William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

moat/mōt/
Noun:   A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.

At Smead Capital Management our investment committee talks and thinks about the moat of a business a great deal. Based on the definition above, we believe that a wide moat is provided by the aspects of the company and their business which prevent competition from damaging highly sustainable profitability. Wide moat is one of our eight proprietary criteria for selecting common stocks. We have seen a number of organizations begin to include logic associated with moats into their equity research formats. Unfortunately, we believe many market participants confuse the by-products of a moat with the actual moat itself. We think this spells opportunity. Looking for stocks with a wide moat that are priced as if they don’t have one adds to the advantage of the long-duration common stock investor.

I read recently that after years of trying and millions of dollars invested, Google (GOOG) is considering folding Google Wallet and Google Checkout together. When it was announced five years ago, Google Checkout was thought by some to be a potential “PayPal killer”. PayPal appears to have successfully defeated one of the largest cash-rich, wide-moat companies in the world from getting into its secure, online payment castle. PayPal’s moat includes over 100 million existing customers, consumer brand recognition and nearly a decade of statistical information on transactions. Google has the same kind of moat in search that PayPal has in payments. The economic need that PayPal meets is identification privacy and ease of transaction facilitation. It’s a huge market and will grow tremendously in the next ten years. We believe as Google admits defeat, it will mean that the moat at PayPal is so strong that it can’t be overcome by massive financial resources and tech savvy. Google had both of those merits.

PayPal is a wholly-owned subsidiary of Ebay (EBAY). Ebay has a wide moat in its core marketplace business. Ebay is one of the most recognized brands in the world and most of its advertising is free thanks to the lock it has on market share for pre-owned items. When an athletic milestone is reached, the ball or puck or jersey is expected to immediately be offered on Ebay. Sportswriter’s frequently mention this fact in their writing. When Michael Jackson dies, his memorabilia becomes an instant hit on Ebay. This moat makes the low-risk, high free-cash flow nature of Ebay’s original business nearly impregnable. After backing out the cash net of long term debt, Ebay trades for 11 to 12 times the 2012 consensus earnings estimate. It is very unusual to see a fast-growing, wide-moat business trade for anything short of a premium to the S&P 500 Index multiple.

The symptoms of a wide moat are things like high, sustainable profit margins, huge market share, pricing flexibility and long histories of these identifying characteristics. However, the symptoms are not the moat. The moat causes the symptoms. Walgreens (WAG) is one of the two largest drugstore companies in America. Their properties dominate the best locations in the US, their brand recognition is the highest in the industry, their real estate ties up very little of the company capital and they have decades of experience in customer needs and satisfaction. Their financial muscle puts them in position to buy Duane Reade and walk away from Express Scripts. A college buddy who did extensive research on the subject told me that one out of every two Americans will never get a prescription filled outside of the walls of a drugstore. Walgreens castle is being attacked by a disagreement over pricing with Express Scripts and their moat is very busy defending the company. We think it will succeed.

HR Block (HRB) has spent the last ten years fighting off the attacks of Jackson Hewitt and Liberty, two tax prep companies started by former HR Block employees. My favorite test for a moat is putting 100 people through a survey. You ask them, “What is the first thing that comes into your mind when the surveyor says tax preparation”? Almost everyone will say, “HR Block”. If the question was online payments, it’s PayPal. If it is, “where do I find pre-owned items, or sporting event tickets?” the answer is Ebay. If the question is, “who do I trust to entertain my children and spouse?” it is Disney/ESPN (DIS). If the topic is coffee the answer is Starbucks (SBUX), burgers it’s McDonalds (MCD), retail service and selection it’s Nordstrom (JWN). The moat in business is about deeply, rooted competitive advantages which business cycles can’t uproot. It is about a love affair between a company and an addicted customer base which grows as population grows.

Warren Buffett was asked by the Financial Crisis Commission what one single characteristic he looks for in a business. He referred to the stickiness of the customer and the company’s ability to raise prices without affecting unit sales. We feel the moat of the business is what protects the ongoing success of a business even when legitimate competition comes along. It is what is behind wonderful long-term profitability and high levels of free cash flow. Moat analysis is not about number crunching, it is about mind-space control and forces which block or kill competition.

