“The weakness in the dollar is going to be incredibly good for the large drug companies over the next three to five years, as the emerging market nations load up brand new hospitals and brand new health clinics with products. We want to provide that to them.” – CIO Bill Smead
William Smead
Chief Executive Officer
Chief Investment Officer
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Dear Fellow Investors:
1982
The stock market bottomed in August of 1982 just below 800 on the Dow Jones Industrial Average (DJIA) during the worst recession that had occurred since the 1950’s. Unemployment exceeded 10%, smokestack industries were decimated (remember Billy Joel’s “Allentown”), housing and forest products were in a depression (foreclosures up dramatically), auto sales almost sank both Chrysler and Ford, interest rates peak at 15% on Treasury bonds and the U.S. had lost its respect around the world. The stock market had peaked in late 1972 at 1000 on the DJIA and investors could look backward and see how fruitless investing in common stocks had been for the prior decade. Business Week had called it the “Death of Equities” on a late 1979 cover.
Wise economic commentators explained in 1981 and 1982 why we could not have any meaningful economic recovery. Unemployment kept going up for months after the stock market exploded to the upside. Housing affordability was at a 38-year low. Credit needed to buy houses, cars and expand business was at such high interest rates that it seemed like nobody would want to borrow the money. Many of the home buyers and businesses who did borrow the money failed to keep up with the interest expense, damaging bank balance sheets in the process. Huge federal budget deficits were going to be exacerbated by the Reagan tax cuts. The government’s borrowing was crowding out private borrowers. Banks were competing with money market funds. The disintermediation of the banking industry forced them to pay competitive interest rates on a relatively new instrument called a Certificate of Deposit (CD). It appeared highly unlikely that a strong economy could get born in those miserable circumstances.
2009
The stock market bottomed in March of 2009 at around 6500 on the DJIA during the worst recession since 1982. Unemployment has reached 9.8%, most cyclical industries have been devastated. Auto sales dropped so low that Chrysler and General Motors went into Chapter 11 bankruptcy. Retail sales have been “reset” to markedly lower levels. The U.S. has lost its respect around the world. Homes have fallen in value more than at any time since the 1930’s. Looking back ten years, investors have suffered losses and many commentators are referring to the first decade of the 21st century as the “Lost Decade” for stocks. Numerous asset allocation experts are advising people to reduce their portfolio weightings in stocks and increase ownership in bonds. We believe this advice is being acted on. Bond mutual fund sales have run more than 20 to 1 ahead of equity fund sales since the start of the year.
Huge budget deficits exacerbated by the U.S. Treasury’s TARP program and the Federal Stimulus Bill have convinced economic experts and commentators that whatever economic recovery comes could be accompanied by much higher levels of inflation. Many economists believe that the huge debt overhang left from the prior cycle, which equals around 375% of GDP, will serve as a drag on the economy for years and mute the magnitude of an economic recovery. Banks have such large write offs from the bad loans made in 2002 to 2007 that they are pulling back from lending to even creditworthy borrowers or asking for traditional down payments and collateral levels. Compared to 2007’s levels these requests look onerous. It appears unlikely that a strong economy can get born in these miserable circumstances.
Pick Your Poison
Therefore, which is worse? An economic recovery which requires people to borrow money at ridiculously high interest rates from crippled banks, when houses are the least affordable that they’ve ever been? Or an economy where houses are the most affordable and the mortgages have the lowest rates they’ve had for 50 years from crippled banks in a society that already has seemingly unsustainable overall debt levels? Pick your poison. Did I forget to mention that the first incredibly miserable circumstance was the beginning of one of the greatest bull markets in U.S. stocks in history (1982-1999)? Did I forget to mention that the economy grew immensely and relatively consistently for 25 years? At Smead Capital Management, we don’t believe all the doomsayers out there who say, “It is different this time”. We think that a weak economy going forward is a “Well Known Fact” and is already factored into current prices.
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. 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
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Dear Fellow Investors:
We are witnessing one of the greatest battles to control the hearts and minds of investors that we at Smead Capital Management have just about ever seen. In one corner you have PIMCO and their fearless leader Bill Gross, buying longer-term Treasury bonds. They see the world as a giant game of deleveraging as the large U.S. government and household debt is worked off in a muted economic recovery. They see a “new normal” set of spending patterns and higher savings rates leading to slow growth rates and low levels of inflation or possibly deflation. It is our opinion that PIMCO and Gross have been super successful, outperforming other bond market participants for years in one of the best bond investing eras in U.S. history. The amount of money they manage has reached legendary proportions and they have huge influence in the debt markets in which they maneuver.
In the other corner are such heavyweights as Warren Buffett, James Grant and Julian Robertson. Buffett is actively buying stocks in the U.S. He fears that inflation is a natural by-product of all the efforts of the Federal Reserve Board and U.S. Government to stimulate the economy. James Grant, one of the best writers and contrary thinkers in the money world, recently shared his opinions in an op-ed piece in the New York Times. Looking back at history, Grant surmises that the deeper the recession the more explosive and powerful the two to three-year economic rebound has been. He sees the large camp of economists assuming a poor/jobless recovery as a good psychological signal. Julian Robertson, one of the deans of Hedge Fund investing, is short U.S. Treasuries across the board and sees very high interest and inflation rates coming as a consequence of quantitative easing and Federal stimulus efforts. Who should you/we believe?
First, I’d like to give you our SCM caveats. We believe that the merits of the companies we invest in based on our Eight Criteria are the most important factor in how we will do over the next ten years. Second, we don’t believe we can predict the stock market or the economy. We like the fact that our criteria has the tendency to find strong balance sheets, powerful brands, high free cash flow generators and wide moats, because they are more likely to withstand whatever environment plays out.
With caveats in hand, here is SCM’s feeling about the arguments from these titans. Bond mutual funds have been receiving $20 of inflows for every $1 received by equity funds since the beginning of March. In our 29 years, we have virtually never seen that kind of overwhelming popularity get rewarded over the next three years. Therefore, Bill Gross and PIMCO look due to have the markets they dominate become more difficult. Since 1984 we have had a huge bull market in Treasury bonds as they peaked at 14% interest rate. At 3.4% today, PIMCO has mathematics working against them. Near the end of the 1982 to 1999 era, Warren Buffett and common stocks were enormously popular. Buffett spoke in Sun Valley to a group of business owners and executives who had been made mega-wealthy by the bull market in stocks. He told them that stocks would do poorly from then to 2016, if history was any guide. He was spot on, as the next ten years proved to be one of the worst decades in U.S. history for stocks. I don’t hear PIMCO saying anything vaguely similar about bonds today.
We don’t agree with Julian Robertson, primarily because of the speed and magnitude of interest rate increases he is advertising. He looked on T.V. the other day like someone who had a big position going and wants to by-pass the normal holding period to see it succeed. There is little evidence that the over-capitalization of the banks in the U.S. is resulting in any meaningful lending and debt monetization (read “Monopoly Money”). We believe the inflation he fears appears to be years away, not months.
Last, but not least, is James Grant. We believe that he has a few powerful forces working in his favor. The economic coma we entered last year in September lasted until the end of March of 2009. Any discretionary economic activity which occurs in the next six months could cause fairly sizable economic growth numbers and possibly boost consumer confidence and hiring. Maybe as important is how unequivocally negative most market participants are about the long-term future of the U.S. economy. I was around in 1982. There was as much disbelief in the possibility of a rousing long-term comeback in the U.S. economy then as there is now. As fellow contrarians, we believe he must be taken seriously. We should harken our thoughts to some of the widespread belief on the part of investors who may be adding more smoke to the “Mythical Argument.”
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. 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.
