William Smead
Chief Executive Officer
Chief Investment Officer

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

Dear Fellow Investors:

At Smead Capital Management (SCM) we have eight criteria for selecting common stocks. Our first five criteria must be met at all times, while one of the remaining three may be temporarily overlooked. We only ignore weakness in one criteria if we believe the strength of the remaining criteria gives the company the time needed to qualify across the board. At SCM, we give grace in these instances because they typically coincide with a price discount which gives us an attractive entry point for initiating a position in our portfolio.

Shareholder friendliness is one of our criteria and can be waved temporarily. We prefer to have leadership with a great vision of the future, a willingness to keep costs down and the wisdom to allocate free cash flow well. One of our top ten holdings is Microsoft (MSFT). We believe Microsoft trades at a significant discount to fair market value because stock market participants view the company as shareholder unfriendly. Below, we have outlined SCM’s quick take on Microsoft shares regarding what we think is the inherent discount due to shareholder unfriendliness. Additionally, we’ve given a few approaches that could be taken by Microsoft to unlock value going forward.

Thomson-Reuters estimates that the S&P 500 Index trades at 15.1 times trailing earnings. For the sake of our discussion let’s assume that a 15 P/E ratio is pretty normal in this environment. This means that if you are perceived to have above average future prospects you trade above 15 times earnings. Your stock would trade below 15 times earnings if your future isn’t as bright as the average large public company.

First, we’ll take a cold hard look and examine Microsoft. Microsoft had nearly $36 billion in cash and near cash net of debt at the end of its last quarter (over $4 per share). Cash earns almost nothing after taxes for Mr. Softie. Therefore, almost the entire $2.05 per share consensus estimate analysts have for this year is created by operational profits and not interest. If you put a 15 multiple on $2 per share and add back the cash you get a $34 share price. With the stock trading at $26 per share, it means that MSFT trades at about a 25% discount to the average stock. The discount is even heavier if you would be so outlandish as to say that Microsoft has many of the characteristics of an above-average company and deserves a 20 multiple. In that instance, the current price of $26 per share sets up a huge discount to the $44 value per share.

We believe Microsoft is a superior company in a variety of ways. They write great software that is needed. They have been enormously profitable on a consistent basis and have such a good moat that the government sued them for it. Their profit margins are to die for and their balance sheet is impeccable. Thanks to the upcoming refresh cycle in business technology, most analysts look for them to have very strong earnings growth over the next 2 to 4 years. US Corporations have very high levels of cash on their balance sheets and as the economy recovers will use some of it to become more competitive through technology upgrades. So where does the intense dislike of once proud Microsoft and its market multiple discount originate?

Many investors hate MSFT because its stock has fallen over 50% from its tech bubble peak in the last ten years. Some dislike the corporate arrogance and others dislike the fact that they didn’t create the “New, New Thing”. We at SCM believe the core of the discount has to do with shareholder friendliness. Microsoft tries to act like the puny dividend and the $2 billion of stock they bought back in the first quarter defines them as shareholder friendly. When you sit on $40 billion of cash and near cash, generate $17 billion of free cash flow and pay a stingy $.50 of annual dividend, you anger investors like us who prefer to champion the company.

We’ve watched the current management squander billions of dollars on the weakest areas of the company (Media and Entertainment Division/Online Division) like a drunken sailor on leave. The problem is that the drunken sailor has been on leave for ten years! We saw a chart last week that showed that Microsoft spends about 14% of revenues in Research and Development, while Apple (AAPL) spends about 2%. In the most recent quarter, MSFT lost $713 million in the online division. If it were a stand-alone company, that would be one of the worst corporate performances in the S&P 500 Index. Hasn’t anyone at Microsoft or on the board of directors read Jim Collins book, “Good to Great”? The book says that great companies build themselves around their strengths. There is zero evidence that there exists any venture capital or private equity talent at Microsoft.

Thank God that time is the ally of the patient investor. We believe there are two scenarios for MSFT. The first goes back to the $34 fair value estimate. If the current management stays in place, Microsoft has $8 upside in the next year and upside going forward equal to growth in earnings/free cash flow at the average stock multiples. Nobody wants to pay up for a company squandering it’s free cash flow. The second scenario would occur if management closed or spun off all non-core divisions and dramatically increased the stock buyback and annual dividends. Since that is a very low probability event, the only way we get the second scenario is to change management. I’m glad there is upside without it, but it could be a huge stock if someone near the top would speak up.

