Buffett’s cancer to be No. 1 topic at Berkshire meeting
by Ben Berkowitz
For more information go to www.reuters.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

Dear Fellow Investors:

Jeremy Grantham is a brilliant asset allocator, writer and thinker. He works for an organization (GMO) of great people in those disciplines. He released his quarterly letter to the public recently entitled “My Sister’s Pension Assets and Agency Problems”. In the process of describing the “career risk” of being a contrarian value investor in the asset allocation world, he left out a more important discussion about what we consider “real” career risk. At Smead Capital Management (SCM), we have been subject in our own careers to the career risk that Grantham described. We think that avoiding the career risk he left out is more important to today’s professional investors.

I come from a small town in the state of Washington. There are approximately 14,000 residents. Let’s assume there are three plumbing and heating businesses in town which employ 20 plumbers in their business. We will also assume that something causes a boom in the plumbing business in my home town and 100 plumbers move there. Seven of those 100 are the type of person who start their own plumbing company. You now have 10 firms employing 120 plumbers. The first thing that happens, even if the boom continues, is the existing pool of business gets divided and diluted. The second thing that happens is whatever caused the boom eventually disappears and those 120 plumbers are left to make a living in a town which only supported 20 plumbers in normal times.

“Real” career risk is too many people doing what you do for a living. Grantham’s problem is that every day three million brilliant people get up and spend most of their waking hours trying to practice wide asset allocation. Most of those three million brilliant people have incredibly strong backgrounds in economics and lean on their ability to make macroeconomic predictions. Too many people are doing the same thing at the same time for a living. Therefore, much like the plumbers who moved to my hometown, they need to either move to another town or wait patiently for most of the other bright people to take up another profession.

To understand how we got here you have to understand where we came from. A booming stock market from 1982-1999 in the US culminated in the tech bubble. By 1998, most financial professionals either picked stocks directly for folks or guided their clients to stock pickers via mutual funds and separately managed accounts. This reached a pinnacle of concentration in US equities which the world will probably never see again. Most of the great tech firms of that era were US companies, so capital came from around the world to get at the boom. The way to get the most out of the boom was to pick stocks and to concentrate your assets. In 1999, virtually every other asset class was starved for capital except US large cap equity. Returns of 20% compounded were realized in that category and quickly became expected. Three million brilliant financial professionals got up every day to think like George Gilder and figure out the next revolutionary technology and the company which was going to make you rich from it.

When the 2000-2002 bear market in US stocks stripped 80% of the value of the Tech-Heavy NASDAQ stock index and 45% out of the S&P 500 index, the financial professionals suffered “real” career risk. Nobody wanted them to do what they did for a living any more. They recognized the sin of concentration very quickly and between 2003 and 2007 morphed themselves into the world of wide asset allocation. Everybody wanted to be David Swensen or Jeremy Grantham and execute something similar to the Yale-Endowment model. Since the other asset classes were starved for capital, this created a multi-year bull market in everything from gold to oil and emerging markets to international bonds. It spawned the urge to reduce your equity risk through employing hedge funds. It caused institutional folks to move heavily into alternatives like commodity indexes and private equity funds (where prices aren’t printed in the newspaper every day).

As if the early decade bear market wasn’t enough to get the lesson, the financial meltdown of 2007-2009 reinforced the wide asset allocation urge and motivated those who do it to use a heavy dose of economic analysis. It was official. As an institutional or individual investor you had to practice wide asset allocation and employ some of the greatest macroeconomic thinkers in the world in the process.

Today, if you walk into the office of any financial advisory firm in any small town in the US, you are likely to get a similar set of macro-economically steeped advice and shepherded through the same kind of asset allocation which you would get from a brilliant man like GMO’s Ben Inker. My friends, in my opinion, there are too many wide asset allocation plumbers and it has ruined the forward returns of effective wide asset allocation. If you’ve been around 32 years like me, you can read the frustration in Jeremy Grantham and Ben Inker’s letter. “We (GMO) are going to play for mean reversion sooner rather than later”. They are avoiding risk because there is very little value to add by taking any in the late stages of a boom in your profession. There are too many smart people attempting to do the same thing that GMO does for a living!

