William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

In prior missives, we at Smead Capital Management have shared with you that there is a large group of money managers and investors who are counted as bullish, but are actually bearish. These investors own the reflation trade or what we like to refer to as “Peak Oil Mini-Me”. Their thesis says that the Federal Reserve and U.S. Treasury are flooding the world with dollars and “printing” money and the only way to take advantage of those facts is to be long oil, gold and other commodities. The current market correction is all about them and the truth behind their thesis.

We believe the truth is that if all that the government is doing causes a rapid improvement in the economy and quickly leads to very high levels of inflation, we’ve got even bigger problems later on to deal with. We sincerely believe these “Long Bears” are wrong. Their frustration is causing a significant and temporary pullback in the S&P 500 Index. We believe that the U.S. Economy will begin a long slow growth phase beginning in the fourth quarter of this year (Oct. 1-Dec. 31). A year ago the economy went into a coma in September. We have since reset our spending 10% lower than the prior year. This spending cut is much deeper than 10% appears because it is about half of the discretionary spending we do each month. The recovery doesn’t occur because of what the government does. Growth occurs because the economic benchmark has been lowered and economic activity is compared to how you were doing in the same quarter of the prior year.

The Federal Reserve’s actions and the government stimulus doesn’t scare us because of the banks need to replenish their capital. They will return to a good business of lending money to credit worthy people with sizeable down payments. A recent study by Stan Liebowitz in the Wall Street Journal has shown that the number one correlation to foreclosure was the lack of any down payment.

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

This return to normal banking will take three to five years. At the same time, individual households and businesses are going to be very hesitant for years and maybe decades to borrow money. Add it all up and you quickly decide that we will not recover by returning to the foolish lending and borrowing of the last ten years. In our minds this means that we won’t reflate the economy. If you don’t reflate the economy, the case for oil, gold and commodities go right out the window and will look foolish; especially after last year’s oil and commodity bubble burst. History shows that bubble markets are dead money for a long time after breaking, just look at the Nasdaq today compared to the peak of the tech bubble in early 2000.

So who wins in this scenario? The winners will be the “Long Bulls”. The “Long Bulls” believe that all the fear of the last 18 months has left the prices of many of the world’s best companies far below their intrinsic value. A long and slow economic recovery with an accommodative Federal Reserve could lay the groundwork for businesses with strong balance sheets and wide moats to gain market share. This would allow them to grow nicely from the “reset” of consumer spending levels. It could be a long period without excesses, which are usually created by too much leverage. As the debts of individuals and the government are paid back, an automatic restraint is put on the economy keeping it from overheating. Single-digit earnings growth in a slow economic era could produce price-to-earnings expansion. We believe large quality company shares will be the place to be for the next five to seven years.

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. The securities identified and described in this missive 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

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Dear Clients and Prospective Clients:

One of the most famous parables in the Bible can be found in the book of Luke, the Seventh Chapter. Jesus compares the Kingdom of God to farming. The farmer spreads seed around the land. Some falls on the path, gets trampled and eaten by birds. Some lands on the rocks and does not grow due to a lack of moisture. Some grows up among the thorns and gets choked in the process. Some falls on good soil and yields 100 times itself.

In the long run, the stock market is the same as farming. Most investors use an approach designed to produce short-run success. Some use momentum models designed to get on the hot path, only to get eaten up by paying too much for future success. Some invest in concept stocks and buck such low probabilities that their losers rob all the moisture from their winners. Some seek to predict the economy or use wide asset allocation and choke on errant macro-economic predictions or faith in obscure or illiquid asset classes. Some rely on wide moats and the generation of ample and long lasting free cash flow that can make many times their original investment over many decades.

At Smead Capital Management, we’d like to focus on the successful part of the farming analogy. It refers to “good soil”. What is good soil for an investor? We believe it is buying shares of an outstanding business for less than its intrinsic value and holding it for years as the company continues to succeed. We believe we are more likely to do that in companies which will survive and prosper much longer than other companies. The most important factors in longevity for a public company are balance sheet, product necessity and strength of moat.

