William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In his recent 2011 shareholder letter, Warren Buffett explained the purpose behind investing, the “real” definition of risk, and the three types of investments which congregate the marketplace. At Smead Capital Management, we believe Mr. Buffett struck at the core of the problem that most institutional and individual investors are having. They are defining risk primarily by what happens in the next twelve months, while the Oracle of Omaha is thinking in five to ten-year time frames, at a minimum. These short time frames are combined with eyes locked on the rearview mirror, inhibiting investors from participating in wealth creation as we look out into the future.

In Buffett’s mind, “investing is forgoing consumption now in order to have the ability to consume more at a later date.” In essence, that is the purpose of investing. Notice that Buffett never includes any physical or mental limitations on investing. As a former 5’ 8” left-handed pitcher and first baseman, I am very glad there are no physical limitations. You don’t need to be a Valedictorian in high school or among the Phi Beta Kappa’s in college. We believe investing is something that is done for the purpose of increasing purchasing power or wealth in reasonable time frames and in securities which make sense at very average IQ levels.

This leads us to how most of today’s market participants define risk. Short-term price movements or volatility are how most academics and current market participants define risk. Buffett refers to it as beta in the letter, “a Wall Street term encompassing volatility and often used in measuring risk”. Beta is how much the price of your security adjusts as compared to the price adjustments of its index. Recent (three to five-year) history, which includes the huge meltdown/liquidation of 2008, is fresh in everyone’s mind. Therefore, in our opinion, institutional investors have organized their asset allocation around surviving the worst possible 12-month price movements. This has caused high commitments to the bond market, commodity markets and emerging stock markets around the world. We feel individual investors are highly over-committed to the bond market after gorging on bonds for three consecutive years!

Fortunately, Mr. Buffett has been kind enough to breakdown the three categories of investment. Those categories are currency based investments (money market funds, CDs, bonds, etc.), unproductive assets (gold, art, collectibles, etc.) and productive assets (common stocks, farmland and real estate). We at SCM believe he did this because of the popularity of the first two categories. We think the popularity has ruined them for use in five to ten- year time frames.

Buffett is very strict in that he asks for an increase in purchasing power above and beyond inflation. Mathematically, if history is any guide, currency investments have very little chance of increasing purchasing power over the five to ten-year pull. We believe the only chance would be a prolonged period of deflation which a number of doomsayers are happily promoting. Here is Buffett’s take:

“Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as ‘income’.”

Currency investments are for money which has a reason to fail the risk test. The owner agrees to give up purchasing power in the long run to have more stability and certainty in the short run.

The second category of investments is what Buffett calls “unproductive assets”. Here is his description:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.”

In his book, “A Short History of Financial Euphoria”, John Kenneth Galbraith explained, “by 1636, a tulip of no previously apparent worth might be exchanged for ‘a new carriage, two grey horses and a complete harness’.”

Buffett chose to focus on the “granddaddy” of all periods of unproductive asset euphoria to shed light on the current mania for gold. Turn on the TV for any extended time period for 24-hour news or business news and you will get bombarded by offers to sell you gold. Our rule at SCM is to sell what the majority of promoters are promoting. Right now that is spelled G-O-L-D! Buffett uses the last two major US bubbles to take a serious punch at gold:

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end’.”

The third category is productive assets like ownership of a business, farm land and real estate. Meeting an economic need and getting compensated with cash profits or rent. Thanks to the commodity bull market of the last ten years, farmland appears over-priced (see chart below).

Here is a picture that is worth a thousand words:

Source: blog.agnetic.com, October 24, 2011 “Black Swans are Landing on Your Farmland”

These are the categories which historically have increased the purchasing power of folks over long-term stretches. Buffett says it best:

“Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

Our nation is dominated by retiring baby boomers in the 50-65 year-old age range who need their money to last 20-40 years and institutions in need of increasing purchasing power for perpetual asset bases. Ownership of businesses, especially common stocks, has dropped dramatically since the stock market bubble peaked at the end of 1999. At SCM, we are willing to accept the possibility of loss in the next 12 months to gain significant purchasing power over the next ten years. We would assume a minority of investors are postured that way currently because of the way they define risk.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

We have been traveling around the world delivering a talk to CFA Societies on why passive indexes beat most active equity funds. We start the talk with the following William Sharpe quote from 2002:

“Should everyone index everything? The answer is resoundingly no. In fact, if everyone indexed, capital markets would cease to provide the relatively efficient security prices that make indexing an attractive strategy for some investors. All the research undertaken by active managers keeps prices closer to values,
enabling indexed investors to catch a free ride without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities.

Should you index at least some of your portfolio? This is up to you. I only suggest that you consider the option. In the long run this boring approach can give you more time for more interesting activities such as music, art, literature, sports, and so on.”

