William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Charlie Munger, the Vice Chairman of Berkshire Hathaway, has said many times that psychology is the most under-utilized discipline in business. He compares the business person or investor, who doesn’t have an inter-disciplinary set of “mental models” including psychology, to a one-legged person in a kick-boxing competition. We believe that those using low consumer confidence as a reason to be bearish about US large cap stocks and consumer discretionary stocks are equivalent to one-legged kick boxers.

At the website, The Big Picture, Barry Ritholtz shared his thoughts (Nov. 4, 2011) on the US employment numbers. We have respected the thoughts and research of his firm because they were early in understanding how damaging the housing bubble was going to be on the US economy. However, this time we believe that the trap that the market has laid for investors in the area of unemployment and consumer confidence is well set. We believe that a number of savvy analysts are not “seeing the forest for the trees” when it comes to understanding the history, psychology and the accounting of consumer behavior.

We at Smead Capital Management believe two things about consumer spending and consumer behavior in the US. First, the income statement of US households tells you more about future spending than consumer confidence does. Second, we believe Andy Grove’s professor at the City College of New York was right when he said, “When everyone knows that something is so, nobody knows nothing!” In other words, is there an investor left in the world who has not anticipated that it will be years before the US consumer makes a comeback? Consumer confidence is a neutral indicator most of the time and a valuable contrary indicator at extremes.

Let me unpack these two ideas. The Federal Reserve Board has maintained statistics on US households since 1980 measuring the percentage of gross household income required to service household debt. You can view these stats by going to www.federalreserve.gov/releases/housedebt/. There you will see that the real estate and borrowing bubble of the 2000’s allowed US households to get to ridiculously high ratios of household debt service (around 14% of income at the peak). This was markedly higher than previous peaks of 12.4% in prior cycles. You will also see that US households have made huge strides since late 2007. These statistics are lagged by three months or more, but you can see that by June 30th of 2011 the ratio had fallen to 11.09%. Assuming that this trend of austerity continues through the next 12 months, the US Household Debt Service Ratio could fall to the low levels of the early 1980’s deep recession at 10.6% and in the job-less recovery of the early 1990’s.

Think of it like this. Who is likely to spend money and do it more consistently, someone who’s in very good shape on their income statement that lacks confidence or someone who is up to their eye-balls in payments but brims with confidence? The unconfident households with room in their income statement will ultimately be part of what we call “pent up demand” for goods and services. The car wears out or the fridge needs replacing or the kids are going to get too old to want to go to Disneyland, so you breakdown and do it. You don’t have much confidence, but you can afford the expense.

These facts have been baffling to most stock market participants for nearly three years. In the world of the supposed “new normal”, why is everything happening pretty normally among US consumers who are providing great business to McDonald’s (MCD), Starbucks (SBUX) and Nordstrom (JWN)? We believe the record-setting low consumer confidence numbers of 2009-2011 and the continuing high levels of unemployment that The Big Picture speaks of have been the reason that the money management community has avoided the consumer discretionary category.

We looked at the correlations between consumer confidence and the stock market between 1977 and 1996. What we found was that there was almost zero correlation and it was a neutral. If you look at the period since 1996, consumer confidence was a valuable contrary signal at extremes and the correlation is significant. Stocks were to be avoided on high consumer confidence and the stock market lows have coincided with low consumer confidence.

Going back to Andy Grove’s professor, the logical thing that everyone knows is that US households have a great deal of debt to work off over the next ten years and the US government has a very large amount to deal with itself. Everyone has assumed that the consumer wouldn’t be able to lead a meaningful economic recovery until those debt levels come back in line from a historical standpoint. This has resulted in significant under-ownership by professional money managers and asset allocators in the consumer discretionary category. We believe that until the money management community capitulates and buys into the consumer sector that it will out-perform the S&P 500 Index. And we believe that the capitulation will come at dramatically higher consumer confidence levels and we are about as far away from those statistics in early November of 2011 as you can be!

