Gold was $1000 an ounce when I was in college 30 years ago. It is $870 today. Am I missing something?

Dumb—Buy and Hold Blue Chip Stocks.
How could anyone be so dumb as to buy and hold the finest companies in the world like Disney or Microsoft or Nordstrom? Don’t they know that we have the worst recession since the 1930’s? Don’t they know what Professor Roubini says? Haven’t they been in China with Jimmy Rogers? Didn’t they see how bad it was last year?

Dumb—Buy American Stocks
Everyone knows that the smart people are investing in China and emerging markets! They must know that Warren Buffett will be wrong this time (NY Times Op-Ed Oct. 16, 2008—Buy American, I did). Didn’t he get wealthy?

Dumb—Leaving your stocks to your alma-mater.
I love reading the stories of the elderly man or woman who leaves their stock certificates to their favorite charity. A schoolmarm who left the school millions or the guy who left the Union Gospel Mission thousands and thousands of dollars of utility stocks buried under his mobile home. It was never gold or trading techniques or complex investments they left, it was common stocks.

At any given time the best investments can look smart or dumb depending on when you look and where we are in the market. However when traditionally solid wealth creation disciplines are challenged, it could be time to get excited. We love what we do at SCM and we hope you all join us in this worthy and hopefully wealth building endeavor.

Happy New Year!

William Smead