Jason Zweig of the Wall Street Journal wrote a blog last week titled, “Simple Index Funds May Be Complicating the Stock Market”. In it he explained how passive investments have risen to 33% of the money in equity mutual funds. He theorizes that all these agnostic investments might be adding to the volatility and the high correlations in the marketplace:

“Recently, leading investing experts—including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University—have been warning that index funds could destabilize the financial markets.

The rise of trading in index funds, these researchers say, is causing stocks to move more tightly together than ever before—as if they “have joined a new school of fish,” as Prof. Wurgler puts it. That is reducing the power of diversification and could make booms and busts more likely and more extreme.

Unlike conventional funds run by highly paid stock-pickers who seek to buy the best securities and avoid the worst, index funds—including most exchange-traded funds, or ETFs—effectively buy and hold all the securities in a market benchmark such as the Standard & Poor’s 500-stock index.”

Let us unpack Sharpe’s theory, Zweig’s hypothesis and our manifesto on “Long Duration Common Stock Investing”, to see if we can make sense out of today’s stock market environment.

William Sharpe was an efficient market believer in 2002. His beliefs are predicated on two ideas. First, “All the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs.” In his research on intrinsic values in February of 2009, Ben Inker at Grantham, Mayo and Van OtterLoo (GMO) concluded that 75% of the intrinsic value of a company comes from cash flows starting 11 years from now and that 50% of the intrinsic value is from cash flows that come more than 25 years from today. Since there is almost no long duration equity research analysis done on Wall Street, the market can’t possibly be efficient. The stock market and its participants have been compacting the duration of their equity investments constantly since the stock market topped in early 2000. Holding periods are down to historically low levels on the NYSE, institutions are heavily committed to hedge funds with very high turnover and active equity fund managers have average turnover around 100%. A manager with 50% turnover is considered a low turnover manager!

Second, Sharpe was expecting that those who get paid to asset allocate would never get so heavily involved in indexing as to ruin the goose that laid the inexpensive and consistent “golden eggs”. Indexing success is predicated on being a small minority of the marketplace. In effect, its popularity is dooming the strategy and making the market even more inefficient than it was before! Between short-sighted active investors and agnostic indexers dominating the market, Zweig explains that you get very high correlations and extreme volatility. The volatility drives potential long duration investors away from the marketplace.

“Considering that index funds charge annual fees about one-10th of those levied by actively managed funds, it isn’t any wonder indexing has become a money magnet. A decade ago, 278 index mutual funds and 119 exchange-traded funds held $347 billion, or about 16% of all assets in U.S. stock funds. Today, according to Morningstar, 336 index funds and 1,148 ETFs hold $1.24 trillion, or fully one-third of all the money in U.S. stock funds.

That worries some analysts. “Markets work best when people think and act independently, not all together,” Mr. Sullivan says. When investors add money to an index fund, it generally will buy every security in the market that it tracks—hundreds, sometimes thousands at a time, regardless of price. When investors pull money out, the index fund has to sell across the board.”

We believe the solution to these times is at the heart of our manifesto. You need to analyze companies with a special focus on characteristics which contribute to long duration. We like wide moats, sustainable high profitability, high free cash flow and strong balance sheets. GMO likes low beta, low leverage, high sustainable profitability and low earnings volatility. These are all factors which contribute alpha over long stretches of time.

In our opinion, you either need to be a low turnover stock selector or hire one to be your equity representative. Warren Buffett is quoted as saying, “The stock market serves as a relocation center at which money is moved from the active to the patient.” The main attraction to the S&P 500 Index is it has low management fees in a mutual fund or ETF form and very low trading costs due to turnover that averages below 5% per year. Boston College’s Center for Retirement Research found that the average US equity fund spent 1.44% per year on trading costs. Add this to management fees and operating expenses in the mutual fund world and you need the equity manager to beat the S&P 500 Index by at least 2.5% per year just to keep up. We strive for turnover in the 15-25% range and seek miniscule trading costs.

Scarcity creates value in economics. In our view, what is scarce today is an equity manager doing long-term/long duration equity analysis and institutions/individual investors willing to employ them. Since 33% of the stock market is indexed and most of the other 67% works in very short analytic time frames, we believe the market must be as inefficient as it has ever been. Time is the ally of the long-duration common stock investor and we believe more so now, because indexing is getting too popular and investing in short durations is at epidemic levels. We wonder what William Sharpe would say today.

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:

Trends which have been in place for years and appear overcooked are hard to wrestle with. In the mid-1980’s, a columnist for Forbes magazine, Shad Rowe, wrote a piece which included the following story:

A Texas oil and gas wildcatter was praying and asked God two questions. The questions were, “Will the price of natural gas ever go up again, and, if so, when?” God spoke to the oil man audibly from heaven. The answer to the first question was yes, but the answer to the second question was “not in my lifetime”!

You probably think that this is leading into a conversation about the current depressed price of natural gas and the huge spread between it and oil prices. Instead, we at Smead Capital Management (SCM) would like to talk about the despair associated with being a contrarian near the bottom of a bear market or the top of a bull market. Are there things which happen at these extremes which set the stage for a change in direction to the existing and powerful trend?

