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William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

In his wonderful book A Short History of Financial Euphoria, John Kenneth Galbraith wrote that human beings ascribe higher and higher levels of intelligence to people based on how much money they make and business success they have. The opposite would be that a lower and lower level of intelligence are ascribe to investors and business people as difficult economic and stock market circumstances dominate the news. Charlie Munger, who is the vice-chairman of Berkshire Hathaway, told Stanford Business School MBA candidates a few years ago that psychology is the most undervalued discipline in business. I’d like to combine the wisdom of the timeless academic Galbraith and the respect for psychology from the super-successful investor Munger to ponder our current market conditions.

The stock market in the U.S. has already fallen 50% from peak to trough since October of 2007 to today. Among many admirable money managers and stock pickers, we at Smead Capital Management appear to have very little intelligence and our IQ seems to get lower by the week. This decline ranks as the worst bear market by magnitude since the 1929-32 market, which lost over 80% of its value from peak to trough.

Perma-bear, Jeremy Grantham, who because of his negative stance on the stock market over the last 10 years is ascribed a great deal of intelligence. He has written extensively recently that he believes “high quality” U.S. stocks provide good long-term value at these levels, but strongly cautions investors that these kind of psychological business crises can overshoot to the downside. He therefore urges consistent buying, but warns that the S&P 500 Index could drop as low as 600 (around 770 today) before it makes a bottom. His main reason for the concern about the downside is that negative psychology and a negative feedback loop can dictate a great deal of panic through human behavior.

It is our view that additional major downside movement in the U.S. stock market could only be justified by a much greater economic contraction than the one we have seen so far (5% contraction year to year) or a substantial increase in U.S. Treasury bond interest rates. Many of the most negative stock market prognosticators look at the market bottoms in 1932, 1974 and 1982. Those market bottoms averaged price-to-earnings ratios of 6-8 and dividends yields of 6%. The 1932 bottom included 25% unemployment and was part of four years averaging 12% year to year contraction in the economy. The economy was chopped in half in four years. The other two bottoms at those historically low average P/E ratios (1974 and 1982) saw Treasury interest rate peaks of 9 to 10% and 13 to 15%, respectively. Therefore, without a near complete collapse in the economy or dramatically higher Treasury interest rates, we don’t see those worst-case scenarios being realized.

None of this makes the bullets we are all sweating fit through our pores any better. However, Grantham points out that his quantitative models show above average returns the next seven years on the S&P 500 Index. Bargain prices on outstanding companies with bright futures outweigh the negative psychology around us and the low level of intelligence ascribed to us for saying so.

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.

If you can’t see the video above, click here to watch the segment

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

Dear Clients and Prospective Clients:

I’m fond of saying that the Math you need to succeed in business is learned by the end of 7th grade. If you can do percentages and simple algebraic equations, you can be a huge success! There are two very important areas of investing and our economy which simple math could tell you are going to change.

The first is in housing. The loans attached to housing are the “Achilles Heel” of this economy. All the securities and balance sheets which are poisoned by mortgages have at their core an unknown. When and at what price will housing bottom in the markets that dominated mortgage origination (California, Florida, Arizona and Nevada)? Those states have also dominated foreclosure statistics and provided the most toxic paper in the most egregious mortgage-backed securities market. If the demand for homes remains relatively constant, then it is the supply of homes on the market which tell you if some kind of equilibrium is being reached.

Here is the simple math. Housing starts were the lowest in 50 years in January at an annualized pace of 466,000 new homes. Don’t just pass that statistic by. MORE HOUSES WERE STARTED IN THE U.S. IN 1960 WHEN WE HAD A TOTAL POPULATION OF 180 MILLION THAN ARE BEING STARTED TODAY WITH A P0PULATION OF 300 MILLION! Home sales are up sharply in the worst performing states. There are about 1.3 million homes absorbed each year in the U.S. The inventory of unsold homes dropped recently to 9-months supply from a high of 11-months last year. The media and internet outlets want you to believe that additional layoffs and foreclosures are the key to housing finding a bottom. However, we believe those negatives are only slowing the positives in rebalancing supply and demand. With more babies being born in the U.S. in 2007 and likely in 2008 than any year since 1957, it is likely that demand is not constant, but rather is growing underneath the surface. The new stimulus bill gives an outright $8000 tax credit to first-time home buyers (anyone who hasn’t owned a home for three years) which does not have to be paid back if you keep the home for three years.

