William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In a recent Bloomberg article, Michael Patterson shared that the relatively new equity division of PIMCO was using the China monetary policy shift to buy basic material, heavy industrial and emerging market stocks. Here is how Bloomberg explained the move by the world’s largest bond fund manager:

“China, which reduced the amount banks must keep in reserve by half a percentage point to 21 percent on Nov. 30, may cut the ratio by as much as three percentage points in the next 12 months, Masha Gordon, the head of emerging markets equity portfolio management at PIMCO, which oversees about $1.35 trillion worldwide, said in an interview. Inflation in the nation may slow to between 3 percent and 4 percent from 5.5 percent in October, she said.

‘We’ve seen the first clear shift from tightening to selective easing on the monetary side in China,’ Gordon said by phone in London yesterday.”

Gordon went further to argue that low PE ratios in those sectors and in emerging market countries make a compelling contrarian case. Here is her argument as quoted by Bloomberg:

“’We started with light positioning in the cyclicals and have been selectively adding to companies in the materials and industrial space where we believe valuations are pricing in extreme distress,’ Gordon said. Some stocks tied to economic growth in developing nations “are very cheap relative to their average earnings power if you take the view that growth in emerging markets on a secular basis isn’t coming to a halt,” she said, without naming any specific companies.

The MSCI Emerging Markets Materials Index trades at about 8.6 times analysts’ profit estimates, or 24 percent lower than the average ratio of 11.4 since Bloomberg began compiling the data in 2006. The MSCI Emerging Markets Industrials Index is valued at a 17 percent discount to its five-year average, the data show. MSCI’s gauge of Chinese industrial stocks trades at 9.4 times profit estimates, down from a historical mean of 16.”

Over the years, we have been very hesitant to buy cyclical companies based on PE ratios. The reason is simple. The best time to buy cyclical stocks is when their industry is hurting and they have little or no earnings. The old adage is “buy cyclical stocks at high PE ratios and sell them at low PE ratios.” We are not big fans of using the Schiller 10-year smoothed earnings for the market as a whole, but for cyclical companies where earnings disappear in downturns, it is a great way to look at the PE ratio. We thought that we would use US companies which have been huge BRIC-trade beneficiaries of the “secular case” on emerging markets to get a feel for where we are at with cyclical stocks in general. Therefore, let’s look at Caterpillar (CAT), Joy Global (JOY), Deere (DE), US Steel (X) and Schlumberger (SLB) on a 10-year smoothed earnings basis and see if they look cheap on the basis of PE ratio. The results are below:

The only stock on this list which looks attractive on a Schiller 10-year smoothed earning basis is US Steel at 7.2 PE. All the others look very expensive relative to the S&P 500 Index.

We believe that buying cyclical stocks and emerging markets under the assumption that secular forces in emerging markets will nullify the cyclical nature of sectors like energy; mining and heavy machinery exposes investors to a great deal of risk and shows a lack of understanding of the history of the markets. Please show me a cab driver or shoeshine boy who doesn’t know that there are secular forces at work in emerging markets.

Over-paying for stocks based on “well-known facts” is not a good way to take advantage of the “current distress”. We believe it would be better to wait for three to five years of poor performance in these stocks, which we expect to see, and until earnings have declined quite a bit before you buy. After all, it is just the first monetary easing move after a year of constant tightening in China. Besides, China could be starting its first real economic contraction as a quasi-capitalist country.

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:

Two watershed events were announced in the last two weeks. First, Warren Buffett disclosed a massive amount of open market purchases of US large-cap stocks. Second, Legg Mason announced that Bill Miller is “stepping down” as Chief Investment Officer of his firm and as manager of the Value Trust. These are two of the greatest stock pickers of all time and the change in direction for both men is driven by who they answer to and how favorable investing could be in the US large-cap space going forward.

In 1999, at the Allen and Co. event in Sun Valley, Buffett warned how poorly technology stock investments would do going forward and how muted US large-cap returns would be from 1999 to 2016. He explained how the Fortune 500 companies were trading at 30 times profits and that profit margins were at the high end of historical ranges. Therefore, he laid out an incredibly difficult road for those who pick large-cap US equities.

Buffett runs a holding company in which he is the largest shareholder. In effect, he answers to no one. When publicly traded US large-cap stocks got way over-priced in the late 1990′s, Buffett shifted to private equity purchases of entire companies. He bought all the outstanding shares of General Reinsurance and Geico. He made numerous smaller acquisitions like Mid-American Energy. Buffett got his investments away from having the prices quoted every day and allowed his publicly traded portfolio to become a minority of Berkshire’s assets. He continued that approach in 2009 by buying all of Burlington Northern and recently bought Lubrizol.