Lastly, we at SCM are value investors. Something very difficult has usually had to happen to open the door for us to get a good entry price on common shares of a wide-moat company. Ironically, in many cases, the temporary reason for the disfavor actually increases the size of the wide moat. Big pharmaceutical companies have had the most hostile political, regulatory and legal environment in the industry’s history the last four years. Major drug stocks have seen blockbuster products lose their patent and the combination of the aforementioned forces have brought many drug stocks down to the lowest PE quintile (bottom 20%) in the S&P 500 index. Instead of doing permanent damage to companies like Merck (MRK), Pfizer (PFE) and Bristol Myers (BMY), these circumstances have increased the depth and width of their moat. It is estimated that a new drug costs over one billion dollars to create and bring to market. Nobody besides these large pharma giants can afford to fight the battle. This high original investment threshold has turned the biotech industry into mostly farm teams feeding the major leagues. Smaller drug and biotech firms do research for creating wonderful new health science and are forced to hand it off to someone with deep pockets and an international manufacturing and sales force. Now that companies like Merck and Amgen (AMGN) are having great success with new products, the naysayers can begin to recognize how incredibly well defended these companies are from competition going forward. We believe they have wide moats.

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 are owners of both EBay (EBAY) and Amgen (AMGN). We believe the dividend policy and price action in the shares of these two companies can teach us about stock price performance over the next three to five years.

History shows that for a few decades after terrible stock price performance (like we’ve seen from 1999 to 2011) investors demand more of their return from cash dividends because they do not trust appreciation. In the 1940’s and early 1950’s, investors demanded a higher cash dividend from stocks than they demanded from Treasury and Corporate Bonds. Treasuries yielded around 2% in 1950 and the Dow had around a 6% yield from dividends. However, in the aftermath of the 1929-32 crushing bear market in stocks and massive bank failures which followed, public companies hoarded cash. Howard Silverblatt at S&P reports that the payout ratio in 1936 of US public companies was 29%. Ironically, in our opinion, we are in the same kind of circumstance and have the same kind of payout ratios today. See our June 1st, 2011 missive called “Cash Hoards” to understand the history more fully. Click here for missive.

Last summer, Amgen was trading in the low $50’s on a per share basis and had never paid a dividend as a public company. Amgen declared their first ever cash dividend at $.28 quarterly last summer. Since then, they did a Dutch auction, buying back 9% of their shares and raised the dividend to $.36 per quarter. Amgen’s first ever dividend was a higher yield on share price than the 10-year Treasury bond yield! I have been in the investment business for 31 years and can’t ever remember an initial dividend offering more than the 10-year Treasury interest rate. We believe it is no coincidence that Amgen is trading above $64 per share on December 29, 2011. At the $1.44 annualized dividend rate, it yields around 2.23%, still significantly above the Treasury bond yield.

Amgen still has a payout ratio below 30% and has massive free-cash flow. They could be an aggressive dividend growth company going forward as we believe their balance sheet is strong and the future earnings look bright. Their newest product Denosumab is selling briskly in the form of Prolia for Osteoporosis and Xgeva for treating cancerous tumors. Management seems to have learned what scared investors want from a company.

At the end of June in 2011, EBay closed at $32.27 per share. We believe they have a fortress balance sheet. Their PayPal division is growing like weeds and throwing off massive free-cash flow. Their legacy Marketplace business has turned the corner and is growing nicely, while continuing to throw off over a billion dollars in free cash flow. EBay is buying back stock, but they don’t pay a dividend. The stock was trading between $30 and $31 per share in the last week of 2011. Investors can’t help but like the operating results of EBay’s management team, but they are too scared from the last 12 years of non-existent price appreciation to bet on it alone.

Silverblatt pointed out that the historical payout ratio over the last 50 years is 52.6% and over the last 20 years it was 46%. At Smead Capital Management, we believe that the companies which raise their dividend payout ratio towards the historical averages from the position of strong balance sheets, wide moats and relatively non-cyclical earnings performance will enjoy the kind of outsized price gains that Amgen has seen in the second half of 2011. Hopefully, EBay will get the memo.

Best Wishes,

William Smead

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

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In a Gallup Poll last week, 75 percent of Americans said the nation’s biggest problem in their mind was an economic problem. Precious metals and most commodities have hit records in the last six months. At an institutional investor conference we presented to last week, the participants championed risk reduction strategies using either highly illiquid, risky private equity, emerging market equity and debt offerings. Or they bragged about loading up on a commodity index, commodity ETFs and/or gold and silver. Some were puffed up about diversifying away from China by pursuing “Frontier” stock markets in Pakistan, Indonesia and other unsavory places. The pinnacle was my nephew telling me that he had purchased five ounces of silver recently at $50/ounce. He’s 19 and it was his first attempt at speculative risk.