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 opinion of Smead Capital Management, computers, cable TV, the Internet, 24-hour news and a variety of other forces have greatly affected successful participation in the US stock market. These forms of information gathering attempt to push people away from the most important fact that exists in common stock investing. The fact which we believe matters more than any other is that owning all or part of an outstanding company for many years is one of the simplest ways to attain wealth and compound liquid assets at high rates of return. In today’s missive, we will look at how far “out of season” the fact we believe in is and think about how important it is to be ready for the season to come.

The Ibbotson Group has been kind enough to share statistics on the returns from liquid asset classes since 1927. Treasury bills have returned about 3% per year, Long-Term Bonds have earned about 5.5% and US common stocks (as represented by the S&P 500 Index) have averaged around a 10% return. Running parallel to these statistics are the studies (including the one provided below) which show how poorly investors actually do who participate in the stock market compared to how the market itself does. As you can see, about 58% of the return from stocks gets lost in the poor timing decisions of owners by adding to their stock portfolios at high points and selling at low ones.

“Average Investor Equity” is represented by the mutual fund inflows and outflows over the corresponding time period to simulate the behavior of the average equity investor. Average equity investor results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net sales, redemptions and exchanges for the period.

Source(s): Index Fund Advisors, from Dalbar, Inc. report QAIB (Quantitative Analysis of Investor Behavior)

Computer access leading to internet provided information is drowning the average amateur and professional investor. How much computer time do you need to know that Disney (DIS) is the world’s number one baby sitter? How many Walgreen’s (WAG) locations do you need to see or visit to conclude that they have a very consistent business? What number of hours online causes you to appreciate the branding power of the Aflac (AFL) duck? Investors only need a little drink of water in the way of information, but instead, they get drowned in a fire hose of info.

Thanks to 24-hour cable TV news, investors have a constant stream of bad news. This world of 7 billion people is kind enough to provide us a daily disaster and to teach all of us more about macroeconomics and scarcity than any college under-grad would ever want. As Jim Collins has pointed out in his new book, “Great by Choice”, the great companies are not considered great because they existed in a world where bad things never happened or bad luck never occurred. Rather, it was that they did the things that they could control and assumed that the circumstances around them would be chaotic and difficult along the way. In the Jim Collins world, it does you no good to predict economics or natural disasters. It is much more important to own part of a very strong organization which expected numerous possibilities and scenarios.

Why is our view of the world “out of season”? Most investors do their investing in the rear-view mirror. They look at what has been successful the last 5-10 years and expect more of the same. They see that emerging market investments, commodities and related industries have boomed since ten years ago. They see Caterpillar (CAT) selling gigantic machines to China, Joy Global (JOYG) helping miners dig up copper and gold, and major oil companies/oil service organizations going gangbusters to satisfy an insatiable demand for crude oil and its derivatives. In the month of October which just finished on Monday, basic materials companies were the best performing category in the huge rally off of the early October lows. They’ve only been “in season” for about ten years.

Second, they see that the US stock market has made no meaningful headway since 1998. The last 13 years has been a poor stretch from a historical standpoint and those who sought to become wealthy by owning outstanding, non-cyclical companies struggled compared to history. Those who traded the market swings successfully are well reported on TV and through dissemination online. This market timing is always admired after years of range-bound markets. Unless I’ve missed something, there are few market timers in the Forbes 400 wealthiest Americans. However, most of those on the list got there by owning successful businesses for a long time and did it in a concentrated way. They never checked to see how the folks on TV or online thought about holding on to their company.

Third, those who gorge on stock market information currently see unbelievably high correlations among risk-oriented assets. One study shows that since 2008, oil and US stocks have been positively correlated. For the thirty years prior, the correlation was negative by almost that exact same degree that it’s been positive lately. This is ludicrous! Unless you are a massive net exporter of oil, higher oil prices are a nightmare. We are watching for those correlations to move back to normal in the near future. Recently stocks in the US have traded more persistently in tandem than nearly any time within the past forty years , with the possible exception of the 1987 crash. High correlations are “in season”, but history shows that they have always reverted to their mean.

Lastly, the most damaging aspect of these forces which provide too much information is that they produce activity. Activity is the enemy of those who own all or part of an outstanding company. Ignoring the crowd and temporary problems eliminates trading costs, reduces IRS access to your wealth and allows you to gain the benefit of dividends and dividend growth. Most studies show that over very long periods of time (30-50 years) that dividends make up 40% of that 10% return which Ibbotson calculates for US stocks.