In a recent piece called “Diversification Remains Difficult”, Richard Bernstein makes our argument in a slightly different way. He explains that US Treasury bonds are the only “uncorrelated” asset class. He included a chart that shows back in 2002, real estate, gold, commodities, high grade and municipal bonds were inversely correlated with US equities and today they move in tandem with them. Here is how he explains the current situation: “In particular, we remain quite concerned that investors appear grossly under-diversified,” he writes. “Diversification is not dependent on the number of asset classes, but rather it depends on the correlations among those asset classes.” By everyone in the institutional and individual investor world becoming closet economists and wide asset allocators, most of the ways to actually diversify have disappeared.

At our firm we are guessing that this is a very good time to be a long-duration stock picker or to employ good long-duration stock picking in your asset allocation process. We don’t believe there are even three thousand brilliant people who wake up each day in our profession and attempt to compete with us. In that way, we believe we are avoiding the “real” career 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 at Smead Capital Management admire the great thinking and research done by people like Warren Buffett and Jeremy Grantham. We also admire thoughtful writing by professional journalists like Martin Hutchinson from Reuters and Charles Stein from Bloomberg. They’ve all written or commented on the affect that corporate profit margins have on stock price performance in the US. Buffett, in his speech to the Allen and Company gathering at Sun Valley back in 1999, and Grantham more recently, remind people that there are finite limits to corporate profit margins. They also repeatedly remind us that there are limits to corporate profitability as a percentage of Gross Domestic Product (GDP). Below is a chart of corporate profits as a percentage of GDP:

We first want to answer the question, “Is there something we should do in our portfolio to adjust if these historically high profit margins revert to the mean?” Second, we want to ask if there is a huge difference in what you do with this information if you are an asset allocator or a stock picker. Third, we would like to discuss the forces which might lead to a reversion to the mean in the ratio of corporate profits to Gross Domestic Product (GDP) on this chart.

Mr. Grantham has pounded the table on why the reversion to the mean on profit margins means significantly lower stock prices. As recently as late November, Grantham called for a decline in the S&P 500 index from the then 1158 to his estimate of fair value between 950 and 1000. As I review this piece on March 26th, 2012, the S&P 500 is trading intra-day at 1400. Even though Grantham seems to some investors to be permanently bearish on US stocks, this is a big disconnect for someone who is supposed to be among the most highly-rated asset allocators in the world.

Hutchinson made the same case as Grantham in a piece called “E Not PE”, which was repurposed on the New York Times online website. Here is how Hutchinson explained it:

“There’s a bubble in U.S. stocks – but it’s in profitability, not valuation metrics. The S&P 500 Index trades at 14 times historical earnings, so the valuation multiple isn’t excessive. But a measure of domestic U.S. profit margins stands 50 percent above its long-term average. Global profitability has soared even higher. This is unlikely to last long.”

The main forces which affect corporate profit margins are interest rates, labor, productivity enhancement-technology, globalization-emerging markets and commodity prices. We would hypothesize that understanding those forces could play a big part in being successful in either asset allocation or stock picking during the next decade. Most folks who are interested in this topic expect the mean reversion to be very bearish for the overall stock market. We disagree and believe profit margin mean reversion is at the core of our belief in a bifurcated US stock market over the next ten years.

In his Sun Valley speech, Buffett pointed out how massively important interest rates were to both profit margins and stock price performance from 1964-1981. Interest rates affect corporate profitability in multiple ways, but two obvious ones are by affecting borrowing costs for companies (a direct expense) and borrowing costs for customers (an indirect reduction in demand). Ultimately, very high interest rates greatly impacted economic growth by the late 1970’s. This all culminated in the very low level of corporate profitability in the early 1980’s.

When it comes to stock prices, interest rates instantly affect discounting models of future earnings and cash flows. The higher the rates, the lower the present value, the lower the rates, the higher the present value. Secondly, high interest rates on more secure “currency” investments like CDs, money market funds and Treasury Bills/Bonds proved to be stiff alternatives to common stocks. All of these corporate profitability and stock price forces peaked in 1981-1982. Interest rates hit their highs and stock market PE ratios hit their lows.

When comparing what happened in the US stock market from 1964-1981 to the period from 1981-1998, Buffett noticed that corporate profitability as a percentage of GDP rose from 4% to over 6%. He also noted that interest rates on long-term Treasury Bonds had fallen from 13% to 5%. He then talked about how ridiculously over-optimistic investors were at that time. The 30 PE multiple for the Fortune 500 was used as a reference point of how expensive and over-priced stocks were in 1999. Buffett argued correctly back then that equity returns would be historically poor going forward. The only way that he felt that he could be wrong was if a huge decline in interest rates occurred and /or corporate profitability climbed markedly to historical extremes. The irony of it all is that his prognostication was spot on even though the profit margins did soar and interest rates did plummet! This could certainly explain his recent bullishness on US large cap stocks when you factor in a trailing PE multiple of 14.1 on the S&P 500 index.