Bill Miller beat the S&P 500 index for 15 straight years making his shareholders, his parent company and himself very wealthy. The last five of those years included much less spectacular returns between 2000 and 2005. He ran relatively concentrated portfolios and was adored by the media. The index has gone nowhere for 12 years and Miller answers to shareholders. They have expressed their disappointment by driving Value Trust’s assets down to $2.8 billion from a peak of $20 billion. Bill stepped down voluntarily or was asked to. Either way, it is exactly what happens at the end of a stretch where investors have been massive net liquidators of US Large-Cap stocks.

Buffett has no career risk and no one to answer to. He told Becky Quick on TV that he feels US large-cap stocks are undervalued relative to other asset classes. He bought $10.7 billion of IBM (IBM) and added to Wells Fargo (WFC). His underling, Todd Combs, bought shares of numerous US large-caps for Berkshire as well. Buffett is happy at these prices to get back into public shares priced every day.

In 1999, Buffett felt that two things beside market levels could affect overall stock prices. He said that a drop in government interest rates from 6 percent to 3 percent would double the value of stocks. He also said that high sustained profit margins would positively impact stock prices. Both of those have happened. Lastly, stocks have done worse than Buffett expected despite these facts.

We believe putting this all together for us as contrarians means one thing. The time to net liquidate US large- cap equity is over because Bill Miller is being given up on and Warren Buffett believes the risk reward in these stocks is very favorable. In our opinion, it is time to buy a concentrated portfolio of US large-cap stocks. We suggest you do this while avoiding the BRIC trade, in case you have someone to answer to.

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:

In his new book “Great by Choice”, Jim Collins talks about the discipline that the companies which performed the best over the last thirty years had exhibited. He used comparisons between companies in various industries. In property casualty insurance, he compared Progressive to Safeco. The watershed moment when the success of the two companies parted was in the late 1980′s and early 1990′s. Prior to that time both companies ran underwriting profits each year. This meant that they paid out less than 100% of the premiums collected. Unfortunately, for the shareholders of Safeco, the high interest rates of the 1980′s and the favorably stock price increases of the 1980′s and 1990′s lured them into allowing investment returns to override underwriting discipline. When interest rates became historically low and stock market returns gravitated to the mean, Progressive’s underwriting profit left Safeco in the dust.

What triggered our thoughts here was a blog I read at Barron’s online last week. It said that a Credit Suisse analyst was recommending that investors swap out of Walgreens (WAG) into Rite Aid (RAD). The reason for the negative view of Walgreens on the part of the analyst was his expectation of only a 25% likelihood that Walgreens will settle their dispute over pricing with Express Scripts. Walgreens would have lower revenue and profits in the near future if they lose the Express Scripts revenue. Walgreens has already told analysts that it could cost them as much as $.21 of their 2012 earnings per share (EPS). We at Smead Capital Management believe that the weakness in Walgreens stock created by the uncertainty associated with the Express Scripts negotiation and separation has created a wonderful buying opportunity.

Collins focused on the companies which overcame unforeseen economic and business problems and returned a 10-fold increase in stock price. He calls them 10x companies. His work is done looking backward, while our work is done looking forward. Progressive didn’t earn as much in the years when investment markets provided high returns, but they prospered in the 2000′s when investment returns were problematic at best. They gave up some income in the short run to be a 10x company in the long run.

Why would Walgreens walk away from billions in revenue from Express Scripts? For the same reason that Progressive did. At the pricing levels dictated by Express Scripts, Walgreens would produce meager margins on that part of its business (3-5 percent of revenue) and drag down return on equity. Their stock has already fallen from the mid 40′s to the low 30′s. According to our calculations of intrinsic value based on multiple current earnings possibilities, Walgreens trades at a 33-50% discount to its intrinsic value. Walgreens stock has risen from around $4.17 twenty years ago and pays an $.80 dividend to those fortunate enough to have held on. It meets all eight of our proprietary criteria and is a stellar corporate citizen.

Which brings me to the lunacy of recommending a sale of Walgreens in exchange for Rite Aid. Rite Aid is a small-cap company with a deeply checkered past and porous balance sheet. Trading Walgreens at these prices for Rite Aid would be like swapping a new Lexus for an over-sized ten-year old gas guzzler, box seats for the nose bleed section or Kate Middleton for a troubled Hollywood Starlet! Rite Aid has accounting problems and a consistent history of shareholder unfriendliness. It might go up, but it should not be included in the same conversation. We believe that Walgreens is going to be “Great by Choice”.