The great irony of today is that most of the companies which fit our eight proprietary criteria for selecting stocks sell at a PE ratio at or below the S&P 500’s average. In addition, at the end of October the S&P 500 traded at 12.9x trailing earnings, well below its median of 18.1x over the prior twenty years. The nice thing about being in the business for 31 years is getting to see that the seasons of investing do change. In our opinion, the next season could last a long time.

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:

Mark Hulbert does a great job of explaining how sentiment works in bull and bear markets. He has examined market statistics and investment newsletter writers for the same 31 years that I have been in the investment business. His analysis shows that bull markets climb a wall of worry and that bear markets decline on stubborn bullishness. Investors buy the dips in bear markets and become more committed all the way down. It reminds me of the main characters in the movie, “Dumb and Dumber”. Lloyd Christmas (Played by Jim Carrey) and Harry Dunne (Played by Jeff Daniels) seemed to compound their mistakes in every pursuit they undertook.

What brought this to mind is the price action of the last week in the US stock market. Stocks have rebounded sharply from the lows of Monday, October 3rd. The rebound has been led by Energy and Basic Materials stocks like Apache (APA), Joy Global (JOYG), Freeport McMoran Copper and Gold (FCX), Schlumberger (SLB) and Caterpillar (CAT). These have been the heart and soul of the BRIC trade for the last 5 to 10 years. The theory is that the growth in China and India will cause immense demand for energy and basic materials. This in turn causes Brazil and Russia to prosper by providing China and India with the energy and basic materials they need. They are not in the BRIC acronym, but you can throw Australia and Canada into that mix.

If you read David Barboza’s columns in the New York Times, you’ll see that a major credit crunch in China is causing all hell to break loose in the world of small to medium size businesses. They are the entrepreneurs in China and they have not received loans from the four largest banks in China which are government owned. The Chinese government’s dictated lending spree of the last three years went to communist party officials at the municipal level, who formed special purpose vehicles to develop condo, office building and other infrastructure projects. Instead, a massive underground lending system has developed where risk takers with cash have sought higher interest rates than the government-controlled banks offer. This money was loaned to businessmen and developers who couldn’t get the cheap financing offered by the government. The borrowers wanted these loans to ride the boom. These small to medium-size businesses operate on fairly thin margins and the slowdown in the world economy of the last six months, triggered by supply chain problems in Japan, has put many of them over the edge.

Thousands of Chinese business owners are disappearing and walking away from their business because they can’t meet the demands of the high interest rates and the underground loans they have taken to fund their business. Here is how David Barboza describes the situation in his October 13th piece called, “As China’s Economy Cools, Loan Sharks Come Knocking”:

WENZHOU, China — The 300 employees of Aomi Fluid Equipment here were delighted recently when the owner offered an all-expenses-paid, two-day trip to a mountain resort three hours away.

The owner, Sun Fucai — or Boss Sun, as he’s known — was so insistent that his workers attend that he imposed a $30 fine on any employee who refused the getaway. Nearly everyone went.

Except Boss Sun.

When the employees returned from their holiday, they found that the factory had been stripped of its equipment and that Boss Sun had fled town. “It was entirely empty,” Li Heying, a former Aomi worker, said of the factory. “It was like what happens in wartime.”

The boss, as it turned out, was millions of dollars in debt to loan sharks — underground lenders of the sort that many private businesses in China routinely use because the government-run banks typically lend only to big state-run corporations.

As China’s economy has begun to slow slightly, more and more entrepreneurs are finding themselves in Mr. Sun’s straits — unable to meet debt payments on which interest rates often run as high as 70 percent in this nation’s thriving unregulated, underground loan system. Such illegal lending amounts to about $630 billion a year, or the equivalent of about 10 percent of China’s gross domestic product, according to estimates by the investment bank UBS.”

