William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In the Bible’s books of Genesis and Exodus we are told that as Prime Minister of Egypt, Joseph was wise enough to store up massive amounts of grain in a seven–year prosperity period. When the seven-year famine followed, his family came to Egypt to buy food. After revealing himself as their brother, Joseph’s family, the Hebrew people, moved to Egypt to live. They successfully got relief from the famine, but chose to stay and live in Egypt long after the famine had ended.

This is a perfect picture of what has happened to US institutional and individual investors over the last eleven years. A seven-year prosperity period, led by a boom in everything technology oriented, ended in 2000. Stocks, as represented by the S & P 500 Index, were the most over-priced that they had been since 1929 and 1972. Beginning with institutional investors who had the resources to do so, the money was moved to Egypt in the form of a variety of other asset classes. Bonds, emerging stock markets, gold, commodity indexes, oil, small cap stocks and a wide list of illiquid “alternative investments” all became populated with the money which fled the large-cap US stock market famine. Soon, all the major financial advisor, registered investment advisor and institutional consulting firms created strong systems to move institutional and individual investors to Egypt. For individual investors, the most popular destination for the money has been bonds, CDs and money market funds.

Long after benevolent leaders like Joseph had died, Egypt eventually was led by people who enslaved the Hebrews and put them to work building monstrous orifices like the pyramids. These gigantic undertakings were heavy on the manual labor and unbelievably time consuming due to the limited technology of that era. The more the Hebrews complained, the more burdensome the Pharaohs of Egypt made their work. The Hebrew people screamed for a savior to lead them out of bondage. Unfortunately, the time to get out of Egypt was long before the people had become enslaved. It was as soon as the end of the famine allowed them to prosper in Israel, the “land of milk and honey”. The land promised them by God.

Ten-year Treasury bonds have paid 2% or less for much of the last year. Since the stock market famine’s peak consternation in late 2008 and early 2009, every stock market decline in 2009-2012 has been met by a mad dash to the bond market. This is only a good idea if there isn’t money to be made where they started out in the first place. Stocks, as measured by the S&P 500 Index, trade at 13 times consensus estimated earnings. This puts them below the historical average of 15. Secondly, stocks have performed quite well in the last three years and have represented the fact that prosperity has returned to the asset class that people came from originally. Thirdly, stocks pay a higher dividend than the ten-year Treasury bond and all other secure bond investments like CDs.

All hell had to break loose in Egypt to get Pharaoh to release the Hebrews from bondage. God brought ten plagues onto Egypt. The Egyptians were abused by everything from bloody rivers to insects/pestilence, to the death of their firstborn sons. The Hebrews had to walk across a peeled back Red Sea and wander in the desert for 40 years to get back to the “promised” land.

The last time that ten-year Treasury bonds hung around 2% was in 1950. Stock investors had suffered the plague of the “great depression” and the plague of World War Two. First, the entire financial system was challenged and then folks had to wonder if they were going to have to learn to speak German or Japanese. From 1951 to 1981, those who stayed in bonds (bondage) were punished by multiple losing years in the bond market. This all culminated in 11% inflation and five consecutive years of losses from 1977 to 1981. Ten-year rates peaked at 15% in 1981. Bonds had done so poorly that nobody wanted anything to do with long-term bonds.

The last indignation for the Hebrews during their time in Egypt was being asked to create bricks without straw. Pharaoh doubled the labor and the misery. This is exactly what the bond market is asking institutional and individual investors to do. Bond investors are seeking “fixed income” with no interest. Their financial advisors and consultants are being asked to create something out of nothing.

The chart below shows 20-year Treasury bond performance annually since 1925. From 1951-1981, there were 17 years that investors lost money in long-term Treasury bonds. The plagues on bond investors during those years were especially vicious from 1955-59, 1967-69, 1973-74 and the aforementioned 1977-81. Are today’s institutional and individual investors going to invite similar plagues over the next 30 years or will they get out of bondage?

Source:  InvestorsFriend.com, Stocks Riskier than Bonds, February 14, 2011

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

Printable Version

Dear Fellow Investors:

moat/mōt/
Noun:   A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.

At Smead Capital Management our investment committee talks and thinks about the moat of a business a great deal. Based on the definition above, we believe that a wide moat is provided by the aspects of the company and their business which prevent competition from damaging highly sustainable profitability. Wide moat is one of our eight proprietary criteria for selecting common stocks. We have seen a number of organizations begin to include logic associated with moats into their equity research formats. Unfortunately, we believe many market participants confuse the by-products of a moat with the actual moat itself. We think this spells opportunity. Looking for stocks with a wide moat that are priced as if they don’t have one adds to the advantage of the long-duration common stock investor.