We at Smead Capital Management feel compelled to make a US stock market bullish case which feels as good to this writer as avoiding tech stocks did in late 1999. It is so lonely that it is divine. Andy Grove, former Intel CEO, said that the best advice he ever got came from his City College of New York professor. He said, “When everyone knows that something is so, it means that nobody knows nothin’.” John Maynard Keynes said, “Investing is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.” We have travelled the country over the last two years, spoken at CFA Societies, presented to numerous institutional, consulting, RIA and financial advisor organizations. We believe the majority has put their assets into investments that will provide defeat, insecurity and failure. Out of this knowledge comes a very optimistic bull case which is available to those who have the courage to look foolish in the short run and avoid today’s popular asset allocation.

Large cap growth stocks received the highest PE ratios in US history in the late 1990′s as the world crowded into the 25 most popular tech stocks. As large cap fund managers got deluged with money pulled from every other asset class, they attempted to reduce risk by bloating the PE ratios of large-cap growth names like Pfizer, Merck, Colgate and Clorox. At 40-50 times earnings and with the majority piled in for the ride, these mature company stocks were doomed for 10 years. Other asset classes were starved for capital and you could have thrown darts at them back then. Only a small minority had the courage to flee the crowd and widely diversify into other asset classes. Harvard’s endowment did, as did Warren Buffett. He stopped buying individual US stocks and sought to protect his capital by buying whole businesses and removing his large capital base from the judgment of public markets.

The investments which were wise in 1999 and were owned only by the small minority of investors, brought victory, security and success. Unfortunately, it is 12 years later, and the same asset allocation that was wise in 1999 is now the majority, and is unwise today. These trades are so crowded that it has reached the deserts of Africa, the jungles of Indonesia and the Westfield Mall near my hometown of Washougal, Washington. To understand the bull case, you need first to believe that today’s popular asset classes are doomed to ten years of misery and those companies, sectors and countries which benefit from their misery could produce immense relative and solid absolute performance.

I am very fortunate to have been taught by my Econ professor that economics is a lot like physics. For every action there is an equal and opposite reaction. What will happen to make emerging markets, precious metals, oil, farm commodities, natural resource based countries, and US stocks in the energy, basic materials and heavy industrial areas turn incredibly sour? Lipper reported last week that April 2011 was the 23rd consecutive month of net liquidation of US equity mutual funds. This occurred in one of the biggest up moves in 23 months in US stock market history. What could reverse the direction of these flows?

The linchpin of the bull case is the violent economic contraction about to occur in China. We will not bore you with a rehash of prior missives, but let it be said that they have deceived investors into massively over-capitalizing these popular asset classes. China’s growth is behind all the over-confidence in every market I’ve mentioned. When the fact that China is hitting the wall becomes more clear, wide asset allocators who don’t take what I’ve written seriously will sit for ten years in misery, in our opinion.

Out of this comes the bull case. The US economy has spent four years cleansing itself. We’ve recapitalized our banking system by recognizing over $1 trillion in losses. We are foreclosing and short selling billions of dollars of real estate. Housing is the most affordable in 60 years. We are learning to live inside our means and US households are close to Household Debt Service Ratios similar to 1982 and 1992. These were the start of five-year prosperity periods where the Gallup Polls showed numbers like they are today. We are in control of the keys to the virtual reality economy and have all the best companies who are helping us to maximize interactions between the virtual and real economy. Think Ebay/PayPal, Apple, Facebook, Linkedin, Groupon, Fedex, UPS, Amazon, etc. We feed the world, keep it secure, invent a large part of the best medical science and share productivity/higher living standards with anyone who wants to interact honestly with us. Our greatest days are ahead of us.

We are all frustrated by how long this cleansing is taking. What will trigger our next great prosperity period is a collapse in commodity prices and a reversal of all the misery which asset allocators are set to profit from, but missed by ten years ago. Less money leaving to pay for oil and the repatriation of emerging market money will set off a bull market in the American dollar, in our opinion. The rising confidence will force short-term interest rates up. Businesses will be rewarded for how they participate in our bright future and how well the business throws off free cash flow. Capital intensive industries and countries will see profit margins plunge as they are in no position to produce free cash flow unless commodities are soaring and China is building projects which have no rental income!

