William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

We at Smead Capital Management (SCM) shared with you recently a comparison between the behavior of lemmings and investors, both individual and professional. Lemmings multiply in a geographic region until the food supply is incapable of providing proper nutrition. Investors congregate in markets, sectors and strategies until there is very little opportunity for profits. Unfortunately investors, both professional and amateur, don’t have a built in natural instinct to move to the next area like the lemmings do. We‘ve had quite a few questions asking for clarification on our piece last week and it brought out some salient points which might help all of us interested in common stock appreciation.

In the article by E.S. Browning called “The Herd Instinct Takes Over”, we enjoyed research being done at Birinyi and Associates. It was led by Jeffrey Yale Rubin and produced the following chart. The chart shows what percentage of the stocks in the S&P 500 Index are moving in step with the index price movements.

A few things were left a little fuzzy last week that need clarified. First, we got a number of questions asking if today’s circumstances are significantly different than in the 1987 Crash, when the correlation was this high. The answer is that program trading and portfolio insurance were dominating the stock market in 1987 in the same kind of creepy way that it has been the last couple of years. THIS IS NOT THE FIRST TIME THAT PROFESSIONAL INVESTORS CONGREGATED IN A VERY ACTIVE STRATEGY AND SPOOKED INDIVIDUAL INVESTORS! However, we believe you don’t need to worry about it because there are so many people doing it and those lemmings will go somewhere else as the pendulum swings back toward stock picking.

Second, the best time to be stock pickers is to begin with an extended period of high correlations stretching into elongated periods of low correlation. While the mindless program trading and ETF flipping is going on, be one of the smart, instinctual lemmings who can recognize that someone “moved their cheese”. Go where the nutrition is rich. At SCM our capital appreciation portfolio is loaded with companies which fit our eight criteria and trade at 10 times free cash flow or better. If you owned the entire company, you could take ten percent of the current price out in cash and not disturb the ongoing maintenance of your company’s business! Compare that to the average stock in the index (where program traders and ETF investors have squatted) or to the money market funds, CDs, Treasury bills and bonds, high grade and junk bonds, and gold where individual investors have geographically located themselves. The difference in nutritional value is stunning as interest rates on quality securities are miniscule from a historical standpoint. We believe the lemmings are smart enough to have gone somewhere else already.

What is holding everyone back? At SCM we believe fear is holding back individuals, institutions and professional investors. Individuals are afraid of losing money because of the last huge bear market and are completely intimidated by the scare mongering in the media. Institutions make changes in committees and move much slower normally and are afraid of looking presumptuous. Professionals are afraid of losing clients because of whatever time it takes for the new area of nutrition to make itself obvious to non-lemmings. They all need leadership and at SCM we stand ready to do our part. We believe correlations are headed down and probably for an elongated period.

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:

One of the most excruciating and entertaining things to watch in nature is a group of lemmings going off the cliff together. In truth, this rarely happens in nature. What really does happen is that the population of lemmings gets too concentrated in a geographic area and the lemmings scatter to get a better supply of food. Thanks to a couple of great pieces written by E.S. Browning in the July 12th Wall Street Journal, we can see that investors and money managers operate the same way that lemmings do.

His first piece on the front cover of the Wall Street Journal was titled “Small Investors Flee Stocks”. It pointed out that individual investors have been consistent net liquidators of US common stocks for three consecutive years. In fact, they have been the most negative on stocks in 2007-2010 as at any time since a similar bearish stretch from 1979-1981 according to the Investment Company Institute. The lemmings have fled to money market funds, CDs, Treasury Bills and Bonds, high grade and junk bonds and gold. Much of the bond ownership has come through bond mutual funds which have had as great popularity and inflows as the Investment Company Institute has ever seen.

The second piece on the front of the Money and Investing section was titled, “The Herd Instinct Takes Over”. The research team at Birinyi and Associates, led by Jeffrey Yale Rubin, analyzed the correlation of the price movements of individual stocks in the S&P 500 Index to the Index itself. Very low levels of correlation means there are a large number of stocks resisting the market’s direction. High levels of correlation mean that everything is moving the same direction at the same time. The recent decline in stock prices saw the highest correlation number (81%) as had been seen since the stock market decline from late August of 1987 through the crash day on October 19, 1987. Back then it hit 83%. Even in all the super nasty declines of 2008, the correlation never exceeded 79%. As we wrote recently in a missive we called “Mini 2008”, the fear in the last few weeks ranked right up there with our fears of depression and abyss in the fall of 2008 when a wide variety of indicators showed that our financial transmission system had broken down temporarily.

