William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

We have now seen the S&P 500 Index drop below 1150 five times since the first of August. The overriding reasons, listed in no particular order, are fears of another contraction in the US economy, European sovereign debt and bank problems, a lack of political leadership in Washington D.C. and persistent unemployment data. These problems have caused an 18% decline in the index from peak to trough and have given those of us who stay fully invested in high quality stocks another opportunity to examine our thesis.

Our thesis is that by owning the companies which fit our proprietary eight criteria and making changes very sparingly, we can garner the historically superior returns which come from equity ownership and exceed the return of the index over long-term time periods. This comes from a combination of dividends, dividend increases and capital appreciation.

Even though we are not traders or short-term oriented, we at Smead Capital Management would like to throw out a few opinions which cause us to be very positive about the stock market over the next one to two years.

1) While market participants look to the US government and the Federal Reserve Board for answers, US Households are doing remarkable and historical work of getting their finances in order. The Household Debt Service Ratio dropped to 11.09% at the end of June after being as high as 14% in late 2007. This is the ratio of how much of the average family’s gross income is dedicated to debt service. The statistics are reported on a 90-day lag, which means that the ratio is probably below 11% by now. At the pace that households are improving their income statements, we could see a ratio of 10.6% in the next year. Numbers below 11% existed in 1982 and 1992 at the beginning of extended periods of prosperity. What this means is that households could take on monthly payments comfortably and that bodes well for the employment rich automobile and housing industries.

2) Usually bearish firm, Grantham, Mayo, Van Otterloo (GMO), recently put out an extensive research piece indicating that US housing participants are making the “Error of Pessimism”. They are arguing that US housing is in position to become a bright spot in the US economy.

3) Commodity prices are plunging. In the same piece, GMO argued that China is making the “Error of Optimism” in residential real estate. If real estate activity falls off in China, commodities will continue to decline. No politician could duplicate the incredibly simulative effect of lower gasoline prices, not to mention the enormous psychological benefits in a mobile society like ours.

4) Pretty much all stock market participants are bearish. Mutual funds specializing in US Large-Cap equities have suffered huge net liquidations for months. Sentiment polls look similar to the spring of 2009, right before a huge gain in the following two years. Stock correlations are running at highs only seen in the 1987 crash period. This means that the professional traders are selling baskets of stocks simultaneously without regard to their quality. When low correlations come back in the future there is a lot of wheat to separate from the chaff.

5) We believe our companies have performed well in a less than stellar environment. The dividend growth the next five to ten years could set records as these lean powerhouses gush free cash flow. Howard Schultz pointed out, as an example, that Starbucks has $2 billion in cash on their balance sheet and might be interested in strategic acquisitions.

6) Insiders (officers and directors of public companies) have been as aggressive in their purchases of their own company’s stock as they were in early in 2009.

We believe many of our stocks have held up quite well in this environment, but some of them look especially attractive at this point. Financial stocks seem to be in a capitulation phase and Wells Fargo (WFC) and Aflac (AFL) look particularly attractive. The household debt ratio inspires us about Disney (DIS), Cabela’s (CAB) and H&R Block (HRB) in what we call our “staple” consumer discretionary category. In healthcare, Mylan Labs (MYL) is retesting its August low and saw significant insider buying at these price levels last month. We would be remiss to not mention that PayPal/ Ebay (EBAY) is preparing to become a major payment force in stores for the first time. It is nice to start a business with 100 million existing customers.

In conclusion, we have reasons for being the optimistic contrarians, even over the next one to two years.

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:

Once upon a time there was a bank based in Seattle, Washington called Washington Mutual. The bank grew by acquisitions in the 1990’s and enjoyed the prosperity of the United States of America. It raised its common stock dividend every year from 1989 to 2006 and on April 18th of 2006 reported their 1st quarter 2006 earnings. Profits grew 15% in the first quarter of 2006 as compared to the prior quarter ended December 31st of 2005. Here is how Washington Mutual’s Chairman and CEO, Kerry Killinger, described the results:

“We are very pleased with our first quarter results,” said Kerry Killinger, Washington Mutual chairman and chief executive officer. “The company’s strong performance demonstrates the benefits of our continued diversification and enhanced operational focus. This past quarter we had particularly strong results in Retail Banking and Card Services.”

