William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version
Subscribe to the Missives Podcast
Click here to listen to this Missive

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.

The information contained in this tv appearance represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this tv appearance 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.

by Joe Galante

For more information go to www.businessweek.com.

The information contained in this article represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this article 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
Subscribe to the Missives Podcast
Click here to listen to this Missive

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.