As we discuss the forces which could lead to a mean reversion for profit margins, we at SCM want you to know that we are in the camp which agrees that a reversion is coming. First, interest rates today are very similar to the early 1950’s, the last time that profit margins approached 10% of GDP. Long-term Treasury bonds have averaged 5.5% since 1926 (Ibbotson). With the ten-year T-bond at 2.28% and the thirty-year T-bond at 3.36%, there is plenty of reverting to do. We believe that interest rates will rise significantly over the next ten years. We’ve written about this in missives titled “Out of Bondage” and “Not in My Lifetime”. We believe bond prices will tumble once the fear of a new major meltdown dissipates. Profit margins would be impacted by the result of those higher interest rates.

Charles Stein, a writer for Bloomberg, wrote a terrific piece on November 27, 2011 discussing the forces which affect corporate profit margins. The discussion on labor resulted in this quote:

“The globalization of the workforce and a U.S. jobless rate of 9 percent last month have given management the upper hand in dealing with labor, Zandi said. Wages and salaries as a share of national income fell to 49.4 percent in the third quarter, the lowest since the government began collecting the numbers in 1948, Moody’s data show.”

High unemployment rates and high US government expenditures on unemployment compensation/welfare also contribute to high profit margins. A person who is unemployed and buying things anyway adds to revenue without being a labor expense. As a firm, we believe that an improving economy, lower government expenditures as a portion of national income and higher wages in the emerging world will help reduce profit margins absolutely and as a percentage of GDP.

We believe the number one thing affecting employment in the US is the depression in home building. Housing and related industries are blue-collar heavy. As “echo” boomer children of baby boomers turn 30 years of age in droves the next five years, we expect they will begin to buy houses without abandon. Rents have moved up dramatically, but the large stack of foreclosures and short sales has not yet been overwhelmed by household formations. In his 2011 shareholder letter for Berkshire Hathaway, Warren Buffett said, “Wise monetary and fiscal policies play an important role in tempering recessions, but these tools don’t create households nor eliminate excess housing units. Fortunately, demographics and our market system will restore the needed balance – probably before long. When that day comes, we will again build one million or more residential units annually. I believe pundits will be surprised at how far unemployment drops once that happens. They will then reawake to what has been true since 1776: America’s best days lie ahead.”

In a CNBC interview on the 27th of February, 2012, Buffett added, “Well, if I thought I was going to live-if I knew where I was going to want to live the next five or 10 years, I would, I would buy a home and I’d finance it with a 30-year mortgage, and it’s a terrific deal. And if I literally, if I was an investor that was a handy type, which I’m not, and I could buy a couple of them at distressed prices and find renters, I think that’s and again take a 30-year mortgage, it’s a leveraged way of owning a very cheap asset now and I think that’s probably as an attractive an investment as you can make now. But I think equities are very attractive compared to anything else.” Over the next two to three years, we see housing rebounding, labor participation rising and the government pulling back from its Keynesian demand strategy. This would put pressure on profit margins.

Technology improvements and the affect they have on productivity will be an offset to the totality of labor’s improved position. Whether using the “cloud”, allowing employees to work from home or using technology to reduce paperwork, productivity is being enhanced and profit margins are benefitting. We see it all the time in the results of the companies in our portfolio of stocks. Nordstrom (JWN) has seen a big part of its growth come from its online sales in the last five years. Online sales are labor and capital un-intensive. Many businesses are selling through smart phone apps like Ebay (EBAY). Imagine how many employees are getting usurped by these efficiencies.

The next two forces affecting profit margins are globalization-emerging markets and commodity prices. We at SCM like to refer to this as the “Global Synchronized Trade”. Emerging markets like Brazil, Russia, India and China have seen huge and relatively uninterrupted GDP growth the last ten years. The kingpin of this growth has been China. They appeared to even be oblivious to the steep recession of 2007-2009! With massive fixed asset investment stimulus, fed by the four large government-owned banks, China jumped right back up to the 10% GDP growth level in 2010 and 2011.