Best Wishes,

William Smead

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

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

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

When the first President Bush failed to get re-elected in 1992, many considered his lack of a vision or agenda for the country to be his primary downfall. It seemed he wanted to be the custodian of the country as opposed to a leader who had a place he wanted to take the USA as a country. Voters like a vision from their political leaders, no matter whether the vision is tilted from the left or the right.

We at Smead Capital Management think about “the vision thing” as it pertains to the companies which meet our eight criteria for stock selection. Over long periods of time, it makes an enormous difference if you are invested in companies that have a clear agenda. It is a key component of our shareholder friendliness criteria. The CEO and executive team are seeking to make the vision happen by using the free cash flow of the company judiciously and in a very focused way. Any free cash flow not needed in executing the vision is then returned to shareholders through dividends and stock buybacks.

The current stock market correction is a perfect time to examine the behavior of the leaders of our companies. We will focus on three of our current holdings, Starbucks (SBUX), Nordstrom (JWN) and Abbott Labs (ABT). Starbucks had a small group of portfolio managers, which included us, into their headquarters recently for a morning meeting with CEO Howard Schultz and CFO Troy Alstead. Their vision for the company and its growth looks to be on three fronts. First, they will grow the store count around the world thoughtfully, and simultaneously seek to grow revenues in older markets like the United States. Howard pointed out that the company only has 700 stores in China. This compares to three in our company’s building in Seattle and 150 locations on the Island of Manhattan. A dramatic slowdown in the Chinese economy would not affect their vision.

Second, Starbucks is making a big push into the middle of the gourmet coffee market through its Seattle’s Best Coffee brand. Burger King, Subway, convenience stores and vending machines will be the sales locations added. Howard pointed out that Coke is sold at various price points everywhere from vending machines at Motel 6 to the cocktail lounges at the Four Seasons Hotels. Third, Starbucks is seeking to become a big player in instant coffee and grocery outlets through the VIA instant coffee. Why not have better tasting coffee at home and gain a larger share of cups consumed each day? Starbucks intends to execute this vision while paying stockholders 35% to 40% of the after-tax profits in the form of dividends. Overall, you couldn’t leave the meeting without being excited about the future of Starbucks.

While we met with Starbucks, I asked Howard Schultz and Troy Alstead if they realized how similar their vision and strategy looked to the one being executed at Nordstrom. Nordstrom is selling premium products with maximum service at their flagship stores. They are enticing fashion conscious discount shoppers to their Nordstrom Rack stores. These bargain hunters get great brands and aren’t coddled quite as much as at the premium level. Lastly, Nordstrom meets your shopping needs at home through its Nordstroms.com online store. Once again, three fronts to their vision as well. Nordstrom raised its dividend 25% last week. It was recently on the front of the New York Times Business section and the author was raving about their first Nordstrom Rack store in Manhattan. Both of these premier brand name companies look attractive, especially after the recent pullback in the US stock market.

Abbott Labs was one of the companies featured in Jim Collins book, “Good to Great”. They announced last week that they are paying $3.7 billion to buy the largest maker of medicine in India. We have argued that the demand for medicine (vaccines, treatments and cures) in both the developing and developed nations would grow as prosperity reached emerging markets and aging populations added demand in countries like the United States. Abbott Labs is one of many strong pharmaceutical companies which have been completely neglected in the stock market the last two years. All this growth comes with regular stock buybacks and consistently good dividend growth. Medicine makers are the smallest percentage of the S&P 500 Index they have been since 1984. We at SCM have a vision of that changing over the next two to three years and have added to our medicine companies including Abbott Labs.

While most stock market participants worry about the short-term direction of stocks, we will keep our eye on “the vision thing”.

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:

As a reward for executing a hectic east coast business trip, we went to a play called “God of Carnage”. Jeff Daniels and Lucy Liu starred in this four-actor, one-act play about two couples seeking to deal with a fight between their two 11-year old sons. The 90 minutes of conversation originally centered around how to deal with Lucy’s son punching the other boy and breaking two teeth. It was amicable at first, but then ultimately descended into arguments. The conversation exposed most of the individual flaws of all four parents and definitely exposed all the cracks in each marriage. It was very humorous.

Lucy’s husband played the part of an attorney who represented a drug company. He was on the cell phone constantly dealing with a crisis related to the side effects of one pharmaceutical product. His dishonest attitude and lack of ethics were on display as he interrupted the discussion on how to deal with the consequences of the fight between the two boys. Since art is a reflection of the culture of the day, the inherent evil of this man and the company which he represented were one of the main centerpieces of the play.