When correlations are low it means a significant amount of value can be added by good stock picking. When correlations are high it means that whatever discipline you are using to pick stocks isn’t doing you any good. We at Smead Capital Management call high correlations, “throwing the baby out with the bath water”. Browning correctly identifies the culprits in all this with the help of the folks like Mr. Rubin at Birinyi.

“It is an indexing market and not a market for stocks. On good days everything goes up, and on bad days everything goes down. Everyone talks about baskets or sectors. It is harder for individual investors and even for mutual fund managers to distinguish themselves by doing individual stock picks. They might get the product right and the earnings right, but the market goes down and the stock goes down as well.”

Through passive investments, Exchange Traded Funds (ETFs) and computerized trading, a massive group of lemmings (and wealthy individuals who have put their money with them) have come to dominate the market as much as program trading and portfolio insurance did in 1987. We thank E.S. Browning for such great work.

What does this all mean to SCM and to you as investors and/or money managers? First, there is very little food value in bonds and the individual investor lemmings are due to scatter. They have massive cash and near cash with which to scatter elsewhere and any part of that could drive stocks higher. At least in 1979-81 those individual investors were fleeing stocks to receive double-digit interest rates. We believe this time the returns from high quality bonds are set up to be negligible.

Second, a potential future curse for market timers and long/short hedge funds would be a consistent Bull Market in US stocks, especially one led by household names. The primary reason that small to mid-cap stocks have outperformed over the last ten years was that they were cheap in 1999 when large caps were expensive and offered a great deal of food value to the lemmings back in 2000. The length of their outperformance has outlasted their nutritional value. We believe the lower PE ratios and food value is in large caps. The trend persists because of how dominant hedge funds, ETFs and go anywhere mutual funds have become as individual investors have retreated and poor performance among stock picking disciplines has dragged away massive amounts of capital from long only portfolio managers.

Ask yourself, what should investors have done back in 1982 after liquidating stocks for three straight years? They should have bought and enjoyed a huge five-year bull run. What should they have done in the aftermath of the high correlation in 1987? Pick good stocks to buy or find a strong discipline through a portfolio manager to pick good ones for you. The S&P 500 Index rose from 225 on October 19th, 1987 to 1527 by March 24th, 2000 and good stock picking could have enhanced those returns. We think the lemmings are about to disburse seeking better nutrition and we’d like you to get your share.

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:

Somewhere along the time line there are going to be stock market rewards for being in the market for the last 30 years. At Smead Capital Management (SCM) we think that somewhere is coming soon. It all has to do with replacing the courage needed at the absolute lows with the wisdom needed on the retest of those low points.

From the early 1950’s through 1981, few things were more assured than the fact that inflation marches ever higher and bond prices march ever lower. Interest rates on 10-year Treasury bonds started at around 2% in 1950 and peaked in 1981 at 14%. When I started in the investment business in 1980, the local brokerage offices ran advertisements touting tax-loss swapping of long-term bonds. If you changed coupon, maturity date and issuer, you could swap to a similar bond and get a big capital loss to use against gains or ordinary income.

Inflation had climbed almost constantly for 30 years and peaked at 13.58% in 1980. Almost all of the respected economists back then thought that inflation and interest rates were going much higher. Therefore, investors kept their bond maturities very short and were more attracted to 3 and 6 month CDs at 18 % or money market mutual funds at similar interest rates.

Since no policy maker or Federal Reserve Board had the constitution to stop the inflation freight train in the prior three decades, it became a “well known fact”. Everyone knew that inflation only goes up and bond prices only go down. To buy those T-bonds at 14% you had to bet that Paul Volcker at the Fed and President Ronald Reagan would be willing to absorb massive political grief to break the back of inflation. You had to have massive courage to bet against the crowd of investors and economists to buy at the 30-year bond low and interest rate high.