I read recently that after years of trying and millions of dollars invested, Google (GOOG) is considering folding Google Wallet and Google Checkout together. When it was announced five years ago, Google Checkout was thought by some to be a potential “PayPal killer”. PayPal appears to have successfully defeated one of the largest cash-rich, wide-moat companies in the world from getting into its secure, online payment castle. PayPal’s moat includes over 100 million existing customers, consumer brand recognition and nearly a decade of statistical information on transactions. Google has the same kind of moat in search that PayPal has in payments. The economic need that PayPal meets is identification privacy and ease of transaction facilitation. It’s a huge market and will grow tremendously in the next ten years. We believe as Google admits defeat, it will mean that the moat at PayPal is so strong that it can’t be overcome by massive financial resources and tech savvy. Google had both of those merits.

PayPal is a wholly-owned subsidiary of Ebay (EBAY). Ebay has a wide moat in its core marketplace business. Ebay is one of the most recognized brands in the world and most of its advertising is free thanks to the lock it has on market share for pre-owned items. When an athletic milestone is reached, the ball or puck or jersey is expected to immediately be offered on Ebay. Sportswriter’s frequently mention this fact in their writing. When Michael Jackson dies, his memorabilia becomes an instant hit on Ebay. This moat makes the low-risk, high free-cash flow nature of Ebay’s original business nearly impregnable. After backing out the cash net of long term debt, Ebay trades for 11 to 12 times the 2012 consensus earnings estimate. It is very unusual to see a fast-growing, wide-moat business trade for anything short of a premium to the S&P 500 Index multiple.

The symptoms of a wide moat are things like high, sustainable profit margins, huge market share, pricing flexibility and long histories of these identifying characteristics. However, the symptoms are not the moat. The moat causes the symptoms. Walgreens (WAG) is one of the two largest drugstore companies in America. Their properties dominate the best locations in the US, their brand recognition is the highest in the industry, their real estate ties up very little of the company capital and they have decades of experience in customer needs and satisfaction. Their financial muscle puts them in position to buy Duane Reade and walk away from Express Scripts. A college buddy who did extensive research on the subject told me that one out of every two Americans will never get a prescription filled outside of the walls of a drugstore. Walgreens castle is being attacked by a disagreement over pricing with Express Scripts and their moat is very busy defending the company. We think it will succeed.

HR Block (HRB) has spent the last ten years fighting off the attacks of Jackson Hewitt and Liberty, two tax prep companies started by former HR Block employees. My favorite test for a moat is putting 100 people through a survey. You ask them, “What is the first thing that comes into your mind when the surveyor says tax preparation”? Almost everyone will say, “HR Block”. If the question was online payments, it’s PayPal. If it is, “where do I find pre-owned items, or sporting event tickets?” the answer is Ebay. If the question is, “who do I trust to entertain my children and spouse?” it is Disney/ESPN (DIS). If the topic is coffee the answer is Starbucks (SBUX), burgers it’s McDonalds (MCD), retail service and selection it’s Nordstrom (JWN). The moat in business is about deeply, rooted competitive advantages which business cycles can’t uproot. It is about a love affair between a company and an addicted customer base which grows as population grows.

Warren Buffett was asked by the Financial Crisis Commission what one single characteristic he looks for in a business. He referred to the stickiness of the customer and the company’s ability to raise prices without affecting unit sales. We feel the moat of the business is what protects the ongoing success of a business even when legitimate competition comes along. It is what is behind wonderful long-term profitability and high levels of free cash flow. Moat analysis is not about number crunching, it is about mind-space control and forces which block or kill competition.

Lastly, we at SCM are value investors. Something very difficult has usually had to happen to open the door for us to get a good entry price on common shares of a wide-moat company. Ironically, in many cases, the temporary reason for the disfavor actually increases the size of the wide moat. Big pharmaceutical companies have had the most hostile political, regulatory and legal environment in the industry’s history the last four years. Major drug stocks have seen blockbuster products lose their patent and the combination of the aforementioned forces have brought many drug stocks down to the lowest PE quintile (bottom 20%) in the S&P 500 index. Instead of doing permanent damage to companies like Merck (MRK), Pfizer (PFE) and Bristol Myers (BMY), these circumstances have increased the depth and width of their moat. It is estimated that a new drug costs over one billion dollars to create and bring to market. Nobody besides these large pharma giants can afford to fight the battle. This high original investment threshold has turned the biotech industry into mostly farm teams feeding the major leagues. Smaller drug and biotech firms do research for creating wonderful new health science and are forced to hand it off to someone with deep pockets and an international manufacturing and sales force. Now that companies like Merck and Amgen (AMGN) are having great success with new products, the naysayers can begin to recognize how incredibly well defended these companies are from competition going forward. We believe they have wide moats.