A major credit crunch for businesses is now occurring in China. Its economy, which was built on its businesses having a significant cost advantage over other competitors around the world, is losing its advantage to inflation. As that advantage dissipated over the last five years, China chose to go on the world’s biggest building spree. In the process, they have made fixed asset investment an unrepeatable 50-70% of the GDP of the second largest economy in the world, depending on whose estimates you use. Real estate transactions and development is estimated to be 74% of municipal revenue.

In other words, if China doesn’t keep on building at the same pace as the last three years, their economy will contract. Therefore, the two-pronged economy of China, exports and infrastructure construction, are both threatened at the same time. Exports are threatened by the underground markets ability to over-leverage small to medium sized businesses and the construction world is over-leveraged on cheap money force-fed into an economy that doesn’t need what is being built. There is nobody to rent the condos and too few citizens who can afford a train ticket.

This brings us back to the US. Most of the US economy’s recovery has been held hostage by incredibly high commodity prices. We have had the worst and deepest recession since 1981 and the deepest depression in construction since the 1930’s. On a per capita basis, home building is at 70-year lows! This means that demand for copper, steel, iron ore, cement, coal and oil are way down from four years ago. We are using the least amount of gasoline since 2000 and the least oil since 1996.

We have been struggling to recover against a back drop that includes record high input prices. At the same time, energy costs and demand for food in China and India have made Americans pay much higher prices for food and other goods. All of these facts stem from the demand coming from China and the faith that has been placed in the idea that their economy is not subject to normal business cycles. David Barboza’s article is proving them wrong:

“That tycoons in a city known for its savvy entrepreneurs are running scared has raised concerns that private business, a vibrant part of China’s economy, may be losing steam — while exposing the high-risk, unregulated financial system on which so many of the nation’s small and medium-size businesses have come to depend.

“There have always been people running away because they couldn’t pay their debts,” said Wang Yuecai, general manager at Wenzhou Yinfeng Investment & Guarantee, which guarantees state bank loans when small businesses are lucky enough to get them. “But recently, the situation here has gotten much worse.”

Last week, Prime Minister Wen Jiabao and a delegation of top officials, including the head of the nation’s central bank, visited Wenzhou, promising to get official banks to lend more to small companies and to crack down on underground lenders that charge high interest rates.

And on Wednesday, China’s state council, or cabinet, announced a series of measures aimed at helping small businesses with tax breaks and new lines of credit.

Beijing no doubt worries that similar problems could surface in other parts of the country.

“This is not just happening in Wenzhou,” said Chang Chun, who teaches at the Shanghai Advanced Institute of Finance. “Some companies borrow from the state banks and then lend into the underground market. Many are doing this type of arbitrage.”

Thanks to research done by Kynikos Associates LP and its founder, Jim Chanos, we believe that many of the premises used to create faith in the idea that China’s economy won’t suffer normal business cycles is unfounded. For example, many China apologists argue that 25-30 million people will move each year to the cities from rural areas and support the added infrastructure. I don’t know how to say, “If they build it, they will come” in Chinese, but that is the theory. Chanos argues that Kynikos research found 8.5 million people migrated in 2009 and a total of 118.7 million since 1998. However, all that movement is predicated on jobs being available in the cities and that is predicated on the building boom continuing along with those entrepreneurial businesses surviving. It sounds so much like the retiree migration that was anticipated in Miami, Phoenix and Las Vegas in 2005 and we all know how that myth worked out.

Michael Pettis has provided us statistics that which show what an unusually large part of the world’s commodities have been used in China in recent years. This was backed up this week by a report which puts China as having 1.9 million metric tons of copper stockpiled at the end of 2010. This is equal to all the copper used each year in America. The credit crunch for small to medium sized manufacturers included them using copper as collateral for loans.

We have argued for three years that commodities are ridiculously over-priced and have argued that China has to have a deep recession/depression if it wants to become a major and sustainable world economic power. We believe this is all unfolding before our eyes, yet US hedge fund, institutional and individual investors are buying every dip in the commodity markets and playing the same risk-on trade that worked in 2009. Hulbert would say that their dogged bullishness is a bad sign for contrarians.