We are playing the bull case by over-weighting consumer discretionary powerhouses like Disney, Nordstrom and Cabela’s, domestic financial heavy weights like Franklin Resources, Wells Fargo and Berkshire Hathaway and over-weighting the geniuses of medical science like Merck, Amgen and Mylan Labs. We at SCM can’t wait to get to the future because we are in a lonely minority and making the bull case nobody wants to even admit to.

Best Wishes,

William Smead

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

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

 Dear Fellow Investors:

As value managers, we at Smead Capital Management are as interested as anyone in secular trends. We seek company characteristics which lead us to non-cyclical businesses which are not capital or labor intensive. For this reason, we love businesses which need more people (as customers) to become more profitable. Unfortunately, from time to time, markets massively over-capitalize industries and sectors which they believe will benefit the most from having more people.

A few historical examples are in order. The 1929 stock market peak in the US was built around the idea that there would be more people to listen to radio, drive cars and fly on planes. They were correct that there ended up being more people using all of these relatively new technologies. This didn’t stop them from losing most of their money by 1932. The concept was over-capitalized.

The 1999 US stock market peak was predicated on more people using the internet as it “changed our lives”. Huge national fiber optic infrastructure was built and tech stocks in the US became the darling of the world of investments. Were they right about more people using the internet and the internet “changing our lives”? Yes, they were right and they lost about the same percentage of their assets that the folks did back in the early 1930’s.

The residential real estate bubble in Las Vegas, Phoenix and Miami relied on the idea that more people, especially retiring baby boomers, would move to the Sun Belt states. Prices doubled from 2000-2005 and the sky appeared to be the limit. I have a vacation home in Scottsdale and have had a front row seat on both the boom and the bust down there. After a cold, wet spring in Seattle, I can tell you that more people do want to go down there. The over-capitalization of residential realty destroyed the finances of many investors/owners from then to today.

Where is the “more people” argument being used now to over-capitalize investment markets? We believe it’s in China and other Emerging Markets. Uninterrupted GDP growth in countries with a large part of the world’s population has everyone drooling. They are drooling over what more people means for food and industrial commodities, energy, automobiles, transportation infrastructure, housing and virtual technologies. Residential real estate in China has been so hot the last three years that it has even greatly affected prices for residences in any city with a large population of Chinese Nationals (Vancouver, B.C., London, Hong Kong, etc.) The concept is that more people will move from rural areas of China to industrial centers and that residential real estate is one of the few investments that newly prosperous Chinese citizens can invest their money. This argument is used to justify such gargantuan over-building that it could easily end up making Las Vegas and Miami’s real estate bubbles look like a common cold compared to China’s life- threatening pneumonia.

China has been dumping billions of dollars worth of low quality initial public offerings (IPOs) of common stock into US stock markets. Most of them are attached to virtual technology and the other drooling categories previously listed. Some of them are even legitimate businesses! I was a guest on CNBC a few months back and Chinese IPOs were ringing the bell on both the New York Stock Exchange and the NASDAQ Market site. We noted in a prior missive the danger in these high risk Chinese IPOs.

Where can you make money by finding value in an industry or sector which could be a beneficiary of more people? We see this in the makers of medicine. Aging baby boomer populations around the world could cause demand for pharmaceutical products to soar at the same time that emerging market countries put in their first meaningful social welfare networks and health systems. In 2005, China and India bought 4% of the world’s prescription pharmaceuticals despite making up nearly 40% of the world’s population. IMS Health, a leading research organization, calculates that China will be the third largest market for medicine in 2011 and believes that prescription pharmaceutical use could double from 2011 to 2013.

Companies like Merck, Pfizer, Bristol Myers, Amgen, Abbott Labs and Mylan might see a huge ramp up in demand. The beauty of their business is that the manufacturing and sale of their products has very high profit margins and the patent protection would drop off at different times and in different countries over the years. Add in the fact that the total number of major medicine makers/distributors has shrunk through mergers in the last three years and you could have a bonanza. The beauty of all this is that most of them trade in the lowest PE quintile in the S&P 500 Index and are hugely under-owned by institutional, international and individual investors. They make up close to 3% of the index, one of the lowest figures in the last 30 years. They’ve been neglected while investors over-capitalized companies whose stock prices are already inflated by sales and profits increases from meeting the other needs of the same set of more people!