We believe at SCM that the bottom of a bear market or “point of maximum pessimism” comes when the sellers at the margin are market participants who would actually prefer to be buying. Whether selling to meet mutual fund redemptions or responding to margin calls, the seller at the bottom sells exactly the securities which they prefer to buy. A few examples might be helpful. The Bass family held a huge position in Disney (DIS) since 1984 when they served as the “White Knight” to Saul Steinberg’s accumulation of a 6.3% position and a takeover threat. With a heavy investment from the Bass family, Disney paid Steinberg over $300 million to go away. Near the bottom of the 2000-03 bear market, the Bass family had to sell Disney shares at $15 to meet a margin call in their portfolio. Today it is around $40 per share.

Aubrey McClendon, the CEO of Chesapeake Energy (CHK), was hit by a massive margin call on his shares in October of 2008. This virtually wiped out his ownership in the company. He has rebuilt his position, some say at shareholder expense, but the stock is still dramatically higher today that at the lows. He would have preferred to be a buyer. Recently, Bruce Berkowitz, the highly respected manager of the Fairholme Fund, was forced to sell many of his favorite financial stocks to meet mutual fund redemptions because of the nightmarish performance of financial stocks as investors capitulated in the second half of 2011.

At the top of a bull market, the buyer is a short seller being forced to cover an overvalued security or portfolio managers who are window dressing late in the cycle to preserve their jobs. When you are short at the end of a bull market, the old saying goes, “the market can stay irrational longer than you can stay solvent”. Short sellers have unlimited downside risk. As a portfolio manager myself back in late 1999 and 2000, I was encouraged by friends to take 15% of our portfolios and put them into tech stock alternatives like Cisco (CSCO), EMC (EMC) and Microsoft (MSFT), so that my clients wouldn’t fire me. I was stubborn, but a number of investors left us because they couldn’t stand everyone around them getting rich quickly on tech stocks and Initial Public Offerings (IPOs) of dotcom stocks. US large cap equity managers were flooded with money from 1998-2000 and were forced to buy over-priced common stocks against their better judgment.

This brings us to where we are today in the investment marketplace. In early February of 2012, the US Federal Reserve Board revealed their intent to leave short-term Treasury interest rates near zero for as long as the end of 2014. The answer to the question is “not in my lifetime”. The question is, “When will the Federal Reserve allow the open market to set short-term Treasury bill rates?” In other words, when will short-term rates gravitate to the level of inflation around 2-3%?

We at SCM felt like Ben Bernanke punched us in the stomach. We own companies which have strong balance sheets and produce very high levels of free cash flow. Our assumption is that the P/E ratios on the companies we own will move from the current discount to a premium as short-term capital becomes more expensive. We believe that when short-term interest rates are held artificially low the capital market participants overpay for shares in companies which are capital intensive, highly indebted and inconsistent producers of free cash flow. These “capital eaters” have been provided “free capital” and have been the place to be for the last five to ten years. Investors are like my father, who was a child of the depression. When he was a kid, food was hard to come by in the 1930’s. When he walked into an all-you-can-eat buffet restaurant in the 1960’s and 1970’s, the owner shook with fear. He stayed for two hours and made sure he made up for the food he couldn’t eat earlier in his life.

This “artificial” cost of capital has caused a long bull market in the stocks of capital intensive energy companies, basic materials producers and heavy industrial stocks. Long bull markets forced money managers and asset allocators to overweight “capital eater” industries. These industries have suckled on the “bounteous teat” of the emerging market economic growth story. These emerging market nations are themselves massively capital intensive with very high levels of GDP coming from fixed asset investments. Their currencies are boosted by “zero” interest rates in the US, even though their own interest rates are nothing to write home to mom about.

The weak dollar and international economic fears have sparked multi-year bull markets in gold, oil and most major commodities. This has forced asset allocators at the largest institutions, consulting firms, registered advisory firms and financial advisor networks to over-emphasize all aspects of the “capital eaters” and the longer-term Treasury bonds which compete for these dollars. In effect, the Federal Reserve Board caused the last of the unbelievers to give up in early February because it does not appear that rates will rise “in our lifetime”.

Since we are not asset allocators or bond fund managers, we assume that all of those who agree with us felt like giving up on the idea that short-term Treasury rates will rise soon enough to give our thesis any benefit when Ben Bernanke made his announcement. The start of the year 2012 has seen a big move in the same kind of investments which have starred for ten years like gold, oil and emerging stock markets. The largest bond fund in the world, Pimco Total Return Fund has moved from shorting long-term Treasuries to a 35% long position recently. Our guess is that the buyers of securities in these markets are covering short positions or window dressing their portfolios due to “career risk” at the end of a bull market. They are doing this because Bernanke effectively told them that rates would rise someday, but “not in their lifetime”.

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

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

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

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

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

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

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

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

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

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

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

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

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

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

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

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

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

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

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.