To understand why we think this way we would like to refer you to the writing of Brett Arends of the “Wall Street Journal” in a May 11th article called, “How to Value Stocks? Ignore Economic News”. In it he chronicles the work of Ben Inker, Director of Asset Allocation at contrarian fund company Grantham Mayo Van Otterloo & Company (GMO). Inker points out that the present value or intrinsic value of a company is the discounted value of all future cash flows and dividends. And Inker can’t understand why people put so much emphasis on what is going on in the stock market right now or in the economy next year when they seek to analyze common stocks. He thinks they are mistaken for two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. “Since stocks do not have an expiration date and dividends grow over time,” Mr. Inker argues, “the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future.”

How distant? Using Mr. Inker’s hypothesis, it turns out that about 75% of the value of shares is actually based on dividends that will be paid more than eleven years from now. Half the value is based on dividends to be paid after 25 years, and a quarter on those to be paid after about 50 years.

In other words, when you look at the market today, three quarters of its true value is based on what companies will earn and pay out after 2020 and half is based on what they will do after 2034. So really, how much attention should you pay to next quarter’s earnings?

We at SCM love his logical and mathematical conclusion. Since most of the current value of a company comes from discounting cash flows and dividends coming years and decades from now, our analysis should be spent trying to ferret out the companies which can survive at high levels of profitability the longest. It reminds us of why Warren Buffett paid an astounding 18 times trailing earnings to buy a large stake in Coca Cola back in 1988. When asked why Buffett answered, “‘Let’s say you were going away for ten years,’ he explained. and you wanted to make one investment and you know everything that you know now, and you couldn’t change it while you’re gone. What would you think about?’” He knew that he could discount cash flows and dividends thirty, forty and even fifty years out and Inker proves that those future flows make up most of the current or intrinsic value of a stock.

His second reason is that economic performance follows a fairly consistent long-term path and gravitates towards the mean. If the economy has been terrible, it is likely to revert back to acting better. If it has been terrific for quite awhile, it is headed for difficulty. At SCM we are asking whether the current economic trouble is making our companies more or less likely to survive and prosper for many decades? We think the overwhelming answer is that the current circumstances are making the kinds of companies we like to own more likely to survive! Six Flags declares bankruptcy and Disney gets stronger. Washington Mutual disappears and Wells Fargo gets stronger. Nobody wants to finance young biotechs, so Merck and Pfizer will buy most of the great future science. The list goes on and on. The economic cleansing of the last two years has done more to strengthen and widen the moats of strong balance sheet companies with powerful brands and distribution chains than any phase in history in our opinion. However, since these facts are long term in nature, the marketplace actually discounts these virtues rather than giving them their usual premium. We believe that the next few years could very well rectify the under valuation of the most valuable franchises in business and our companies could turn out to be “good soil”. We will leave investments on the path, on a rock or in the thorns to someone else.

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. The securities identified and described in this missive 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

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Dear Clients and Prospective Clients:

There are two opinions we hold at Smead Capital Management which are very contrary to the conventional wisdom in the marketplace. First, we feel that we are much closer to behavioral changes in the automobile and environmental world than most people think. Second, we believe we are about to enter a long stretch of outperformance among U.S. stocks by large capitalization companies which fit our eight criteria. We think our “gut feelings” on these subjects are correct, but once in a while you need a little encouragement when your opinion is especially contrary. Jeremy Grantham, of Grantham, Mayo, Van Otterloo & Co. (GMO) fame, is probably the most respected institutional asset allocator in the world today. He chose in the last few weeks to forcefully back us on our arguments and reasoning.