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

Printable Version

Dear Fellow Investors:

Last week the Federal Reserve Board released the minutes of its meetings in 2006. There were discussions of the current economy, numerous credit tightening moves and a consistent belief in the idea that the US and its policy makers could engineer a “soft landing” from our grossly over-heated residential real estate bubble. As we now know, the landing that we had from our real estate bubble was the hardest landing since the “Great Depression”. In the opinion of Smead Capital Management, this is all symptomatic of free market capitalism and the way the economy cleans itself after years of excesses. It is not an indictment of the Fed or any monetary authority in other countries. Here are a few examples of quotes from these meetings in 2006:

March 27-28, 2006—(Ben Bernanke) “Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to-quarter fluctuations,” Bernanke says. He identifies housing as a crucial issue, but adds that he agrees “with most of the commentary that the strong fundamentals support a relatively soft landing in housing.

May 10, 2006—(Ben Bernanke after being warned by Board Member Susan Bies about securitization risks) Bernanke acknowledges the risks, but doesn’t sound overly worried: “So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy.”

Dec. 12, 2006– The meeting that closes out the year sees policymakers showing little rising awareness of the storm coming their way. Indeed, much of the conversation officials have was about employment and inflation. Some of the evidence of rising weakness in housing was seen largely as a correction for past excess, rather than the genesis of the worst financial crisis since the Great Depression.

The US Federal Reserve Board has been trying to smooth out business cycles for almost 100 years. By late 2006, our monetary policy makers were not close to understanding the problems the economy was facing from the meltdown that the residential real estate market was going to create.

Why was our landing so hard and what can be learned as you analyze other massively overheated real estate markets like China? First, everyone believed and got caught up in the mania. From the first-time homebuyer to the investors owning multiple homes to the condo flippers, nearly everyone bought into the idea that real estate only goes up. Second, there was no geographical diversification safety. Florida, Arizona, California and Nevada were the most over-heated, but every state allowed too much debt to get attached to its homes. Third, the banking system got poisoned. Loan losses critically damaged the balance sheet of the major mortgage lending and securitization companies. It was so wide spread that the states of Illinois, Georgia and Washington have ranked in the top five states for the most bank failures even though they didn’t have the worst performing price action. Lastly, the liquidation in the stock market in 2008 and drastic fall in consumer confidence allowed the breaking of the real estate bubble to deeply impair the entire economy.

The chart below shows us where we are in China at the end of 2011 compared to other housing bubbles in the last thirty years:

Source: “Between Errors of Optimism and Pessimism” GMO White Paper September 11 by Edward Chancellor

China’s real estate bubble has had nearly everyone believe in it and has had additional forces driving it. The belief is first driven by movement of Chinese citizens from rural areas to the cities. The popular myth is that 20-30 million people are moving to the cities each year. According to work done by Kynikos Associates, less than a total of 120 million individuals have urbanized into China’s urban centers since 1998. The mythical part is not directional, but magnitudinal. The urbanization levels are closer to 9 million a year, which is a far stretch from the 20-30 million believed.

The real estate bubble has happened all over the country and has spread to every town of over one million people in China. Beijing and Shanghai are the most populated and have seen prices reach the most extreme multiples of household income. A lack of trust in stocks and low interest rates in banks have driven Chinese citizens to invest in what is close by and easier to understand. Private property investments have only been around for ten years and they had only gone one direction in China until last summer.

Most of the housing built in the last ten years in the major cities has been condominium projects. These developments have been funded by the four largest government owned banks in China. These loans are made to special purpose entities formed under the blessing of local municipal government officials. Of these loans made in 2009-2011, the range of estimates of loan losses on these projects runs between 70% (former party official Yin Zhongqing) to 30% (Fitch). Since these loans are equal to $2.5 trillion US dollars, it means that between $750 billion to $1.75 trillion could be written off by the four largest government owned banks in China. This would wipe out the equity of these banks many times over.