Wenzhou is one of China’s many manufacturing metro areas. Barboza relied on research from Wang Tao, a UBS economist based in Hong Kong. Here is how Tao and Barboza show the current circumstance:

“As long as China’s economy was racing along at an 11 percent growth rate, small companies could hope for enough business to stay a step or two ahead of their underground creditors. But there was little room for error.

Now, businesses here and elsewhere in China are being caught short because the national economy has begun to moderate a bit, to a projected 9 percent rate by year’s end, in response to government-imposed measures to fight inflation and let air out of the real estate bubble.

Ms. Wang, at UBS, said the slowing economy and weakening exports would hurt many small Chinese businesses. Already, according to a recent survey by the city’s small-business council, one in five of Wenzhou’s 360,000 small and medium-size businesses have recently stopped operating because of cash shortages.”

This means that 72,000 businesses have recently been shut down in just one city in China. A major credit crisis and recession/depression is in the offing, in our opinion. Yet US investors continue to pursue the BRIC trade all the way down. This is why the investor behavior reminds me of the movie, “Dumb and Dumber”. We believe the next great bull market in US stocks will not be led by the best performing sectors of the last ten years, because leadership in energy, basic materials and heavy industrial can only come from uninterrupted growth in China. If China can continue its charade, we believe the US economy will continue to suffer. If not, the seeds of US prosperity will be watered and fertilized by lower commodity prices.

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:

Thanks to a super well-written piece from Emily Kaiser at Reuters, we can frame the discussion about the Chinese housing bubble as the difference between the US Savings and Loan/Bank debacle of the late 1980’s/early 1990’s and the US housing debacle from 2006 to today. Emily laid out the argument quite well. Many economists and experts believe that the large down payments by Chinese home buyers and the fact that their total mortgage debt is less than 20% of Chinese GDP is a reason for comfort. They argue that the Chinese government is in a position to deal with letting the air out of the bubble because of this big equity cushion. Here is how Reuters explains it:

“As housing bubbles go, China’s looks relatively benign. Unlike in the United States, Chinese home buyers typically put down at least 40 percent of the purchase price. That means they don’t have to worry about a modest decline wiping out all their equity, and banks have little reason to fear an influx of “jingle mail” from defaulting homeowners returning the keys.

Household debt amounts to less than 20 percent of China’s gross domestic product, according to the International Monetary Fund, one fifth of the U.S. ratio.

“In the United States, housing was a borrowing vehicle for households. In China, it’s a savings vehicle,” said Stephen Green, an economist with Standard Chartered in Hong Kong.”

By framing the analysis of China in the context of the US housing bubble, apologists are put in a perfect position to claim that it is not going to be a big problem to deal with for the Chinese government. The 2005 US housing bubble was about banks like Countrywide Credit lending money to people who couldn’t or shouldn’t have wanted to afford their big “dream” home. They made unbelievably large loans to millions of people who wouldn’t be able to pay it back. Countrywide’s President was Angelo Mozilo, who sported a great tan, a fat bank account and a fatter investment portfolio. His bank reported a ton of profit until all the bad loans came to roost. The China apologists are correct that China’s real estate bubble only has historically large price increases in common with Phoenix or Miami or Las Vegas in 2005 (even though China’s price increases are much more ridiculous). The Chinese end buyer puts a great deal of equity into a house purchase because owning a home is a “savings vehicle”.

What they should be putting China’s real estate bubble into the context of is the Bank and Savings & Loan debacle of the late 1980’s. China’s housing bubble is huge. In our opinion, it will cripple their financial system in several ways. The negative wealth effect, as their bubble gets unwound, will contribute to a deep recession/depression. For the most part, the impact of unwinding China’s real estate bubble will be felt in China, in the emerging markets surrounding it and the countries which have benefitted the most by selling them the inputs to massively over-build in the major cities.

Some review of the debacle in the late 1980’s is necessary. Savings and Loan institutions had huge deposits which were insured by the Federal government through an under-capitalized agency called FSLIC (Federal Saving & Loan Insurance Corporation). The leaders of these “Savings” organizations took the liberty to loan these deposits out to real estate developers to build both commercial and residential projects. These loans became a concentrated part of the assets of these companies and the tangible assets as a percentage of outstanding loans became dangerously low. The mortgage borrowers themselves had plenty of equity in their homes and the late 1980’s down cycle was not marked by high foreclosure statistics and “jingle mail”. Of the 3234 savings institutions in the US in 1987, 747 were eventually closed by the mid to late 1990’s.