For our thoughts on Oil and Oil-oriented investments, see our recent Missive titled “Bull Markets in Oats and Hay”. Our thesis assumes that the change to electric and hybrid cars will be much swifter than most investors think (5 to 10 years). This swift transition could destroy the “Peak Oil” mentality which had developed last year as oil reached $147 per barrel. It took 25 years for the U.S. to move from horses to cars (1900 to 1925) and we believe everything changes much faster now than in the past. We are under-weighting Oil and Oil service stocks despite their recent popularity.

Grantham seems to be in agreement on the changes in autos, but his opinion is driven by climate change. In a recent interview with Smart Money he said this: “The people who move quickly in this market can make money. The people who invest in energy alternatives will make more. Alternative energies and combating climate change are the single most important economic initiatives over the next 10 years-really over the next 50 years. It will be a very exciting next 50 years.” A victory for energy alternatives is a loss for Oil and Oil Service companies in our opinion.

We always like our investment style of seeking out high quality “blue chips” companies which are out of favor, but once every 10 to 15 years they get especially attractive relative to all the other places people can put their money in the U.S. Grantham and his firm run intense mathematical models to try and determine which asset classes should perform the best over the next seven years. They now manage directly over $80 billion in assets. Here is what Grantham said in a series of interviews at Morningstar’s recent investor conference and Forbes magazine:

Grantham expects a subset of U.S. stocks — those he labels “high quality” — to produce after-inflation annualized returns of 11.5% over the next seven years. Five-and-a-half percentage points on an annualized basis is an enormous difference — and gives investors plenty of incentive to identify those “high quality” stocks.

Although Grantham doesn’t directly define “high quality,” he provides some clues in an interview with Forbes in which he said, “And the best bet, for my money, then and now, a year later, was to buy the great franchise companies, the great quality companies.” This suggests that he favors companies that possess a moat — a sustainable competitive advantage — and that earn excess returns over their cost of capital.

At Smead Capital Management we have solved Jeremy Grantham’s dilemma and have come up with the eight criteria below to define high quality and use it to create our common stock portfolios.

1) Strong Balance Sheet – Preferably more cash than debt, the ability to pay off debt in the next couple years out of free cash flow or companies with debt that have very consistent customer bases

2) Long History of Profits and Dividends (or stock buybacks)

3) History of Shareholder Friendliness – Making shareholder friendly choices with available capital

4) Strong Insider Ownership – Preferably with recent purchases

5) Easy to Understand – Business meets a sustainable economic need

6) High levels of free cash flow

7) Wide Moat – High levels of profitability maintained by barriers to entry

8 ) Low Price in relation to the fundamentals of the business (price-to-earnings/sales/cash flow/book value) in comparison to the last five years

Grantham believes as we do that economic growth could be muted by the debts over-hanging the economy from the last ten years. He thinks that China and India can’t grow as fast without the U.S. returning to our prior spending levels and he doesn’t foresee that in the next seven years. We believe a huge number of retirement age baby boomers could result in sustained high unemployment figures. This “New Boomer Austerity” or attitude could cause the existing spending “reset” (like what we’ve seen since September of 2008) to last for as long as a decade. In that environment, competing with financially strong and well entrenched companies like WalMart, Microsoft, Merck and Disney could be difficult at best and impossible in many cases. The ultimate irony of all this is these “quality” companies trade at or below market P/E ratios and pay above average dividends for the most part. Numerous years of under-performance and reversion to the mean is driving GMO’s computer models and Jeremy’s opinion. Our stomachs are strengthened!

Stay thirsty for investment success my Friends,

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 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

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Dear Clients and Prospective Clients:

We are all being drowned in information each day. Most of this information has to do with the effect of the current economic contraction and the policies being used to turn things around. Since it seems that nobody wants to talk about wonderful companies, I’d thought we’d share some of Smead Capital Management’s opinions on the subject.