Lastly, we believe that when someone finally yells “fire” and there is a rush to sell out of the ownership of multiple condo dwellings, prices will plummet in China. When prices plummet, then consumers in China will back off aggressively. Simultaneously, a huge credit contraction will unfold and China will be faced with a deep recession/depression, in our opinion.

The Chinese version of the Federal Reserve Board has been around for thirty years. The head of China Investment Corporation, Yin Liqan, was interviewed last year by David Faber on CNBC. He said, “Our government (meaning China) over the last 30 years has developed a very much, you know, sophisticated skills to manage the macro economy.” Here are some of the recent quotes of major China experts and policy makers referring to the “soft landing” that they hope to engineer for their economy, even though the price of homes to average household income appear to be twice in China what they were at the top in the US:

The Economist
Is this the soft landing?
Jul 13th 2011, 20:39 by R.A. | WASHINGTON

–THERE has been a fair amount of anxiety over the state of the Chinese economy of late. News of unexpectedly large debt burdens among Chinese local governments generated a wave of concern that recent Chinese growth has been entirely unsustainable. As the government was forced to turn off the credit tap, some supposed, property prices would fall and a hard landing would result.

That seems an unlikely scenario to me. Chinese debt burdens are manageable and its property market dynamics are quite different from those that prevailed in western bubbles markets prior to the crash. That doesn’t mean that all is entirely well in China, however. Many observers have taken some comfort in the latest GDP report from China. Output rose 9.5% year-on-year in the second quarter. That constitutes a moderate slowdown from growth in the previous quarter, and was a little above expectations. It would seem that the government’s efforts to slow credit growth have not precipitated an uncontrollably rapid downturn in activity.

Bloomberg
World Bank Sees Soft Landing for China as Asia Withstands Europe: Economy
Nov 22, 2011

–Bert Hofman, the World Bank’s chief economist for the East Asia and Pacific region, talks about the prospects for China’s economic growth and its implications for the region. The World Bank said China is heading for a soft landing of growth in excess of 8 percent next year, and with most Asian nations has fiscal scope to cushion its economy from an escalation in Europe’s debt crisis. Hofman spoke yesterday in Singapore with Bloomberg’s Haslinda Amin.

Miningmx Reporter
Soft landing in China forecast
Jan 6, 2012

–FOURTH quarter company results should support expectations of a slowdown in minerals demand, some of it seasonal, but for 2012 a soft landing in China would buoy metal shares, said Goldman Sachs in a report published January 3.

Goldman Sachs Global ECS Research team estimated China’s gross domestic product will slow to 8.2% in 2012, a relatively soft landing for the economy, providing sufficient growth to remain supportive of metals.

And if there is some softening in commodity prices, it may be enough for China to launch another stimulus programme rather than risk lower growth, Goldman Sachs said.

At SCM, we believe all the pieces are in place for a “hard landing” in the China real estate markets. By the end of 2012, this bust in real estate will start to affect the major banks in China and severely inhibit policy maker’s ability to stimulate the economy. Credit contraction will follow in 2013, in our opinion. Commodity prices could come down as much as 50% in anticipation of drastically reduce Fixed Asset Investment and energy use in China. In other words, a “soft landing” in China following one of the biggest real estate booms in history is a “Mission Impossible”!

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

Printable Version

Dear Fellow Investors:

What is required for a whopper of a secular bear market is for most market participants to believe the positive side of the story all the way down. We at Smead Capital Management believe that all the pieces are in place for commodities to suffer a multi-year bear market which will wipe out up to 70% of peak prices on most major commodities. We have shared the graph below before, but we want to make sure everyone sees the potential for a massive reversion to the mean.

Source: Stifel Nicolaus “Interlocking Structural Challenges: Traction, Unity and Rebalancing” July 7, 2011

For commodity prices to revert to the mean in the next ten years and to reach negative rolling ten-year returns requires a massive bear market. Some of the preconditions for a massive bear market in commodities are:

1. Significant over-valuation. Most commodities trade for 3 to 4 times the cost of production.

2. Massive ownership by financial and non-economic owners like Endowments, Foundations, Pension Plans and consultant recommended portfolios.

3. Well identified cheerleaders with great fifty-year arguments (Jim Rogers and Jeremy Grantham).

4. Smart money either short or on the sidelines. Commercial interests have their biggest short positions in CFTC records.

5. Conagra, Cargill and Glencore selling to “bigger fools” at the top. Conagra sold their commodity trading business at the top in 2008, Cargill spun off Mosaic in 2011 and Glencore went public in 2011, both near the top.