All the economic history we have studied and the history studied by professors like Michael Pettis from Peking University in Beijing, shows that most all emerging market nations get to the point where the only way they can maintain high growth rates is to manufacture GDP growth through unsustainably high fixed asset investment levels. Here are his latest thoughts in a recent NPR appearance:

“China’s economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.”

“In every single case it ended up with excessive debt,” Pettis says. “In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has.”

In the phase of heavy fixed asset investment, countries are incredibly inefficient in their level of commodity use as a percentage of GDP produced. Professor Pettis has estimated that China used nearly 40 percent of all the major input commodities consumed in the world in 2010 to produce 9.4% of the world’s GDP. Brazil and Russia effectively suckle on the “bounteous teat” of the China Boom, so their growth has been tied directly to the affect that China has had on commodity prices, especially oil. India’s growth has had a very large impact as well on commodity use as they have also built a great deal of infrastructure in the last ten years.

Therefore, any country like Australia or Canada which has also suckled on China’s “bounteous teat” or US company which has anything to do with designing, engineering and building infrastructure has had a boom themselves. Simultaneously, any US company which is involved in the production of commodities has not only had a boom, but they’ve had it while interest rates are historically low. Profit margins for these US companies are the backbone of the historically high profit margins. Here is what the 205-year chart of ten-year commodity price performance looks like from a US standpoint:

Source: Stifel Nicolaus Mid-2011 Macro Outlook Slide Deck, July 7, 2011

Without going into great detail, we believe that China’s coming recession will trigger a huge multiple-year bear market in commodities. The profit margins of those who have suckled will get crushed, in our opinion. Hutchinson might have written it best: “Globalization is one factor driving up profit for companies in the United States. According to a March 2011 paper by the Bureau of Economic Analysis, foreign earnings represented 40 percent to 45 percent of total profit between 2008 and 2009, against around 20 percent in the 1980s.”

We believe that foreign earnings could back off to closer to 30% of profits by ten years from now. This would come from the combination of the slowdown around the world coinciding with the rebound in US housing and the explosive affect lower commodity prices would have on US economic growth and confidence.

Therefore, a summary of the forces affecting US profit margins over the next ten years is needed at this point. We believe that interest rates will rise. We believe the unemployment will decline as the economy picks up steam. This will negatively affect margins, but be somewhat offset by significant GDP growth. We also see productivity enhancement through technology maintaining some of the profit margins reduced by other factors. Lastly, we see international fixed asset investment declining rapidly and commodity prices plummeting. The positive side of this would be the stimulative affect it would have on US GDP growth.

What do we think this means for asset allocators? Currency investments (interest bearing) have trapped investors both institutional and individual. They will prevent another 2008, but they will volunteer you to lose purchasing power over the next ten years. Commodities are a ticket to losses, in our opinion, led by oil and gold. Emerging markets will be a big disappointment for both stocks and bonds. Once the bloom comes off the rose, a number of the emerging markets like China and their suckling countries will see their credit quality questioned. In the US, stocks and residential real estate should outperform, as long as you avoid the companies who have benefitted from the prior boom.

From a stock picking standpoint, we believe the US should be a great place to be in retail sales and consumer services. We like Ebay (EBAY), Nordstrom (JWN) and H&R Block (HRB), as examples. Banks, which are loaded down with under-water residential real estate, should rebound. Higher interest rates could help spreads for the likes of Wells Fargo (WFC) and Bank of America (BAC), two very domestically-oriented banks. The media companies should enjoy a more prosperous US economy and benefit stocks like Disney (DIS), Comcast (CMCSK) and Gannett (GCI). Lastly, Americans will be able to afford quality healthcare though the most inexpensive part of the healthcare system, pharmaceuticals and biotech. We like Merck (MRK), Pfizer (PFE), Amgen (AMGN) and Mylan Labs (MYL) in that area.

We feel investors should avoid capital intensive companies which are tied to commodities or emerging markets. As interest rates rise and capital becomes dear, those who eat capital lose and those with strong balance sheets and who generate high and consistent free cash flow, win. As Buffet, Grantham, Hutchinson and Stein pointed out, someone loses in the reversion to the mean of profit margins when compared to GDP. Lastly, don’t be fooled by those who are bearish on the stock market because of their belief in profit margin reversion. The Dow Jones average rose from 260 in 1952 to nearly 1000 in 1966 while profit margins plummeted from near 10% of GDP to 5% in the recessions of 1953-54, 1957-58 and 1960-61. Profit margins dropped to 5% when our economy melted down in 2008, but stocks have rebounded nicely.