The poster child was Lincoln Savings and Loan in Phoenix run by Charles Keating. His bank took in deposits through very high interest rates on Certificates of Deposit (CDs). The money was loaned to build projects like the Phoenician Hotel, which Keating just happened to have a financial interest in. Keating was constantly moving money back and forth between Lincoln Savings and Loan and his real estate development company, American Continental Corporation. The Phoenician was the most expensive hotel ever built in Phoenix.

The difference between the US in the late 1980’s and China today is that the Chinese government is completely caught up in this debacle. They dictated to the four government-owned Chinese banks that they would provide the economic stimulus in China. The primary vehicle has been spurious loans made to real estate developers. Chinese Communist Party officials and Chinese Army leaders are in control of both the banks and the special purpose vehicles created at the municipal level to build these booming structures. In late 2008, China needed to avoid recession to prevent civil unrest. In the US version, Keating attempted to get the government involved to perpetuate his scheme. His problem was that in the US we have political and speech freedom. The Keating Five Senators got called to the carpet and our system came clean. Who is keeping China’s system clean? In case you are wondering, Phoenix has a history of booming and busting and one of those booms was in the 1980’s. The theory behind that boom was that retirees would move to Phoenix in droves and because of that fact, it didn’t matter how much the real estate you were buying was over-priced. The same logic about people moving from the rural areas to the cities dominates the real estate bubble in China and is used by the apologists all the time.

At the same time that real estate development was running wild from cheap deposits insured by the US government, major money center banks like Bank of America and Citigroup were recycling the massive wealth created by oil production in the late 1970’s and early 1980’s from Arab investors and Texas oil men. This money was turned into loans to fast growing countries like Brazil and Mexico. These were the hot emerging market nations of the time. These emerging-market loans became a large part of the loan portfolios of these money center banks and when these countries went through their business cycle, they were unable to meet their debt service obligations (if this sounds like today’s problem with Greece and other PIGS in Europe, you are starting to track with me properly).

Treasury Secretary Nicolas Brady from the George Bush Sr. administration ultimately came to the rescue with his bailout program called Brady Bonds. The Resolution Trust Corporation was formed by the US government to clean up the Savings and Loan debacle and the US economy languished for many years in a jobless recovery. The clean-up costs were in the hundreds of billions of dollars. The loans involved in these two institutional debacles were development loans and had an enormous impact on US economic growth from 1988-1993, costing President Bush Sr. his job and ushered in the era of the “jobless” recovery.

We believe the only way that the Chinese apologists can feel comfortable about a soft landing in China’s economy is if the development loans in the four largest government-owned banks are not a concentrated part of the loan portfolios. Second, they can be comfortable if the losses the banks will have to take from real estate developer failure don’t wipe out their tangible assets. Thirdly, they can be comfortable if the municipalities in China have a way to replace the 74% of their revenue that currently comes from taxing real estate transactions and creating money out of mid-air by capitalizing raw land much higher as it is developed. Lastly, they can be comfortable if the wealth effect of substantial price drops in the primary risk investments (savings vehicles) of their citizens don’t crush consumer spending. Consumer spending is estimated to be 30% of Chinese GDP. The apologists in Emily Kaiser’s article in Reuters are correct that this isn’t closely analogous to the US real estate bubble of 2005. Unfortunately, we believe they are very wrong about the magnitude of the damage to the economy that the real estate stimulus loans from 2008-2011 will ultimately have on China’s economy.

These loans were estimated to be $2.7 trillion and were originated from late 2008 to today to stimulate the Chinese economy via real estate development. We have seen estimates of loan losses ranging from 30 percent (Fitch) to 70 percent (Yin Zhongqing). The four largest lenders in China would likely have most of the $810 billion to $1.9 trillion in loan losses on their books. We believe this would devastate their tangible equity, force recapitalization and stop new development in its tracks. It would stop the ability of folks to move to the cities to get jobs, it would crush demand for commodities involved in construction and it would cut off surrounding Asian countries which have been suckling on the bounteous teat of China’s boom. The currency outflows and the bank recapitalization could vanquish China’s foreign currency reserves fairly quickly.

