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:

If the year 2010 gets any more like the year 1983 in the stock market, it will be us at Smead Capital Management saying “It’s déjà vu all over again,” not Yogi Berra. First, we will recount what happened from 1972 to 1982 in the economy and stock market. Then we will compare it with 2000-2009. Lastly, we will compare the 1983 stock market with 2010.

In 1972 at the end of the year, a group of growth stocks called the Nifty Fifty commanded incredibly high PE ratios. For that reason, large cap stocks became massively over-priced in relation to small and mid-cap stocks. The economy was preparing to go through a nasty recession in 1973-74, exacerbated by the first Oil Embargo, which drove energy costs dramatically higher. Stocks got crushed in 1973-74, led by the Nifty Fifty, but at the stock market bottom of late 1974, small caps were cheap in comparison to their large-cap brethren. The second Oil Embargo in 1979 contributed to the incredibly high inflation and interest rates of 1980-81 and an inverted yield curve was produced by Fed Chairman Paul Volcker. This tight credit laid the groundwork for the worst recession in the US since the 1930′s. At its depth, the 1981-82 recession produced unemployment well above 10% nationwide and decimated “smoke-stack” American industry. Credit was unavailable to the masses because interest rates were too high (20% Prime Rate and 15% Mortgages) for businesses and home buyers to afford. The economic experts at the time said there was no way that the US economy could grow until those high interest rates had come down for years. A Bear market in stocks started in June of 1981 and lasted until August of 1982. At the bottom in August of 1982, large-cap stocks were very cheap in relation to their small cap brethren. However, investors didn’t want to own mature companies with slower and more consistent earnings growth patterns back then, because the feeling was that double-digit inflation required well above double-digit earnings growth. Only small cap growth stocks could provide 20% plus earnings growth in the late 1970′s and they were favored with high PE multiples.

In early 2000, a group of tech stocks commanded incredibly high PE ratios. The success of the large cap growth mutual funds which owned these tech titans caused the funds to get deluged with capital. To reduce risk, the portfolio managers bought non-tech large cap consumer staples and healthcare companies, which in turn inflated PE ratios in those sectors to over 30 times earnings per share. Large cap growth became massively over-priced in relation to small caps and just about any other asset class which existed. When the tech bubble burst from 2000-02, a recession occurred. Unfortunately, we were attacked by Al-Qaeda on 9/11/01 and it was politically unfeasible to allow the natural economic cleansing of a recession to take place. We then used cheap money from the Federal Reserve Board (led by Alan Greenspan) to spur an enormous borrowing binge tied to housing. From 2005 through 2008, energy prices soared and triggered the deepest recession since the 1930′s. The recession included over 10% unemployment as all industries tied directly to residential real estate and the financial service companies serving the mortgage industry, contracted from 2007 to 2009. Stocks got crushed from October of 2007 to March of 2009, falling over 50% for the first time since the 1930′s and creating one of the worst ten-year stretches in the stock market since 1972-1982 and one of the worst in the history of the US stock market. Economic experts say that we can’t have strong economic growth until the high levels of household and government debt are reduced drastically. In their estimation, that will take years.

In the bull market of 1982-87, small cap stocks outperformed during the first nine months. A company called Apple Computer went public in 1980 and bottomed at around $1.45 in July of 1982 (adjusted for stock splits). It led the charge in the first stage of the 1982-83 bull market by quadrupling to over $7 per share. Small caps had been the place to be from the stock market bottom in 1974 to the top of the first leg of the 1982-83 bull market, an up move in the S&P 500 Index of 70%. Large caps had rarely been so cheap in comparison on a PE ratio basis. From June of 1983 to August of 1987 large caps were the place to be in the US stock market as the Dow Jones Average rose from 1200 to 2700.