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:

When I was in college, the hardest concept for freshman and sophomore economics students to understand was that bond prices fall when interest rates rise and bond prices rise when interest rates fall. Most of my classmates just memorized the concept without understanding why it happens. Since 1980, when I came into the investment business, the hardest concept for investors to understand is that stock prices rise when the Federal Reserve Board practices “easy” money policies during very poor and anemic economic growth periods. When normal business does not use the newly created money supply, it sloshes around and finds its way into the stock and bond markets. Stocks also have a tendency to perform poorly when the US economy grows at rates above 6% for an extended time. See the chart below:

Source: Liz Ann Sonders, Charles Schwab, Market Outlook February 2011

We at Smead Capital Management are very excited about the next three to five years because we believe it is likely that Main Street will start to compete with Wall Street for capital and economic growth will accelerate. Unemployment rates would fall in that scenario and “pent-up” demand for goods and services could come out of the woodwork among average American households. What we mean by saying this is that capital will begin being demanded for business activities. As capital gets demanded for business activities ranging from housing to business expansion, the cost of capital will rise and bond prices would fall.

In a better Main Street economic environment where capital is being demanded, investors would be put in a position of having to differentiate between companies. As the US stock market rebounded from the once in 50-year fears of another great depression, almost every boat was floated by the wave of money created by the activities of the US Treasury and the Federal Reserve Board. Commodities rebounded, gold went parabolic, corporate bond prices soared and common stocks of all shapes and sizes moved in tandem off of the March, 2009 lows. This culminated last fall in the highest correlations among S&P 500 index stocks in the last 25 years at around 86% in October of 2011. The tide came in and all boats floated. As we wrote in July of 2011, we had reached what we call asset allocation “Nirvana”.

The question for those of us who like to “skate to where the puck is going to be” is which sectors of the S&P 500 and which companies are likely to be strong investments in this coming environment? This would include economic growth at 3-5% and would likely allow the Fed to let short-term interest rates gravitate to market rates. This new environment would also see those historically high correlation levels disappear. Lastly, improved economic growth, higher interest rates and less government dole could severely impact corporate profit margins.

In a normal economic cycle, the energy, heavy industrial and basic materials sectors of the S&P 500 index are slow out of the starting gate in the early stages of a bull stock market. They don’t begin hitting their stride until economic growth accelerates, because their attractiveness usual coincides with capacity becoming scarce. It makes sense, because sales usually pick up before inventories are replenished and before new capital goods are required. However, the globalization of large-cap US cyclical stocks like Caterpillar (CAT), Deere (DE), Schlumberger (SLB) and Joy Global (JOY) has caused them to be much more sensitive to the international economy and much less sensitive to US economic growth. Caterpillar only gets 27% of its revenue from the US and we believe the US is the least reliant on commodities and most energy efficient it has ever been. For example, energy consumption per real dollar of Gross Domestic Product was 18% in 1970 and was 7.3% at the end of 2011. The US is the largest economy in the world. It is as big as the next four country GDP totals combined, yet commodity prices have increased more in the last ten years as in any ten-year stretch over the last 205 years. This is despite the fact that commodities matter the least to the gross domestic product of the US as they have ever mattered.

Therefore, we believe that the normal bull market in cyclical sectors has been spent on the excitement that China and the BRIC-trade related countries have created the last ten years. We also believe that the slowdown in the emerging world and acceleration of the US economy is the death knell of the commodity bull market of 1999-2011. Finally, utility and telecom companies should enjoy some positive effect of the rebound in the US economy, but that is offset by potentially higher borrowing costs for these capital intensive industries. We are avoiding all five capital intensive sectors of the S&P 500 index.

This leaves us consumer discretionary, financials, healthcare (Pharmaceuticals) and technology. We believe all of these sectors stand to benefit from the next stage in the US economic recovery. Consumer discretionary companies would benefit from the unleashing of the pent up demand, while financials would prosper from the rebound in housing and lending. Pharmaceutical companies would gain from lower unemployment and greater prosperity and technology profits would be driven by meeting the capital good needs of these commodity efficient industries. We believe this is especially true for companies with the best balance sheets and those which have the best free cash flow, because they won’t have to fight with Main Street for borrowed capital as it makes its comeback.

