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.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

As the chart below shows, correlations among the S&P 500 Index companies was the highest on October 10th of 2011 as it has been for 25 years.

In the opinion of Smead Capital Management, this means that more investors are participating in market directional strategies, macro-economic strategies and tactical portfolio strategies than at any time in US history. John Maynard Keynes was a great investor, as well as a famous economist, and he said, “Investing is the only sphere of life where victory, security and success go to the minority, and never to the majority”! As it does every time, Wall Street creates new instruments to satisfy the demand that comes from individual and institutional clients to pursue what was successful in the prior five years. These directional investments come mostly in the form of Exchange Traded Funds (ETFs). The tactical portfolios come from go anywhere mutual funds, which have become immensely popular and the macro-economic investments have been the domain of the hedge fund world. They are all designed to fit into the wide asset allocation models which are being employed by almost everyone in the wealth management world.

Wayne Gretsky, when asked why he was such a good hockey player said, “I skate to where the puck is going to be”. We believe that the correlation chart is screaming for reversion to the mean. It tells us that stock picking will never get more out of favor in the investment business than it was on October 10th. In other words, there is an over-capacity of asset allocation and a scarcity of stock picking. Large-cap stocks in the US have done poorly since 1998.Those who moved away from US large-cap stocks between 1998 and 2003 to other asset classes took advantage of inexpensive asset classes and made a smart shift. By 2007, the shift was nearly complete and has only been exacerbated by 2008′s cataclysmic decline in stocks. After two 40% or greater stock declines in one decade, stock picking became overwhelmingly out of favor. The assets under management gravitated from the large cap US funds to the directional, macro -economic and tactical strategies, where we stand today.

Alas, all of this came to a peak in 2011. The asset classes like commodities and emerging/global markets ended up with a massive amount of money and US large cap suffered record setting net liquidation. We believe the commodity and emerging market asset classes have entered a terrible bear market for the next five to ten years. Fortunately, two of the best stock pickers have rung the bell for everyone. Warren Buffett announced that he is an aggressive open-market buyer of individual large-cap stocks and Legg Mason punctuated the cycle by nudging Bill Miller out the door as CIO and lead manager of the Value Trust Fund. (see link)

As large-cap value managers and stock pickers, we are very excited about the next three to five years as all the chips have moved to the other side of the table and stock picking has become a scarce resource.

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

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

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

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

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

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

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

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

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

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

Best Wishes,

William Smead

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

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

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

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

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

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

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

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

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

Best Wishes,

William Smead

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

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

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

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

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

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

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

Best Wishes,

William Smead

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