We could go on. China is the largest marginal user of commodities in the world at the moment and the largest economy in the world (USA) has been busy teaching itself to use dramatically less of these commodities in the last four years. China’s internal stock market, the Shanghai Composite, the only index which seems to reflect the truth about the immense slowdown occurring in China, made a new low on January 5th at 2148. While China burns, devoted commodity speculators/owners hang their hat on Iran’s effort to flex its muscles in the Straits of Hormuz. Oil is the lynchpin to the commodity markets. It is the biggest single factor in the commodity indexes and has a huge impact in the production and transportation of all the other commodities. Oil and gas production is going wild all over the world and supply is up dramatically everywhere. Oil trades completely uncorrelated to natural gas, even though the process of finding them is deeply intertwined.

We’ve got what we at SCM think is great news for investors around the world. We believe this is Nero’s (Iran’s) last chance to fiddle. In our opinion, the recession/depression coming in China’s economy will break the back of oil prices for decades. Lower oil prices could strip the economic relevance of Iran, Saudi Arabia, Syria and Yemen. The institutional investing crowd will wonder why they got tied up in commodity indexes at their peak of popularity and will spend the next five years moving away from an over-commitment to oil, basic material and heavy industrial stocks. These were nothing more than a back-door play on the commodity boom triggered by the BRIC trade and all of its global synchronization. As we believe that the news will ultimately show that Rome (China) is burning, watch the case on commodities become something that the cheerleaders used to “harp” about.

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

Printable Version

Dear Fellow Investors:

We are owners of both EBay (EBAY) and Amgen (AMGN). We believe the dividend policy and price action in the shares of these two companies can teach us about stock price performance over the next three to five years.

History shows that for a few decades after terrible stock price performance (like we’ve seen from 1999 to 2011) investors demand more of their return from cash dividends because they do not trust appreciation. In the 1940’s and early 1950’s, investors demanded a higher cash dividend from stocks than they demanded from Treasury and Corporate Bonds. Treasuries yielded around 2% in 1950 and the Dow had around a 6% yield from dividends. However, in the aftermath of the 1929-32 crushing bear market in stocks and massive bank failures which followed, public companies hoarded cash. Howard Silverblatt at S&P reports that the payout ratio in 1936 of US public companies was 29%. Ironically, in our opinion, we are in the same kind of circumstance and have the same kind of payout ratios today. See our June 1st, 2011 missive called “Cash Hoards” to understand the history more fully. Click here for missive.

Last summer, Amgen was trading in the low $50’s on a per share basis and had never paid a dividend as a public company. Amgen declared their first ever cash dividend at $.28 quarterly last summer. Since then, they did a Dutch auction, buying back 9% of their shares and raised the dividend to $.36 per quarter. Amgen’s first ever dividend was a higher yield on share price than the 10-year Treasury bond yield! I have been in the investment business for 31 years and can’t ever remember an initial dividend offering more than the 10-year Treasury interest rate. We believe it is no coincidence that Amgen is trading above $64 per share on December 29, 2011. At the $1.44 annualized dividend rate, it yields around 2.23%, still significantly above the Treasury bond yield.

Amgen still has a payout ratio below 30% and has massive free-cash flow. They could be an aggressive dividend growth company going forward as we believe their balance sheet is strong and the future earnings look bright. Their newest product Denosumab is selling briskly in the form of Prolia for Osteoporosis and Xgeva for treating cancerous tumors. Management seems to have learned what scared investors want from a company.

At the end of June in 2011, EBay closed at $32.27 per share. We believe they have a fortress balance sheet. Their PayPal division is growing like weeds and throwing off massive free-cash flow. Their legacy Marketplace business has turned the corner and is growing nicely, while continuing to throw off over a billion dollars in free cash flow. EBay is buying back stock, but they don’t pay a dividend. The stock was trading between $30 and $31 per share in the last week of 2011. Investors can’t help but like the operating results of EBay’s management team, but they are too scared from the last 12 years of non-existent price appreciation to bet on it alone.

Silverblatt pointed out that the historical payout ratio over the last 50 years is 52.6% and over the last 20 years it was 46%. At Smead Capital Management, we believe that the companies which raise their dividend payout ratio towards the historical averages from the position of strong balance sheets, wide moats and relatively non-cyclical earnings performance will enjoy the kind of outsized price gains that Amgen has seen in the second half of 2011. Hopefully, EBay will get the memo.

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.