“These businesses added customers at a record pace and delivered significant revenue and earnings even in this difficult interest rate environment,” Killinger added.

Today there is a bank called China Construction Bank. It is the third-biggest commercial lender in China. On August the 22nd of 2011, China Construction Bank reported that its first half profits rose 31% to $14.5 billion, buoyed by higher income from fees and interest. Here is how the web site mystockmarketnews.com described the bank’s results:

“Like other Chinese lenders, the bank has benefited from rising interest rates and higher fees and commissions as it diversifies its revenue sources.

Interest income in the first half of the year rose 24 percent, while income from fees and commissions jumped 42 percent to 47.7 billion yuan ($7.5 billion).”

Unfortunately, Washington Mutual is no longer in existence. The reason they no longer exist was actually shown in the 1st quarter report in 2006. Despite reporting an operating profit of $985 million dollars in the quarter, Washington Mutual and its executives were preparing it to run headlong into the realities of the conflict between the income statement of a bank and its balance sheet. The bank was lending a massive amount of money to people who were buying homes with no money down under the premise that home prices would never drop nationwide. Many of those loans were made to people whose incomes were never verified and logically would never have the income to afford what they bought.

On page two of their earnings report, Washington Mutual reported tangible equity as 5.85% of tangible assets and non-performing assets as .59% of total assets. The provision for loan and lease losses was $82 million and net charge offs were $105 million. Remember, this was in the first quarter of 2006. Residential real estate prices in the most popular markets in America like Southern California, Arizona, Nevada and Miami were already starting to crater. Washington Mutual was a major player in those markets on the West Coast of the US. Washington Mutual had $26.156 billion of shareholders equity at the end of March in 2006, total loans of $240 billion. The percentage of these loans which would default wiped out the bank and put them into the hands of JP Morgan with FDIC assistance.

China Construction Bank was one of the main institutions that the government of China has used between late 2008 and early 2011 to stimulate the Chinese economy through lending to special purpose vehicles for building condos, office buildings and infrastructure. The purpose behind the speculative development loans was to avoid the economic contraction happening around the world which Chinese policy makers correctly foresaw in 2008. The average citizen in China can’t afford to buy the condo residences which are being built by these quick buck speculators. China Construction Bank’s activities are described in the mystockmarketnews.com article this way:

“The bank said it was strictly controlling lending to industries designated by the government as having excess capacity, such as iron and steel, coal and plate glass. Meanwhile, it boosted lending to small and medium-size companies.

Smaller businesses have usually struggled to get bank financing. Such lending increased 9.5 percent by the end of June over December of last year, compared with a 6.8 percent increase in total corporate lending.

Construction Bank, which is relatively heavily exposed to the property sector, also said it was limiting lending to local government investment entities, whose debts have ballooned in the wake of a binge of recession-fighting construction investments.”

It is estimated by Fitch and other reliable sources that more than $2.7 trillion in loans were made to real estate developers at the municipal level on spec developments. We have seen estimates of loan losses ranging from 30% to 70% and reports show that interest payments of as much as $140 billion are due this year alone. The Chinese government has already allocated $464 billion to their version of a TARP program to deal with the capital which these loans are beginning to destroy. Here is how Bloomberg explains these circumstances recently:

“Chinese lenders expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. The surge in loans exceeded credit expansions in the U.S. before its financial crisis, in Japan before its stock and property bubbles collapsed in 1990 and in South Korea before the Asian financial crisis of the late 1990s, according to Fitch.”