In a recent expose’ called “China Ghost Cities”, SBS Dateline shared the truth about what is going on in China. They show how over-built and over-capitalized the country is right now. They tell the story of a toy shop keeper at the (Not So) Great Mall of China. He explains that there are seldom customers and as he speaks you can see how much work needs to be done to repair his teeth. To me it tells you everything you need to know about the emerging market countries of the world. They have more people in need of healthcare and medicine and most of them can’t afford the empty homes that have been built there. Those empty condo buildings are built to maintain the façade that GDP growth is uninterrupted so that investors in the maniacal sectors and industries will keep drooling about more people. We look forward to providing the toy-shop keeper and many more people an anesthetic and other medicines for years to come.

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

Dear Fellow Investors:

Wayne Gretzky was once asked why he thought he was such a great hockey player. He replied, “I skate to where the puck is going to be.” As the first quarter of 2011 ends, this seems like a very good time to look at where the puck is and hypothesize about where it is going to be.

Long-term value investing is about buying the most future success (where the puck is going to be) for the least amount of money. From a theoretical standpoint, academics have looked at attributes associated with being rewarded both absolutely and on a relative basis in common stock ownership. These studies (Fama-French, Bauman, Nicholson and Dreman) show that valuation matters. What you pay for the future success is a huge determiner of future returns. High quality was studied by Grantham Mayo from 1980 to 2004 and concluded that strong balance sheets, earnings stability, above-average returns on equity and below-average volatility are correlated with long-term investing success. In turn, high quality contributes to low turnover which reduces “frictional costs”. Mutual fund costs were measured by the Retirement Research Group at Boston College. They concluded that the average mutual fund in the US spends 1.44% of their returns on trading. This expense hurts both absolute and relative returns.

Today the puck is in Energy, Basic Materials, Heavy Industrial and Commodity-related common stocks. They were severely undervalued at the bottom of the 2000-2002 bear market as the Enron scandal and massive liquidation occurred in the energy sector. These sectors would have popped up in Fama-French on low price-to-book value (PB) and populated the lowest price-to-earnings ratio (PE) quintile of the S&P 500 Index back in 2002-2003. Few portfolio managers were over-weighting these sectors in 2003 and the ones who were leaned on the idea that we’d have uninterrupted growth in China. At the margin, the demand for everything having to do with the building of infrastructure in China has caused soaring prices for inputs and huge earnings gains for companies which satisfy the demand. The puck is also in gold and the currencies of countries whose economies are dominated by oil production, mining, basic material production and heavy industries. A few hours watching CNBC or reading articles at Morningstar’s web site shows all the players gathered around the puck right where it is now!

This cyclical phenomenon is very dangerous from a long-term investing standpoint. First, today’s puck-holding favorites no longer populate low quintiles on the PB or PE ratios. Caterpillar trades at its highest price-to-book ratio in two decades at around 6 times book and Joy Global has a stratospheric PB of 9. The S&P 500 trades at an average of around 2 times book value. Second, they are missing key attributes GMO described in their high quality study. When business is great, their balance sheets are strong, but when business turns down in their industry their balance sheets automatically weaken. For example, Joy Global came out of bankruptcy in 2001 and was formerly known as Harnischfeger Industries. Like they use to say in Dragnet, “The names were changed to protect the innocent.” Returns on equity are high in the boom, but disappear in many cases in the down cycle. The earnings are inconsistent and bounce around wildly based on exogenous forces like commodity prices and macro-economic trends. These stocks are volatile and incredibly difficult to own when their industry is out of favor.

Where would Wayne skate now so that he’d be where the investment puck is going to be five years from now? What sectors are deeply out of favor due to great difficulty in their industry? Where do you find numerous companies in the lowest PE quintile of the S&P 500 Index? Lastly, do any of them have the kind of characteristics described as “high quality” by Grantham Mayo’s study? We believe the Pharmaceutical Industry fills these qualifications to a tee. For us this includes all “medicine” makers; Biotech, Generic, Big Pharma and Diversified Pharma companies. The PE ratios are universally low. The balance sheet strength is immense. Returns on equity are high even in all the political, legal and FDA challenges of the last five years. Profits are historically consistent and demand only grows for medicine as more people enter the world. These company’s shares have been out of favor so long that even spectacularly good news on a new drug for treating cancer can’t produce stock price volatility.

At this time, some of our favorites are Abbott Labs (ABT), Mylan Labs (MYL), Bristol Myers (BMY) and Amgen (AMGN). At Smead Capital Management, we’d like to think about all the capital gains that could be made when Wayne Gretzky and the puck show up in front of our goals.

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.