After living through the worst recession since the 1930’s and staring down the Air Traffic Controllers Union in 1981, inflation did get broken as investors became convinced that strong economic growth wouldn’t come for years. By 1983, 10-year Treasury Bonds hit 11% and inflation dropped down to 3.22%.

Inflation fears were hard to shake. Economic growth accelerated in 1983-84 and everything we’d learned in the 1970’s told experts and Fed policy makers that it meant a reacceleration of inflation was coming. Ten-year Treasury Bond rates soared to 13% and inflation rose to 4.3%. Stop yourself for a moment and think about trailing inflation of 4.3% and 13% on the 10-year bond.

In 1984 you could buy the T-bond at almost the same interest rate as the 30-year high and you didn’t wonder whether Volcker and Reagan had the constitution to take the heat. Inflation could rise and your margin of safety left you well covered. It didn’t take courage, it took wisdom.

By now you are wondering where I’m headed. In late 2008, investors were scared to death of the possibility of Depression and bid 10-year Treasury bonds up in price to yield 2%. They feared depression and sought what Mark Twain called, “return of my money”. Many aspects of the financial markets including commercial paper, money market fund solvency, Libor rates, etc. signaled what Warren Buffett called “an economic Pearl Harbor”. The largest US banks were propped up by TARP capital infusions. We all held our breath and were controlled by dire economic worries. To sell your treasury bonds at 2% took huge courage. The depression was averted and the T-bond seller was happy in April of 2010 with the 10-year bond at 3.98%.

A large group of well respected economists have warned profusely since then that our economic recovery is very fragile and that the depression worries are still valid. They forecast double-dip recession and fan the flames of 2008 worst case scenarios.

In our opinion, there is just one problem. The major stress signals of late 2008 are as evident today as the 11% inflation was in 1984. However, the 2008 style fear drove the 10-year bond down to 2.97% last week. No commercial paper problems, ridiculous Libor rates or money market fund trauma. We believe selling T-bonds right now doesn’t take courage, it takes wisdom.

We at SCM feel the same thing can be said for common stock owners today. In the fall of 2008 and early 2009 it took incredible courage to buy stocks in an environment where we didn’t know that those distress signals would be answered. A buyer on this correction in stock prices is open to the normal risk that you take (which is that you can be underwater for awhile). On the other hand, they don’t have to wonder if TARP stabilized the banks, commercial paper markets would reopen and money market funds would stabilize. In our opinion, it took incredible courage to buy stocks in the fall of 2008 and in early 2009 and in early July of 2010 we believe it takes wisdom.

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:

After the big move up in US stocks beginning in March of 2009 at around 676 on the S&P 500 Index and carrying to mid-April of 2010 to around 1220, you could expect a correction in stock prices. We have a theory at Smead Capital Management that the markets will do whatever they have to do to frustrate the most people. In this particular case, the most frustrating thing that the markets could do would be to put the folks who stayed in common stocks through a correction. This correction would include at least two violent downswings and would reopen everyone’s memories of what happened in the US stock market in 2008. This correction is kind of a Mini 2008.

As if we needed reminding, the bear market which began in late 2007 and ended in early 2009 was the worst decline in the US since the 1930’s. From peak to trough the S&P 500 Index dropped 53%. It wasn’t only the decline itself that was so painful, but it was the across the board selling that regularly hit the market which added salt to the wound. The decline seemed to have no regard for the quality or the future of the companies involved. This made the bear market extra disconcerting. Disregard for shares of companies with better balance sheets and consistent earnings and dividends bothered long-time money managers like us. It was also the culmination of one of the worst decades that the US stock market has ever had. To say that confidence among money managers and common stock investors is low would be a big understatement.