If China Construction Bank has its fair share of these massive loans and the default rate runs 30%, $300-500 billion in bad loan write-offs wouldn’t look very impressive in comparison to a $14.5 billion dollar profit on the income statement. The grave difficulties which are hiding in the capital structure of this bank are showing up the same way they did with Washington Mutual in 2006. The stock market kept giving Washington Mutual a lower and lower price-to-earnings ratio and the stock lagged performance benchmarks in 2006. Here is how Bloomberg describes what is going on recently with the Chinese Bank stocks:

“Investors are cutting their estimates for the value of Chinese bank assets. The MSCI China Financials Index’s price-to- book ratio, a measure of share prices relative to net assets, tumbled to 1.8 on July 29, the lowest level since February 2009, from 2.8 two years ago, according to monthly data compiled by Bloomberg. The ratio for Chinese lenders slipped below that of the MSCI Emerging Markets Index on June 21 for the first time since January 2006, data compiled by Bloomberg show.

Industrial & Commercial Bank of China (601398) Ltd., the world’s largest lender by market value, slumped 8.2 percent from the end of March through July 29 even after saying bad loans dropped almost 4 percent in the first quarter. The stock gained 1 percent today.

Credit-default swaps on Bank of China Ltd. (3988), the nation’s third-largest lender by assets, jumped to 153 basis points from 106 on March 31, according to data compiled by Bloomberg and CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in privately negotiated markets.”

The bottom line is that Washington Mutual is only in existence in the world of litigation. For those of you out there who like to avoid these kinds of risks, we at Smead Capital Management recommend you avoid China, avoid the commodities which are used most heavily in construction, avoid the makers of construction and mining equipment, avoid the countries which have benefitted the most from China’s uninterrupted growth, and avoid the vehicles used for financing all of this growth. Economist Gary Shilling said it this way:

“‘China isn’t this juggernaut that’s going to grow forever without any interruption,’ Shilling said in a July 14 interview with Bloomberg Television’s Betty Liu, adding that the government may be forced to bail out banks as bad debts grow.”

With the capital they use to recapitalize banks like China Construction Bank, we believe China won’t be able to continue their non-economic building spree. The inevitable economic recession/depression in China which we expect to follow will turn the asset allocation world upside down, in our opinion. Buyers beware!

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:

Louis Zamperini was an Olympic distance runner who finished eighth in the 5000 meter race at the 1936 Olympics. His story is chronicled by Lauren Hillenbrand in her book, Unbroken-A Story of WWII Survival, Resilience and Redemption. Zamperini’s promising athletic career was interrupted by the Japanese attack on Pearl Harbor on the seventh day of December in 1941. What happened to Louis can give us some perspective on the endurance and perseverance needed to succeed in what have been very difficult investment markets.

Louis was a B-24 bombardier. In 1943 his plane was shot down on a mission south of Hawaii. He and two other crew members survived against long odds floating on a life raft for 47 days. When they drifted 2000 miles west, they were captured by the Japanese Navy and shipped to a prison camp on the Island of Kwajalein. It was the beginning of a 30-month ordeal in numerous prison camps where he and his mates withstood horrendous torture. The most outlandish punishment came from an officer named Watanabe who the prisoners called, “The Bird”.

The Bird knew that Louis was a famous athlete and that he was very disciplined and well trained. He singled him out for especially egregious beatings in hope that it would affect the entire group of prisoners. By the time the war was over, Louis was emaciated, deeply wounded and suffering from post traumatic stress disorder. He woke up every night dreaming about being hit with the belt buckle or bat held by Watanabe. Zamperini was miserable.

At Smead Capital Management (SCM), we feel like we’ve been in an investment prison camp. First, we were shot down by the 2007-2009 Bear Market and held on to our companies like they were a life raft. We survived, but our portfolios were in pretty rough shape when the bottom came in March of 2009. Since then our portfolios have recovered. Unfortunately, few investors, either individual, professional or institutional, can find the courage to buy these wonderful companies when there could be the most to gain longer-term from employing our eight proprietary criteria for stock selection.