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 at Smead Capital Management (SCM) have made the case that the poor performance of the US stock market from the end of 1999 to the end of 2008 has caused most institutional and individual investors to dramatically shorten the duration of their equity investments. In many cases, we are hearing that institutions and individuals want their advisors to help them insulate or “prevent” them from having another 2008. In a world of short duration common stock investing, sentiment polls have an increased importance. We like to say that an eye on the crowd is important if you have one foot out the door at all times. Professional investors have been forced by the power of the rebound in the stock market since March 9, 2009 to get invested, but they haven’t trusted the durability of this rebound along the way.

Individuals and financial advisors practice short duration through go-anywhere managers, exchange-traded funds and low-cost trading of individual common stocks. Institutional investors have done this by allocating a large part of their asset base to equity managers who attempt market timing and alternative investments in the hedge fund world. Studies show that the money in “alternative strategies” now dwarfs what is held in US long-only equity. See the chart below:

In a wonderful April 1, 2012 article in the New York Times, Julie Creswell presents the facts about pension fund performance in relation to how committed plans are to alternative investments:

“Searching for higher returns to bridge looming shortfalls, public workers’ pension fund across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds.

But while their fees have soared, their returns have not. In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.”

What Julie describes as “riskier” investments have also contributed to these very low levels of participation in long-only US stocks and especially long-only US large capitalization strategies.

When you breakdown the long-only participation, it is spread between US large cap, US mid cap and US small cap. Since small and mid-cap strategies have outperformed since the peak of the US stock bubble in 1999, it is safe to assume that institutions are the most committed to small-cap and mid-cap long-only strategies relative to the total equity long-only mix as at any time since the 1990’s. You can see this in Request for Proposal (RFP) mandate notices for small cap managers in periodicals like Emerging Manager Monthly. Institutional investors seem to like to close the barn door after the animals have run out. After ten years of outperformance by small-mid strategies, they are vigorously looking to increase their participation. Since small and mid-cap strategies are historically more volatile than large-cap strategies, this triggers an additional urge to time the market and has increased the importance of sentiment polls.

The Investor’s Intelligence (II) poll of investment newsletter writers is the oldest of the major sentiment polls and is the one I have followed during my nearly 32 years in the investment business. Our general view at SCM, as long-term investors by nature, is to not be interested in changing what we own based on 6-12 month stock market gyrations. For this reason, our view is that the sentiment polls are only useful at extremes. Therefore, everything that happens in between the extremes is just noise.

This week’s II poll showed that those writers who are bullish total 50.5% and those that are bearish equal 22.6% of the newsletter writers. Our observation is that it is very meaningful historically when the bullish sentiment reaches 60% or greater. In August of 1987, at the end of a run up in the Dow Jones Industrial Average from below 800 in August of1982 to over 2700, bullish sentiment broke 60%. By October 19th of the same year, the Dow fell to 1738. In February of 1999 and in February of 2001 at around 1240 on the S&P 500 index, bullish sentiment exceeded 60%. The S&P 500 index fell to 761 in October of 2002, a decline of 38.6%.

If history is any guide, it would take a large additional spurt to the upside in today’s US stock market to trigger a 60% bullish reading. We feel this could only come through a dramatic increase in long-only institutional large-cap US stock market participation and/or an end to the massive move into bonds made by US individual investors over the last four years. The bond market devotion would have to be replaced by a very meaningful move into US equities.

In 1987, institutions got heavily committed because of the comfort that derivative -related “portfolio insurance” provided many of them. The insurance was designed to protect against “normal” bear markets, not a drop in the Dow Jones average from 2700 to 1700 in 78 days! Both of these instances (August 1987 and February 1999), where the 60% bullish sentiment marker hit an extreme, saw price-to earnings (PE) ratios at historic highpoints. Warren Buffett, in his Allen and Co. talk at Sun Valley in the summer of 1999 mentioned that the Fortune 500 traded at 30 PE.

In our opinion, those who are very bearish about the US stock market need a substantial price increase to trigger historically extreme newsletter writer sentiment. Those who are optimistic should prefer a temporary correction or sideways movement to reinforce fear on the part of the crowd. This would cause the bullish and bearish readings to gravitate to toward each other and remove the risk of having some temporary “hell to pay” for those of us who seek to practice long-duration common stock investing.

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.