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 Printable Version
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Dear Clients and Prospective Clients:

As portfolio managers, we feel like the children of an abusive parent. The parent spent the last 29 years teaching us the difference between right and wrong. We in turn have been executing the behaviors that are preferred by the abusive parent. Unfortunately, the abusive parent chooses to abuse us financially and psychologically. Many have rightly fled the household of the abusive parent and gone to investment shelters until the abusive parent is arrested or in some other way is stopped from inflicting pain on its family.

Here is a list of some of those right behaviors:

1) Buy and hold Blue Chip stocks for the long haul
2) Buy companies with strong balance sheets and strong brands
3) Buy at points of “maximum pessimism”
4) Use insider buying as an indicator of future business success by those who know the company best

The only times that long-term investing hasn’t worked has been if you bought in at a major high point. The bad news is that the end of 1999 and beginning of 2000 was just one of those historical high points. In the American Association of Individual Investor’s sentiment poll in early 2000, their members peaked with 72% bullish one week and two weeks later saw only 6% bearish on the stock market. This total belief and participation caused ridiculously high prices and effectively ruined the normally virtuous behavior. Our look back over the last ten years makes us recognize how abusive this greater than 50% decline has been as a snapshot in time, but the ground work was laid in the enthusiasm of the market bubble ten years ago. Ten years of the stock indexes losing money has successfully convinced a majority of the remaining participants to seek shelter.

To understand how balance sheet strength has been turned on its head, just watch Jeff Immelt, the CEO of GE, try to defend its AAA rating as the stock falls to the recent $6 to $7 level per share. There has been about $300 billion lost in the last 17 months by owners of this former blue chip. Is that any way to treat people you are supposed to reward?

We are probability people here at Smead Capital Management. We feel our job is to stack favorable probabilities into the financial life of our investors. Just look at point number 3. There have been at least four cataclysmic selling waves since October of 2007. Each would have qualified as the “point of maximum pessimism” in 80% of our experiences over the last 29 years. Each effort to be optimistic on our part has just been another good excuse to get bashed around by our abusive parent, the U.S. stock market.

If anything, the insider buying (which has been at record levels for months) has been a contrary indicator. Almost every time a sizable buy or series of buys are made, it seems that a curse has been attached to it. When you buy a financial stock with a strong history and an outstanding management team after an insider buying spree, it is like you pulled your pants down, bent over and said, “Hit me.” Our abusive parent has been glad to do so.

When will we stop getting abused in the stock market for right behaviors? The good news is it could be soon. In the same A.A.I.I. sentiment poll taken this last week, the members were 70% bearish and only 18% bullish. It is a record level of bearishness in 21 years of polling each week. The highest prior reading to now was 67% bearish at the bottom in October 1990 in the middle of the bank and S&L Crisis. More importantly from a psychological stand point, the magnitude of today’s negativity could be as good an indicator as 2000’s ridiculous enthusiasm was. It topped out one of the greatest bull markets of all time. Beware though, those extreme sentiment readings of 2000 came two weeks apart and we could need verification of this one.

Why do we care? We care because the best ten-year stretches in the stock market have followed the worst abuse in the past and the crowd of those already in the shelter far exceeds those of us trying to execute historically right behaviors.

Warm Regards,

William Smead

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.