It is not unusual for our contrarian stance to be shunned, we’ve been in this position many times. However, in the spring of 2010 and the summer of 2011, we have been beaten indiscriminately and unmercifully by the Flash Crash and Sovereign Debt Crisis, respectively. About the tenth time you’ve been punched in the face by the “risk on, risk off” trade or beaten with an algorithm bat through “high frequency” trading you begin to lose some of your dignity like Louis Zamperini did in the prison camps.

As a 31-year veteran of Wall Street, I am well adjusted to regular temporary stock market corrections and occasional bear markets. History shows that most years include at least one decline of 10 percent or greater and that a 20 percent or greater decline happens about one out of every five years. What frustrates us as long-term holders of businesses like Disney, EBay, Merck and Franklin Resources is that there is virtually no respect shown to their superior attributes in these declines of the last two years. The result is that our companies are exceedingly cheap, in our opinion, compared to other stocks and other asset classes.

As if being punished in the investment prison camp isn’t enough torture, we have to stand by and watch the love affair investors are having with Treasury bonds and gold. It is as if a group of war prisoners are being put up at the Ritz Carlton while we join Louis eating seaweed and bug-infested rice. If two percent interest on Ten-Year Treasury Bonds and $1900 ounce gold succeed as investments these next ten years, we believe we’ll have much bigger problems than stock market performance. Grab your guns, ammo, rations and water.

Our wonderful companies already average a higher dividend percentage than the rate of interest on the Ten-Year Treasury did at the close of trading on September 6th, 2011. They trade at very low multiples of earnings and free cash flow. The dividend growth over the next ten years could provide adequate comparative returns to other asset classes without much capital appreciation. In today’s investment prison camp the dividend payout ratio on the S&P 500 Index is the lowest since 1936 at around 29 percent. As people and companies get out of the investment prison over time, we believe those payout ratios will gravitate toward historical norms around 50 percent. This means that a portfolio trading at ten times after-tax profits could easily pay a five percent dividend in the not very distant future.

By now you are probably wondering what happened to Louis. After three years of struggling with alcoholism and PTSD, Louis was dragged to a Billy Graham Revival in 1949 by his wife, Cynthia. He remembered that he’d promised God on the life raft that if He saved them he would devote his life to God. Louis started a major ministry to wayward teens and spoke all over the world about endurance and perseverance. He also forgave The Bird and his other tormentors. The PTSD miraculously went away.

We at SCM are prepared to forgive the hedge fund whiz kids, ETF flippers, algorithm traders and doomsday gold bugs who are making our investment life temporarily miserable. We expect to lead a large group of wayward investors over the next ten years to enjoy long-term ownership of high quality common stocks. All this is possible if we remain “unbroken”.

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:

They say that to make significant improvements or permanently change behavior you have to hit bottom. Once you hit bottom, you have to want to change. There is a special blessing in hitting bottom in the business world earlier than your competitors. This is true for companies and it is also true for national economies.

Home Depot was created by Arthur Blank, Bernie Marcus, Ron Brill and Pat Farrah. The leader of the company for years was Bernie Marcus. He had a passion for the business and for employees which was infectious. When he stepped back from the company in the year 2000, a former GE executive named Robert Nardelli became the CEO and attempted to improve the company through financial engineering. The attention to merchandising detail and customer service suffered once Bernie’s enthusiasm was removed from operational management of the company. Frank Blake was hired in 2007 with the morale and the performance of the company in a deep struggle. Home Depot’s number one competitor, Lowe’s, was running rings around them.

Frank Blake went to work on a company which in many ways hit bottom in 2007. By the time the “Great Recession” was in full force in 2008, Home Depot was already working on improvements which other businesses would make at the depth of the recession. In the most recent quarter of 2011, Lowe’s and Home Depot reported results which effectively were the reverse of 2007. Lowe’s earnings stagnated and Home Depot is growing again and appears to be gaining market share. Hitting bottom early was a competitive blessing for Home Depot.