After the splendid rebound from the March 2009 lows it was likely that market would correct and reestablish a new wall of worry. We’ve seen a number of corrections in 30 years in the investment business. In our opinion, this one is attempting to look the most like the declines of the prior bear market as any we’ve seen. In the process, the wall of worry has erected itself quickly and done so with a magnitude normally associated with major market bottoms. The list of negatives is long and includes:

1. European Sovereign Debt Woes
2. The Worst US Oil Spill in History
3. No significant rebound in housing
4. Fears of a slowdown in China
5. Doggedly High Unemployment
6. Double-Dip Recession fears
7. Low Confidence among Consumers
8. Ten-Year Treasury Rates below 3%

We could go on, but we think you get the point. At this moment, we think the wise thing to do is to ask what companies do we want to own for the next five years and ignore the temporary news. Not because it doesn’t matter, but because it will be replaced by some other bad news in a couple of years. Instead we want to focus on the growth in the use of PayPal and other EBay services. We focus on the rebound in business at Nordstrom or Disney. We love the consistency of business at Merck, Johnson & Johnson and McDonald’s and want to be part owners. By the time that everyone quits equating every market decline with the bear market of 2007-09, we believe we will have made very solid returns in the US stock market.

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:

At Smead Capital Management (SCM) our contrarianism and urge to purchase stocks with low PE ratios has led us to own what we think are the finest and most recession resistant companies in the world. To understand our portfolio and where we are in history you must read Randall Forsyth’s column in Barron’s dated June 21, 2010, an article written by Jason Zweig in the Wall Street Journal over the weekend called “So that’s why investors can’t think for themselves” and Brian Belski’s research note at OPCO yesterday (June 21st, 2010). Randall quotes work by Jason Trennert on “The New Lords of Finance: Policy’s Long Shadow Over the Markets”. In it Trennert argues that a small group of policy makers in places like Washington D.C., Brussels and Beijing (whether elected or not) are “exerting enormous influence over the economic cycle”. He says and Forsyth reiterates, “All of this has led to a certain sclerosis when it comes to the behavior of certain large companies. Among the symptoms is that these companies sit on record levels of cash.” Forsyth points out that it wouldn’t be so bad if the cash was being used to raise dividends and do stock buybacks instead of hoarding it in t-bills earning virtually zilch. He also goes on to show how investor behavior has been led around by reaction to the policy makers and the inaction on the part of the leaders of large US corporations:

“Leaving aside the philosophical implications, the practical investment effect is that investors appear willing to hold cash earning 0% or 10-year Treasuries yielding 3.25% “and yet remain unwilling to buy large-cap growth stocks with fortress balance sheets and decent dividend yields trading at low double-digit earnings multiples,” Trennert says.

Jason Zweig’s article cuts to the core of the current opportunity in Large Cap Non-Cyclical US stocks. Here is his thesis:

“Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear. In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn’t just give investors a sense of “safety in numbers.” It also gives them pleasure. That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the “consensus view” on Wall Street.”

Therefore, at the “basic human level” it is unnatural to be a lonely contrarian and what could be more lonely than owning large quality companies which have not been the place to be since they peaked in popularity back in 1999. Throw in the worldwide policy elites publicly dressing down your industry and demonizing large profitable companies in general and you have what we believe is a prescription for historically extreme undervaluation and absolute low PE’s. This makes us at SCM just drool and lays the groundwork for what we believe will be 7 to 10 years of above average performance.

People say things like, “small to mid-cap stocks are still doing way better”, even though they are dramatically more expensive on a trailing and estimated PE ratio basis. The smaller your company is the less chance that the policy makers are going to use you as a populist punching bag. We believe the biology study proves what John Templeton clearly understood in creating an incredibly good track record in the Templeton Growth Fund from 1950-1990. He said, “The time of maximum pessimism is the best time to buy”. The price you get without any reinforcement from the crowd is the price that will generate the most future success with the least amount of risk.

In a report out yesterday called “Dividends and Buybacks Increasing”, Brian Belski and his folks at OPCO show that despite the coma that the circumstances of the last three years have put companies and investors in, that the dividend increases and stock buybacks are coming anyway. Templeton might have called that the first light at the end of the tunnel. Belski also shows that it bodes well for overall stock market returns. Rejuvenation phases in dividend and stock buyback activity in the past has coincided with very solid and positive results in the S&P 500 Index. Our portfolios are loaded with recent dividend increases and massive added stock buyback activity because our companies have strong balance sheets for the most part and generate way above average free cash flow. From all of this we believe there can be only one conclusion for the patient investor.

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.