Conclusion: More demand and less supply will lead to equilibrium. Equilibrium in housing prices would clarify the underlying value of mortgages and mortgage-backed securities. Clarification of mortgage and mortgage-backed security values could define financial institution book values. Definition of “real” book values would refocus investors on earnings power. Refocusing on earnings power would restore confidence in the surviving financial institutions and the stock market in general!

The second area for discussion is gold. I read recently that approximately 75% of the demand for gold comes in the form of jewelry. If you read the reports of any jewelry company, you’ll find that the demand for jewelry is down significantly (Tiffany Christmas sales down 21%). The price of gold is up to $970 per ounce this morning and has risen over the last three months. If 75% of your demand drops by 20%, you have a loss in demand of 15% (assuming supply is constant). For prices to rise while that was going on, you needed speculators, who make up something less than 25% of demand, to have demanded everything that jewelry buyers normally demand and buy a great deal more! It is too bad for them that supply is not constant. Thanks to M.C. Hammer and Ed McMahon, people are turning in their gold for cash in record numbers; enough to justify expensive adds at the Super Bowl and all day on television.

Conclusion: Less demand and more supply of gold will lead to much lower prices at the point that speculators run out of bullets in their gun (remember what happened last summer when Oil speculators ran out of “Peak Oil Theory” bullets in the face of falling oil consumption). Those bullets are all “fear’ trade bullets. The “fear” trade goes away when equilibrium is reached in housing, the financial institutions are stabilized and some confidence comes back into our economy. We at Smead Capital Management recommend that long-term investors sell their gold before the “fear” trade disappears and before two plus two goes back to equaling four.

Best Wishes,

William Smead

William Smead
Chief Executive Officer
Chief Investment Officer

 
Dear Clients and Prospective Clients:

In his book, Day by Day, Reverend Billy Graham wrote the following: “Columbus was called mad because he decided to sail the uncharted ocean….Martin Luther was called mad because he presumed to defy the entrenched religious hierarchy of his time. Patrick Henry was considered mad when he cried, ‘Give me liberty, or give me death!’ George Washington was thought to be mad when he decided to continue the war after the winter at Valley Forge, when thousands of his men had died and other thousands had deserted, leaving only a handful of men. We have become too sophisticated and too respectable to be called mad in our generation.”

Every twenty to thirty-year stretch in the stock market includes a multiple-year sequence where it seems like those of us who stay invested in quality common stocks have gone mad. Numerous studies have come to the same conclusion over and over again. Human beings sell their stocks after big declines and buy aggressively near stock market tops. In the process, they rob themselves of a large part of the benefit of owning common stocks. Ibbotson measured the return from 1926 through 2007 at around a 10% return including dividends on the S&P 500 Index. Numerous studies show that investor enthusiasm in the form of mutual fund purchases at the top and investor pessimism in the form of mutual fund redemptions at the bottom caused those investors to dramatically underperform the long-term results of the funds they owned.

Is an investor more likely or less likely to make the historical return of 10% from here forward? We believe the math, the history and the crowd psychology all say that it’s more likely. Do we know what we have to put up with to get it? The answer is no. Much capital has been temporarily lost while many investors have deserted the stock market and are sitting on a record amount of cash relative to total stock market capitalization.

Warren Buffett is the greatest investor of all time and many articles are being written about him. They infer that he has gone mad to be buying into strong companies and is recommending others buy as well during this tough economic period (“Buy American, I Did”, New York Times Op-Ed October 16, 2008). We at Smead Capital Management believe that we have never owned more attractive companies at better prices than today.

We must have gone mad!

Best Wishes,

William Smead