Another example of this occurred in 2007 when it became obvious to Howard Schultz that he needed to retake the reins as CEO of Starbucks. The company had over-expanded and lost the attention to detail and efficiency, which was one of its hallmarks. Soon after taking over in mid-2008, Schultz announced that 600 stores would be closed and that earnings would be damaged by charges and lower sales. Starbucks corporate performance hit bottom in late 2007 and early 2008.

By 2008, Starbucks was well on its way to improving almost every aspect of their business. Then the “Great Recession” hit with full force. This caused all the businesses around Starbucks to deal with some of the same forces that their own stumble had forced them to address. In the fiscal year 2011 ended September 30th; Starbucks will have nearly doubled its peak fiscal earnings record prior to the great “reset”. Hitting bottom before most all the other businesses was a blessing.

This is not only true for companies, but it is also true for countries. It was obvious to our firm in late 2005 that residential real estate prices were nuts. We wrote endlessly about this topic during that time. The residential real estate market started to crash in the hottest markets in the US in late 2005 and in the rest of the country in 2006 and 2007. In turn, the market for mortgage loans blew up in 2007 and 2008 leading to the financial crisis of 2008 and early-2009. The US hit bottom in the economy in the first quarter of 2009 and the stock market bottomed on March 9th of 2009.

The US economy has been attempting to cleanse itself of these over-priced properties and bad loans for five years. We’ve had to recapitalize our banks through the TARP program. Businesses had to right-size their employment levels and get their balance sheets in order. Households had to aggressively attack their over-spending ways, turning Dave Ramsey into the high priest of debt reduction and have made massive improvement in their household debt service ratio.

While the US economy has hit bottom and has been cleansing itself for five years, Europe and Japan have been slow to get their act together. Japan never has cleaned their system of the loan problems of their late 1980’s bubble. Europe has a common currency and uncommon problems which they have been hesitant and reluctant to address.

Brazil, Russia, India and China have boomed and caused Australia and Canada to boom with them. The economies of Brazil and India are already showing severe cracks. Australia’s housing market is crashing. Lower oil prices could lead to major problems for Canada and its hot residential real estate markets. Bank loans that are going bad are haunting the economies of the BRIC nations. Here is how Bloomberg Business Week’s Michael Patterson explained what is going on in the emerging market world in their August 15th-28th issue:

“Loans to Brazilian shoppers, Chinese infrastructure projects, and Indian property developers have fueled the global economic recovery and turned emerging-market banks into some of the world’s biggest firms by market value. The party may be ending. Worrisome inflation rates in Brazil, Russia, India, and China have local monetary authorities raising interest rates and tightening credit conditions. That, plus evidence nonperforming loans are on the rise, has investors rethinking their enthusiasm for BRIC bank stocks.”

China has an even nuttier residential real estate bubble than we had in the US, in our opinion. China has more bad real estate and infrastructure development loans in their banking system today than the US did back in the late 1980’s, when we had the Savings & Loan debacle. The US banking crisis in the late 1980’s ended in the Resolution Trust Corporation handling bad development loans at taxpayer expense. It looks to us like a $1.5 trillion black hole waiting to be filled by the Chinese government. In other words, these other countries like China are at the beginning of their skid and nowhere near the bottom as yet.

Fraser Howie, the co-author of “Red Capitalism”, expounds on China specifically in a piece in Barron’s August 29th. He sees, “more problem loans ahead for China’s big banks, with negative consequences for global economic growth.” Here is how he details the problem loans:

“China’s banks issued a record $2.8 trillion in new loans, of which $1.7 trillion went to local governments. While the big four banks— Industrial & Commercial Bank of China (ticker: 1398.Hong Kong), Agricultural Bank of China (1288.Hong Kong), China Construction Bank (939.Hong Kong) and Bank of China (3988.Hong Kong)—reported nice first-half earnings gains last week, as well as limited impact from local-government lending, fresh problem loans are likely to surface in the future, says Howie, a Singapore-based executive at the investment bank CLSA Asia Pacific Markets.

Worse, the banks are ill-equipped to handle them, he said in an interview last week.”