Here’s a list of some of the attributes of a wonderful company in our eyes:
1) High levels of profitability on invested capital with little or no leverage
2) Number one or two in the industry
3) Brand synonymous with product or industry
4) Transparency of management
5) Non-cyclical core business
6) High Barriers to entry (Strong Moat)

We could go on, but let me get to the point. In 29 years in the investment business we’ve learned that wealth is created by owning wonderful businesses for a long time and that your returns are enhanced if you get to buy them when their price is depressed. Usually the only time wonderful businesses get depressed in price is when the whole stock market goes way down and/or the economy contracts and provides short-term difficulty to even the strongest businesses.

We believe that three to five years from now people will look back and say, “What was I thinking about in late 2008 and early 2009 as I sat on low interest paying vehicles and didn’t add to existing holdings or use these bargains to get in somewhere around the ground floor?” Help us to help you!

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. The securities identified and described in this missive 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






Dear Clients and Prospective Clients:

Jim Collins is the author of a book that I have mentioned from time to time called “Good to Great”. He has attempted to help us understand the difference between merely good companies and the few great ones which have been demonstrating “greatness” over the years. What these “great” companies do in the most difficult business circumstances could give us some clues on what to do in this current economic and investment environment. The current environment is already establishing itself as the most difficult set of circumstances we have faced since the 1930′s.

To help us understand the approach of “great” companies in difficult circumstances, Collins retells the story of James Stockdale, a POW camp survivor from the Vietnam War. Stockdale withstood the kind of long imprisonment which Senator John McCain withstood and is still fresh in our memories. This survivor explained that it wasn’t the pessimists or the optimists which survived, but rather the realists. Pessimists died early on trying to escape, knowing that they didn’t have it in them to hold on for years. Optimists expected the very best and would say things like, “We will be out of here by Thanksgiving.” Thanksgiving would come and go and the optimist would turn to Easter as the point where it would all be better. Eventually, a number of optimistic deadlines would pass and the optimist would lose hope and turn into a pessimist. The realist said, “I will do whatever it takes to get through this regardless of how long it takes to get through it.” There is an inherent optimism in the position taken by the realist. The grim reality must be balanced against the great blessing for you on the other side of the valley.We are in the midst of a business coma and stock market liquidation that has to do with financial sins committed over the last ten years. It is holding all participants (workers, investors and companies) prisoner regardless of whether or not we or our companies were part of creating the problem. We do not know how long the “business coma” will last, how long stocks will be liquidated to find a bottom and how soon the inevitable rebound will come! However, we must survive.

At Smead Capital Management we have staked the survival of our portfolios on the balance sheet strength of our companies, the necessary nature of their products and the enduring quality and “mind control” of their brands. In other words, we have sought to own the realist companies which can get through this regardless of how long it takes. And we do this to not only survive, but also because the reward on the other side of the valley is huge from a historical point of view. If you made it all the way through the Great Depression to 1937 with your blue chip stocks, you saw a huge rebound in stock prices from the 1932 lows.

What can you do to be a realistic owner and steward of your assets? Make sure you are investing money in the stock market which can stay invested for at least three to five years. Put the money you need in the next two years in a safe financial instrument like a Certificate of Deposit or money-market fund. Reduce portfolio withdrawals until things improve. Where possible, liquidate non-liquid assets like boats, cars and non-income producing real estate or use them as a charitable donations in a substitution for cash outlays. If needed, review your portfolio with us regardless of whether or not we oversee all the assets.

What should we look for to get a sense that this storm is passing? First, look for low enough new home sales figures to put some of the weaker publicly traded homebuilders into Chapter 11 bankruptcy. Second, look for Arizona, California, Florida and Nevada unsold home inventories to decline. Thirdly, look for some highly respected, nationally recognized stock portfolio managers to give up or get fired (it happened right before the Tech bubble broke in early 2000). Lastly, look for the interest rate differential to narrow between high-grade corporate bonds and Treasury bonds.

We intend to survive these circumstances with you and are here to serve you in any realistic way we can.

Warmest regards,