William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

I’ve seen West Virginia’s Men’s Basketball team play four times in the last two weeks. The first time was live at the Big East Tournament and the last three in the NCAA Tourney on TV. Close observance of them has helped us at Smead Capital Management to be even more excited about our investment discipline.

West Virginia has quality players. These players are molded into a team by a hard driving coach, Bob Huggins. But what got them to the final four is that they run their offense. They not only run it, but they actually set the screens that are required. I have been a rabid basketball fan for over forty years and can’t remember better picks being set. They are wearing out the other teams physically and getting much easier shots in the process.

To us at SCM, this speaks to the fundamentals of successful investing. Buy quality common stocks and do it inside your circle of competency. Let the businesses operate for years, executing the kind of business plans which can be built on for decades. Do it in businesses which sell products and services again and again and again.

Setting a good screen is 90 per cent effort and 10 per cent talent. Finding a coach and players willing to do it is unusual, but could be done by anyone truly committed.

Think of companies we own like Starbucks, Disney, McDonalds and Walgreens. They provide products and services in the same clean and consistent way all over the US and around the world. They wear out the competition through branding, balance sheet strength and scale in the same way the Mountaineers have done through well-placed screens and consistent defense in this tournament. We at SCM like those kind of fundamentals on our side.

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:

“Hoarders” is a popular TV show currently. It tells the story of people who buy and collect things and virtually never throw anything away. As we look out to the rest of 2010, some of the lessons from the show could help us as investors over the coming years.

Like most addictions or idolatrous behaviors in a person’s life, hoarding starts out with the best of intentioned purchases. None of the original items, be they knick knacks, clothing or even collectibles are in and of themselves harmful. Unfortunately, hoarders don’t stop there. They continue to buy new things and never throw anything out.

In the US investment markets there has been some major hoarding going on the last five years. First, between 2004 and 2008, US investors hoarded Oil, Basic Materials and Heavy Industrial company’s common stock and international mutual fund shares to participate in the popularity of the emerging stock markets like Brazil, Russia, India and China (the BRIC trade).

Second, US households and corporations hoarded Treasury Bills and Money Market Funds during the market meltdown between October of 2007 and March of 2009. In a recent Barron’s’ article, money manager William Priest points out that the ratio of cash to total assets surged to 35-year highs for both non-financial corporations and households. Since March of 2009, they have been hoarding bond Mutual Funds, despite the stock market marching upward. Various reports from Lipper and Morningstar have reported net inflows into bond funds at $350-400 billion, while US stock funds and ETFs saw net liquidations.

On the TV show, extreme problem hoarders end up with a great deal of useless trash in their house. The piles of junk collect dust and have no value to future buyers. It would be one thing to hoard works of art from Picasso or Chihuly, but the folks on the show buy and keep things that nobody else ends up wanting.

At Smead Capital Management, we watch what the crowd is hoarding and try to avoid those popular areas. Bond funds and most investments tied to the BRIC trade appear as over-crowded as the dust covered rooms in the TV show. Simultaneously, the lousy results of the last ten years have caused investors to avoid the kind of Hall of Fame companies we like. In our opinion, these works of art can make us wealthy by buying and hoarding their shares for ten years or longer until the building gets overcrowded. We have formed museums (portfolios) to collect what we believe are “works of art”. We do this under the assumption that the companies that meet our Eight Criteria will successfully execute their business purpose and plans. In so doing, they grow their earnings and free cash flow. Ultimately, the hoarders of cyclical businesses, commodities, emerging markets, money market funds, T-bills and bond funds may someday have to look at what they hoarded and reevaluate what creates long-term wealth. This could cause a transition away from formerly useful investments into the kinds of “Hall of Fame” companies we like.

If interest rates in the US rise for many years and/or China’s economic growth slows down, we believe you should watch for a giant yard sale in bond mutual funds and the BRIC trade. Hoard quality when it is out-of-favor and avoid holding Hall of Fame companies only when maniacal pricing threatens to turn future returns into junk.

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.

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.

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.