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:

Charlie Munger, the Vice Chairman of Berkshire Hathaway, has said many times that psychology is the most under-utilized discipline in business. He compares the business person or investor, who doesn’t have an inter-disciplinary set of “mental models” including psychology, to a one-legged person in a kick-boxing competition. We believe that those using low consumer confidence as a reason to be bearish about US large cap stocks and consumer discretionary stocks are equivalent to one-legged kick boxers.

At the website, The Big Picture, Barry Ritholtz shared his thoughts (Nov. 4, 2011) on the US employment numbers. We have respected the thoughts and research of his firm because they were early in understanding how damaging the housing bubble was going to be on the US economy. However, this time we believe that the trap that the market has laid for investors in the area of unemployment and consumer confidence is well set. We believe that a number of savvy analysts are not “seeing the forest for the trees” when it comes to understanding the history, psychology and the accounting of consumer behavior.

We at Smead Capital Management believe two things about consumer spending and consumer behavior in the US. First, the income statement of US households tells you more about future spending than consumer confidence does. Second, we believe Andy Grove’s professor at the City College of New York was right when he said, “When everyone knows that something is so, nobody knows nothing!” In other words, is there an investor left in the world who has not anticipated that it will be years before the US consumer makes a comeback? Consumer confidence is a neutral indicator most of the time and a valuable contrary indicator at extremes.

Let me unpack these two ideas. The Federal Reserve Board has maintained statistics on US households since 1980 measuring the percentage of gross household income required to service household debt. You can view these stats by going to www.federalreserve.gov/releases/housedebt/. There you will see that the real estate and borrowing bubble of the 2000’s allowed US households to get to ridiculously high ratios of household debt service (around 14% of income at the peak). This was markedly higher than previous peaks of 12.4% in prior cycles. You will also see that US households have made huge strides since late 2007. These statistics are lagged by three months or more, but you can see that by June 30th of 2011 the ratio had fallen to 11.09%. Assuming that this trend of austerity continues through the next 12 months, the US Household Debt Service Ratio could fall to the low levels of the early 1980’s deep recession at 10.6% and in the job-less recovery of the early 1990’s.

Think of it like this. Who is likely to spend money and do it more consistently, someone who’s in very good shape on their income statement that lacks confidence or someone who is up to their eye-balls in payments but brims with confidence? The unconfident households with room in their income statement will ultimately be part of what we call “pent up demand” for goods and services. The car wears out or the fridge needs replacing or the kids are going to get too old to want to go to Disneyland, so you breakdown and do it. You don’t have much confidence, but you can afford the expense.

These facts have been baffling to most stock market participants for nearly three years. In the world of the supposed “new normal”, why is everything happening pretty normally among US consumers who are providing great business to McDonald’s (MCD), Starbucks (SBUX) and Nordstrom (JWN)? We believe the record-setting low consumer confidence numbers of 2009-2011 and the continuing high levels of unemployment that The Big Picture speaks of have been the reason that the money management community has avoided the consumer discretionary category.

We looked at the correlations between consumer confidence and the stock market between 1977 and 1996. What we found was that there was almost zero correlation and it was a neutral. If you look at the period since 1996, consumer confidence was a valuable contrary signal at extremes and the correlation is significant. Stocks were to be avoided on high consumer confidence and the stock market lows have coincided with low consumer confidence.

Going back to Andy Grove’s professor, the logical thing that everyone knows is that US households have a great deal of debt to work off over the next ten years and the US government has a very large amount to deal with itself. Everyone has assumed that the consumer wouldn’t be able to lead a meaningful economic recovery until those debt levels come back in line from a historical standpoint. This has resulted in significant under-ownership by professional money managers and asset allocators in the consumer discretionary category. We believe that until the money management community capitulates and buys into the consumer sector that it will out-perform the S&P 500 Index. And we believe that the capitulation will come at dramatically higher consumer confidence levels and we are about as far away from those statistics in early November of 2011 as you can be!

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:

In the opinion of Smead Capital Management, computers, cable TV, the Internet, 24-hour news and a variety of other forces have greatly affected successful participation in the US stock market. These forms of information gathering attempt to push people away from the most important fact that exists in common stock investing. The fact which we believe matters more than any other is that owning all or part of an outstanding company for many years is one of the simplest ways to attain wealth and compound liquid assets at high rates of return. In today’s missive, we will look at how far “out of season” the fact we believe in is and think about how important it is to be ready for the season to come.