At Smead Capital Management (SCM), we are especially interested in what John Templeton called “the point of maximum pessimism”. To understand pessimism you have to look to the media, to the arts and to what we call “the well-known fact”. This is a body of economic information which is known to all participants and has been pretty much acted on by anyone who would care to act. As the City College of New York professor told former Intel CEO Andy Grove, “When everybody knows that something is so, it means nobody knows nothing.” Our politicians, media and artists know that “Drug” companies are evil. Investors know to stay away from them. The major pharmaceutical companies all trade in the lowest Price/Earning (PE) ratio quintile in the S&P 500 Index, and are the cheapest compared to the other sectors of the US stock market as we have seen in 20 years. Drug stocks haven’t been this small a part of the S&P 500 Index since 1984.

This reminds us of the documentary in 2003 about McDonald’s called “Supersize Me”. A young man ate three meals a day at McDonald’s for six weeks and agreed that he would supersize his meal every time an employee asked him if he would like to. He gained a great deal of weight, saw his cholesterol shoot through the sky and was well on his way to killing himself through food over the longer haul. The “well-known fact” in 2003 was that McDonald’s sells unhealthy, high fat foods and doesn’t care whether they are going to kill you in the process. Investors were sure that there would be a big backlash and McDonald’s business would be damaged for years. The stock bottomed out around $15 per share, way down from prices above $30 per share just a few years before.

Pharmaceutical companies make vaccines, treatments and cures by manufacturing medicine. They seek to profit from improving the health of human beings and extending the quality and duration of life. The barriers to entry in their industry are very high because it costs about $1 billion to produce a blockbuster drug. They receive patent protection because many of the medicines they attempt to create never make it to the market and only end up creating expenses. These companies maintain fortress-like balance sheets and earn very high returns on unleveraged capital. In the process, they generate massive levels of free cash flow and pay generous dividends.

The point of maximum pessimism associated with the makers of medicine is tied to four main beliefs. First, they are an easy punching bag for politicians (including the President of the US). Most studies put pharmaceutical sales at around 10% of what we spend on healthcare in the US. Second, they’ve been feasted on by litigators. The Vioxx settlement shows that whatever downside risk there is associated with a medicine will get exploited to the maximum until we get tort reform. Third, the FDA is scared to approve new medicines at the expense of thousands of people who lives might be hugely impacted by use of a drug not yet approved for sale. Lastly, a number of major existing blockbusters are losing their patent in the next four years and investors can’t visualize where these once admired companies will get future revenue growth.

Today, McDonald’s is around $70 per share and has been one of the best large cap performers in the S&P 500 Index since the documentary was released nationwide in theatres. They have added healthier choices to their menu, but they still make most of their money selling clean, inexpensive, high-fat content food all over the world.

At SCM, we believe the makers of medicine have very little downside risk as the result of the attitudes exhibited by the play “God of Carnage”. As we drive up to the New York Stock Exchange window to order our common stocks, we ask for pharmaceutical manufacturers and say, “Supersize Me”.

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.

Printable Version

Dear Fellow Investors:

When I was 5 years old I got a life saver stuck in my throat while grocery shopping with my parents. My Dad grabbed me by the ankles and turned me upside down. He shook me a couple of times until the sweet lozenge dislodged. We just did the same thing in the US stock market in the last week.

We at Smead Capital Management believe that the market has an uninterrupted BRIC trade lozenge stuck in its throat. This lozenge causes the US stock market to choke on over-priced oil, basic materials and industrial shares. While we are seeing a textbook economic recovery, we are using much less gasoline than a year ago. We are also embarking into the world of electric cars. Why is the price of a commodity going up when its best customer is using less?

In our opinion, the answer is that the capital market participants believe as deeply in uninterrupted growth in China as I believed in the good flavor of orange and cherry flavored life savers at age five. The only way to get it out of me was to shake me and the only way to change the investment trend is to shake it with high volatility. The Chinese stock market, as represented by the Shanghai Composite, fell 1.9% last night in overseas trading. That’s a decline of 20% in the last nine months, qualifying for bear market territory. Stock markets have a tendency to look out one year on economic activity.

Ignore the noise and enjoy owning America’s fine companies in areas like consumer, banking and healthcare. When we get this BRIC trade out of our throats, we believe under-priced non-cyclicals will take over market leadership.

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.