In our opinion, China has Angelo Mozilo’s price bubble going, but not his residential mortgages. They have Charles Keating’s development loans. These loans are in a quantity and magnitude relative to China’s $6 trillion economy that Jim Chanos described the potential fallout as “Dubai times 1000”. Let the games begin.

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:

Back in March of 2009 we did a presentation titled “Bull Market Stew”. The idea was that you could look back at the circumstances surrounding major US stock market bottoms just prior to huge bull market moves and compare the current circumstance. The neat thing was that much like a chef on the Food Network, you are simply gathering ingredients, preparing them as the recipe dictates and expecting to cook up the finished product. You’d expect the “new” stew to turn out very similar to prior stews. Today’s circumstance is so similar to March of 2009 that we thought we should run through the ingredients we listed back then and give our viewpoint on where they are today:

1. One or more major Bear Market declines in the prior ten years, preferably with a decline of more than 40% and overall poor multi-year stock market performance—True, 2000-2002 Bear Market and 2007-2009 Bear Market are totally fresh in the minds of investors.

2. Historically depressed stock prices, especially among the traditionally most admired companies—True, PE ratios on the S&P 500 Index are the most depressed they’ve been in 26 years.

3. Massive negative psychology among individual and professional investors—True, American Association of Individual Investor’s and Investor Intelligence Polls show that US investors are as negative as in early 2009.

4. Normally successful and admired money managers are called out on the carpet and in some ways humiliated—True, Bruce Berkowitz, Kenneth Heebner, Bill Miller and John Paulson have all come under recent media criticism.

5. Buy and hold investing viewed as an idea that is no longer useful—True, an example is Jonathon Burton’s quote from a recent Marketwatch.com article:

“Stock investing therefore will need to become more nimble and proactive, a far cry from the ‘set-it-and-forget-it,’ buy-and-hold mantra that most individual investors who came of age in the past 30 years have been taught.
“The next decade will likely be one where buy and hold will generally be a fairly poor option in developed markets,” Deutsche Bank analysts told clients in a report last month. “There will be large cyclical rallies punctuated by recessions and funding crises.”

6. Seemingly unsolvable economic problems as part of a deep recession—True, Grease (Greece) is the Word.

7. Accommodative Federal Reserve Monetary Policy and fiscally stimulative measures from the U.S. Government—True, Operation Twist and deficit spending.

8. The Public doing 80% of New York Stock Exchange Short Sales—Can’t Track, but public fear measures like VIX, GLD and others are off the charts.

9. Cash in Money Market Funds at record levels in relation to stock market capitalization and paying low interest rates—True (Federal Reserve Z-1 Report)

10. Very intelligent and credible economists and analysts explaining clearly and logically how terrible things are going to be for many years—True, Bill Gross’s October letter.

The last time we were in this situation, the S&P 500 Index went from 676 on March 9, 2009 to a closing high at 1363 on the 29th of April of this year. My math tells me that was a gain of over 100%. We believe it will be different this time. The next Bull Market, in our opinion, will be huge and won’t include the risk on, risk off format. As the US recovery continues and China’s troubles multiply, commodities could plummet and US companies in the Energy, Basic Materials and Heavy Industrial sectors could be dead money at best or huge performance drags at worst. This could be a “bifurcated” market like the one that occurred when Tech stocks plummeted in 2000 and “old economy” stocks rose.

We like our “staple” consumer discretionary stocks like SBUX, DIS, JWN, HRB and CAB. We like Pharmaceutical stocks like MRK, BMY, ABT, PFE and MYL. We like quality financials like WFC, BEN, BRK and AFL. Warren Buffett said last week that the US economy is “very, very unlikely to go back into a recession”. If he is right and we think he is, this could be one of the best set ups for a bull market in my 31 years of working in the US stock market.

Best Wishes,

William Smead

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