Summing up the investment landscape from the angle of banking weakness in the BRIC countries Howie said:

“But weakness in China and the knock-on effects will surely hit a raft of investments premised on breakneck growth, among them mining stocks, commodities, construction plays and retailers. China ultimately has an unsustainable banking system.”

We believe that the first country to hit bottom, the first to confess its mistakes the way Frank Blake and Howard Schultz did for their companies, and the first to cleanse the banks, corporations and households will lead to lasting prosperity long before any other country in the world does. We also believe that the investment rewards of US non-cyclical large cap common stock investing has rarely looked more attractive because of the willingness of investors to underestimate the benefit of hitting the skids before everyone else does.

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 we have made it a high priority to pay attention to the investors who have proven over decades that their work proves worthy of great respect and admiration. In baseball, you can make the All-Star team with one great season, but to make the Hall of Fame, you need a long career at very high levels of success to be inducted. Our industry is wonderful because we can look very closely at the investments and writing of these people we have great respect for.

All great money managers reach a point in their career where adulation and self confidence detracts from their better judgment. This interruption in judgment usually coincides with the discipline in use becoming the most popular discipline in the marketplace or the investing style being overdue for a three to five-year correction. Studies of the equity managers with the best long term records show that the best underperform the S&P 500 Index 35% of the time. The pride associated with multi-decade success and the reinforcement of an army of folks enjoying your work is probably the most dangerous thing that can happen in the money management business.

To understand these phenomena, we will review the work of Warren Buffett, Bill Miller and Kenneth Heebner on a backward-looking basis. Then we will examine Jeremy Grantham and Bill Gross looking forward. Our supposition is the following. These men make up a short list of five of the best money managers of all time! However, there is a point in their career when their pride can get in the way of their better judgment and capital can get destroyed.

Warren Buffett is the most successful money manager of all time, in our opinion. His long-term compounding of book value at a rate in excess of 20% is legendary. To this day, I’d rather be a fly on the wall in his office than one in anybody else’s office in money management. In 1998, he was uniformly admired by the media, by a slew of book writers and by a huge army of professional and individual investors. He wrote in his 1996 annual shareholder letter that stocks like Coke (KO) and Gillette (now part of Proctor and Gamble) were the “inevitables”. In Buffett’s eyes, these companies had such dominant moats, sustainable profit margins, strong balance sheets and other strengths that he could ignore the fact that they reached PE multiples of as high as 57 times trailing earnings. These stocks were “maniacal” and were trading at PE multiples which doomed their stock prices for ten years. Coke peaked at around $88 in 1998 and bottomed in 2009 around $38 per share. Warren’s big mistake list is so small that you need a magnifying glass to read it. I believe that everything going on around him in 1998, the adulation and the uninterrupted success got the better of him. His popularity dropped in 1999 as the Tech Bubble went into its highest gear. By early 2000, many writers were asking if Warren Buffett’s investment discipline was old-fashioned and out-dated.

Bill Miller beat the S & P 500 Index for 15 years from 1991-2005. He has the unusual ability to recognize deeply out of favor stocks in widely diverse industries and then has the constitution to hold his winners for many years. He specializes in high reward and volatile positions and is unafraid to average down far longer than most admirable money managers. By the end of those 15 years his streak was followed heavily by the media, his parent company (Legg Mason) boomed and financial advisors nationwide poured billions of dollars into the two funds that he manages. We at SCM believe that he is as brilliant a thinker and money manager today as he was in 2005. He’s only out-performed the market once since 2005 in the year 2009. His five-year numbers are 99th percentile in his category. We assume that the circumstances brought pride into the picture and that these last five years have been incredibly humbling.

Kenneth Heebner manages money in a way that is unfathomable to this writer. He takes concentrated positions based on strong opinions and analysis. He had the best 15-year track record among mutual fund managers in 2008. He produced stunning results in the first eight years of the decade of the 2000’s. However, he turns his portfolio over aggressively and constantly. In May of 2008, he was called “the best money manager around” and featured on the cover of Fortune magazine. Enormous adulation was heaped on him by the media and billions flowed into his mutual funds. At the top of the commodity markets in the late spring of 2008, Ken Heebner was massively over-weighted in energy, basic materials and heavy industrial companies. He immediately went from there to an aggressive over-weighted position in financials. His performance over the three years since the overwhelming adulation has been dismal. He is one of the most talented managers of money, but pride temporarily got the best of him.