The Ibbotson Group has been kind enough to share statistics on the returns from liquid asset classes since 1927. Treasury bills have returned about 3% per year, Long-Term Bonds have earned about 5.5% and US common stocks (as represented by the S&P 500 Index) have averaged around a 10% return. Running parallel to these statistics are the studies (including the one provided below) which show how poorly investors actually do who participate in the stock market compared to how the market itself does. As you can see, about 58% of the return from stocks gets lost in the poor timing decisions of owners by adding to their stock portfolios at high points and selling at low ones.

“Average Investor Equity” is represented by the mutual fund inflows and outflows over the corresponding time period to simulate the behavior of the average equity investor. Average equity investor results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net sales, redemptions and exchanges for the period.

Source(s): Index Fund Advisors, from Dalbar, Inc. report QAIB (Quantitative Analysis of Investor Behavior)

Computer access leading to internet provided information is drowning the average amateur and professional investor. How much computer time do you need to know that Disney (DIS) is the world’s number one baby sitter? How many Walgreen’s (WAG) locations do you need to see or visit to conclude that they have a very consistent business? What number of hours online causes you to appreciate the branding power of the Aflac (AFL) duck? Investors only need a little drink of water in the way of information, but instead, they get drowned in a fire hose of info.

Thanks to 24-hour cable TV news, investors have a constant stream of bad news. This world of 7 billion people is kind enough to provide us a daily disaster and to teach all of us more about macroeconomics and scarcity than any college under-grad would ever want. As Jim Collins has pointed out in his new book, “Great by Choice”, the great companies are not considered great because they existed in a world where bad things never happened or bad luck never occurred. Rather, it was that they did the things that they could control and assumed that the circumstances around them would be chaotic and difficult along the way. In the Jim Collins world, it does you no good to predict economics or natural disasters. It is much more important to own part of a very strong organization which expected numerous possibilities and scenarios.

Why is our view of the world “out of season”? Most investors do their investing in the rear-view mirror. They look at what has been successful the last 5-10 years and expect more of the same. They see that emerging market investments, commodities and related industries have boomed since ten years ago. They see Caterpillar (CAT) selling gigantic machines to China, Joy Global (JOYG) helping miners dig up copper and gold, and major oil companies/oil service organizations going gangbusters to satisfy an insatiable demand for crude oil and its derivatives. In the month of October which just finished on Monday, basic materials companies were the best performing category in the huge rally off of the early October lows. They’ve only been “in season” for about ten years.

Second, they see that the US stock market has made no meaningful headway since 1998. The last 13 years has been a poor stretch from a historical standpoint and those who sought to become wealthy by owning outstanding, non-cyclical companies struggled compared to history. Those who traded the market swings successfully are well reported on TV and through dissemination online. This market timing is always admired after years of range-bound markets. Unless I’ve missed something, there are few market timers in the Forbes 400 wealthiest Americans. However, most of those on the list got there by owning successful businesses for a long time and did it in a concentrated way. They never checked to see how the folks on TV or online thought about holding on to their company.

Third, those who gorge on stock market information currently see unbelievably high correlations among risk-oriented assets. One study shows that since 2008, oil and US stocks have been positively correlated. For the thirty years prior, the correlation was negative by almost that exact same degree that it’s been positive lately. This is ludicrous! Unless you are a massive net exporter of oil, higher oil prices are a nightmare. We are watching for those correlations to move back to normal in the near future. Recently stocks in the US have traded more persistently in tandem than nearly any time within the past forty years , with the possible exception of the 1987 crash. High correlations are “in season”, but history shows that they have always reverted to their mean.

Lastly, the most damaging aspect of these forces which provide too much information is that they produce activity. Activity is the enemy of those who own all or part of an outstanding company. Ignoring the crowd and temporary problems eliminates trading costs, reduces IRS access to your wealth and allows you to gain the benefit of dividends and dividend growth. Most studies show that over very long periods of time (30-50 years) that dividends make up 40% of that 10% return which Ibbotson calculates for US stocks.

The great irony of today is that most of the companies which fit our eight proprietary criteria for selecting stocks sell at a PE ratio at or below the S&P 500’s average. In addition, at the end of October the S&P 500 traded at 12.9x trailing earnings, well below its median of 18.1x over the prior twenty years. The nice thing about being in the business for 31 years is getting to see that the seasons of investing do change. In our opinion, the next season could last a long time.

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.