In the bull market which started in March of 2009 and has stretched at least to today (April 24th, 2010), the S&P 500 Index has risen about 80% and has been led by the more than doubling in price of a stock named Apple. Small caps have dramatically out-performed large caps since the tech bubble broke in March of 2000. In fact, almost every asset class or stock market sector on the planet has out-performed US large cap stocks since then. Small caps have also outpaced large caps since the market low as reported by Brian Belski, chief market strategist at Oppenheimer Asset Management, in a Marketwatch report on April 23rd, 2010 when he said “But the recent rally we’ve enjoyed in small-caps is running at a rate three standard deviations above the historical average; fundamentals don’t support the upside.” Indeed small caps are trading at 27 forward PE and large caps trade for 16 times earnings.

We at Smead Capital Management believe circumstances exist for large-cap recession-resistant quality US stocks to out-perform all other stock market sectors and asset classes over the next five to seven years. If the playbook keeps getting revisited, it would be surprisingly strong US economic growth triggering a rise in short term interest rates. This would lead a transition to cash-rich large-cap stocks, which trade at much lower PE multiples than their small cap brethren.

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
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Dear Fellow Investors:

As we open the year 2010 (sounds like a big number), you are going to hear us at Smead Capital Management talk a great deal about Hall of Fame Companies. One of the hallmarks of a Hall of Fame Company is consistency. Why are we so interested in recession-resistant companies with strong brands and repeat customers?

First, companies with relatively unbroken strings of earnings and dividend growth can be held for long periods of time. Since the holding period on the New York Stock Exchange is the lowest in 70 years, nothing could be more contrary to the prevailing wisdom. Long-term holding periods reduce trading costs and make capital gain tax rates lower and payments rare. Long holding periods put folks in position to collect dividends and enjoy dividend increases from shareholder friendly companies (another Hall of Fame characteristic). Much of the statistical advantage common stocks have over other investment categories (bonds, gold, real estate, etc.) comes from dividend payments.

Second, consistent companies aren’t as likely to have big earnings misses because their success isn’t built around short-term business excitement. It amazes me how much money, thought and time are invested in trying to figure out which businesses will do the best this year or next. Today (January 4th) investors are excited about Oil and Basic Materials companies not only because of the prospect of a rebound in our economy, but also the growth in China and other Emerging Markets. Unfortunately, you’ll also have to figure out when to get out because of the inevitability of the next economic slowdown in either of those places. Apple Computer Company is a terrific company, but they must constantly come up with the next great consumer electronic mousetrap or risk terribly disappointing the massive fan club of investors they have developed. I used two Q-Tips this morning after showering and I think there is much less pressure on the product development team at Unilever (who makes Q-Tips) than there is at Apple (We own neither company).

Lastly and probably most importantly, consistent companies (and mutual funds owning them) make for a better ownership experience and are more likely to be owned for long holding periods. According to Morningstar, Kenneth Heebner has one of the best ten-year track records among mutual fund managers. I admire him as an investing genius, but we don’t envy him because he trades constantly and works way outside our own circle of competency. His Focused Fund (CGMFX) has returned a phenomenal 17.89% per year on average in the ten years ended 12/31/09. However, Morningstar also reports that the average investor who participated in his Focused Fund lost 10.83% per year in that same time period! How could there be such a chasm? One, Heebner goes from the outhouse to the penthouse and back constantly with spectacular penthouse results. Two, investors get really excited about what he is doing right after his hot streaks (pouring in new money). They lose faith during extended cold stretches (withdrawing capital) including his recent cold stretch from July of 2008 through the end of 2009. The taxation of his fund must be horrendous because his good years and high turnover produce massive short-term capital gains. The Dodge & Cox Stock Fund (DODGX) earned 6.05% in those same years. The average investor in that fund returned 3.05% per year. Heebner won the investing battle and Dodge & Cox investors won the war.

Human beings are much more likely to survive as long-term holders with less volatility and more consistent results. Unfortunately, we are very close to the year 2008 which was a total torture chamber for even the buy and hold investors who wanted to own consistent companies (SCM included). Holding larger cash positions was the easiest way to improve performance that year, but that doesn’t help marry investors with the consistent companies in the market. We believe that 2008 was a watershed year and marked the end of the horrific decade for owners of US common stocks. Since scarcity creates value and consistent companies are the most likely to be held long term, we believe we are starting another particularly good era for ownership of recession-resistant companies with strong brands and repeat customers.

Happy New Year,

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. 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.