Jeremy Grantham and Bill Gross are Hall of Fame money managers. Grantham leads the firm of Grantham Mayo Van Otterloo (GMO) which is a leading strategic wide-asset allocation firm. He has been unusually accurate in his long-term predictions in everything from lumber to large caps and emerging markets to energy. His firm is drowning in new money and his specialty area, asset allocation, is the darling of institutions, registered investment advisors, consulting firms and financial advisors. Even stock pickers like us pay attention to Grantham’s thoughts on asset allocation and GMO’s 7-year prediction for inflation-adjusted forward performance expectations. He has been spot on and his research director, Ben Inker, has done some of the best investment research in the marketplace. Grantham is currently known for his “7 lean years” thesis and in his latest quarterly letter titled “Danger: Children at Play” he nearly exhausted himself taking victory laps around the nine pages and an addendum. This comes just three months after Grantham boldly predicted that commodities were in a “paradigm shift” and had , in effect, reached a “permanently” higher plateau!

Bill Gross is the most successful bond mutual fund manager in history. His company, PIMCO, manages over $1 trillion for institutions and individual investors. During the bull market in bonds from 1981 to today, he has handled every environment well and produced a market beating track record. His monthly missives are followed closely by the same crowd which feasts on Grantham’s quarterly letter. The bond bull market in the US has culminated the last three years in an avalanche of money drowning bond managers like Bill Gross. Those investors, advisors and institutions will recite statistics about how much better bonds have done than stocks the last 10 and 20-year periods. Bill Gross even has a very similar forward thesis to Grantham’s which he calls the “New Normal”. It is a relatively negative belief that the US has more than a decade of penance to pay for the financial and real estate sins of the decade from 1998-2008. His firm travels around the world explaining how they are looking for bonds in countries which benefit from emerging market growth to protect against both currency declines and to get a decent rate of interest. When Bill Gross and other major players at PIMCO are on CNBC, the world seems to stop to find out what the markets wisest players have to say. The adulation from all corners is thick enough to cut with a knife and the pride in PIMCO’s opinion continues to rise.

If this piece were a trial rather than a missive, it is safe to say that Jeremy Grantham and Bill Gross are in a very similar and guilty position compared to the Hall of Famers we mentioned in the beginning. Buffett stumbled when his favorite kind of stocks (large-cap/wide moat/strong balance sheet/powerful brands) were wildly popular. Bill Miller became the most respected equity mutual fund manager at the height of eclectic stock picking. Kenneth Heebner headed into the tank right after he got unusual media attention and his “go anywhere” discipline squeezed every dollar out of the marketplace it could. They have been in Jeremy and Bill’s shoes.

Therefore, what could happen to ruin the party for these two great money managers? They would have to have a very rough three to five years of performance and the thesis they are operating on would have to be wrong. We believe bonds will never be more popular in the next thirty years than they are now. We believe that so many people are practicing wide asset allocation that it will be a “nightmare” the next five to ten years. We believe that a bear market has started in oil and commodity indexes which will embarrass today’s bulls. Lastly, we believe that the ability of the US economy to heal itself is being badly underestimated by these two great money managers.

As contrarians, we can’t run away from the opinion of these great money managers fast enough. This is not because they aren’t deserving of Hall of Fame status, but because they are trapped in today’s two most popular disciplines with all the same adulation and pride that our other great managers had before them. Both favor emerging markets over the US, have confidence in commodities, assume China’s economy will grow uninterrupted; both think the US consumer is dead for years and both think that the US is a political disaster area. We will still admire them when those who fawn over them today no longer have respect for them. This will be after the “pride that leads to destruction” turns into humility in the marketplace.

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.