William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

We have looked at many academic studies over the years which break the market down by valuation. These studies like Fama-French, Bauman, Dreman/Ibbotson and Nicholson show that the lowest quintile of stocks as measured by price-to-earnings (PE), price-to-book or price-to-cash flow ratios all reach the same conclusion. Valuation matters over all the time periods studied, and if anything, proves to matter more greatly over longer holding periods. In each case, the “ugly duckling” portfolio outperforms the other categories. Why do stocks with such low expectations perform so well and are there examples available in the current market which has rebounded nicely from 2009 lows?

In the summer during my college years I worked mostly swing shift from 4pm to Midnight at the Crown Zellerbach Mill in Camas, Washington. I had no social life, but I had plenty of time to handicap greyhound races. The Multnomah Kennel Club was straight across the Columbia River from our house in Gresham, Oregon. Most of the time, I would make my selections through morning analysis and send my bets with one of my cousins. I wouldn’t know the results until later. You might be surprised to learn that I had a certain criteria for selecting dogs. We looked for dogs based on the quality of its history, early speed, post position, late speed and how well it had been running lately. Greyhound handicapping and common stock selection are different from baseball in that there is no penalty for letting pitches go by. When the pitches look fat to us, we sent specific wagers.

We made money on our analysis by being patient and waiting for high probabilities to show up. However, there was a valuation opportunity that I passed up by not being there. Between races the “Tote Board” showed how many bets were being placed to win, place or show on each of the nine greyhounds. Since I had been attending greyhound races for ten years, it was easy to see occasional mispricing. Sometimes a dearth of show bets would get placed on a quality dog. This low price to potential earnings made it a bet that would pay off in a big way if repeated faithfully over the course of the season (June-August). It was Fama-French and Nicholson in action. I bought a new truck in 1978 with the money my Dad and I made from those picks.

Which dogs are mispriced and trade in the bottom PE quintile currently? Big Medicine Makers like Abbott Labs, Merck, and Johnson & Johnson are the cheapest on a market-relative basis I’ve seen in my 31 years. “Staple” consumer stocks like Gannett, Nordstrom, Disney and WalMart trade like we are late in the economic recovery, not early. Finally, certain financials trade at microscopic PE ratios like Goldman Sachs and Aflac. Which sectors look most over-priced based on Fama-French? Growth cyclical stocks in Energy, Basic Materials and the Heavy Industrial sectors trade at high price to book ratios. Along with commodities, they have too many bets placed on the “Tote Board”.

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 traveling around the US giving a talk about a template for managing equity portfolios which can be used for choosing active managers. Our theory is that the average active manager cedes too much advantage to passive indexes by being overly-active (averaging more than 100% turnover vs. less than 5% for the S&P 500 Index over the last 18 years), by under-owning high quality and ignoring significant undervaluation. In this missive, we’d like to talk about why most investors underestimate the importance of undervaluation because it usually comes with warts.

Studies led by Nicholson, Fama-French, Bauman and Dreman have all come to the same conclusion. Broken into quartiles or quintiles, the index produces significantly better results by owning the lowest Price-to-Earnings ratios, Price-to-Book ratios, Price-to-Cash Flow ratios and Price-to-Dividend ratios in both the short run and over very long stretches of time. It happens both on a static and annually readjusted basis. It has been true in every country study and in each of the three stock market capitalization levels (Large, Mid and Small). Why don’t more active managers stack these probabilities in their favor? We believe the answer is warts. They just can’t stand to look at owning these out of favor securities and are afraid they will get fired before these ugly ducklings come back into some kind of favor.

We think you’ll understand this if we look at a specific and current example of these circumstances. Big Pharmaceutical company shares are in the lowest quintile by Price-to-Earnings ratio, Price-to-Cash Flow ratio and Price-to-Dividend ratio. It is a veritable triple whammy of undervaluation! However, just look at the warts. Merck reported earnings last week. They reserved for leftover Vioxx litigation. They are in arbitration with Johnson and Johnson over the rights to Remicade. They are losing patent protection on important products and facing the stingiest FDA approval process which has been seen in decades. If all that is not enough indignation, the President of the United States has used the industry as a punching bag for the last two years. The same basic story is true for Amgen, Bristol Myers, Pfizer, JNJ and Abbott Labs among our portfolio holdings.

History proves that the best time to buy these out of favor areas of the market are when the warts are the biggest and the alternatives are the most attractive. Ten years ago, folks were agog over technology stocks and wanted nothing to do with energy producing investments at $11/barrel of Oil. There was no hope for the industry. They were in the low quintile for Price-to-book, Price-to-Earnings and Price-to-Dividend yield. They have been spectacular on both a relative and absolute basis since then. Twenty years ago, in the aftermath of the Savings and Loan/Banking Crisis of the late 1980’s, bank shares sold for less than book value, mega-low PE’s and offered above-average dividends. They were the stars of the next fifteen years in the market.

The wait typically isn’t as long as most equity managers or asset allocators think. Research we use in our presentation shows that equity research analysts do a great job of predicting next year’s results for companies based on PE ratios. The highest PE companies produce the best earnings growth and the lowest PE companies produce the worst earnings results. But over one year, the lowest PE stocks outperform the average by 3% and the highest PE group underperforms the index by nearly the same percentage. Our conclusion is that managers who stack these favorable odds in their favor and buy some Compound W should ultimately attract a great deal of interest from asset allocators when the warts fall off.

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

Dear Fellow Investors:

Morningstar did some neat fund flow analysis recently which was picked up by a column written by Mark Hulbert on MarketWatch called, “Active vs. Passive”. In it he described how fund flows had moved toward passive or index investing among US equity funds and away from active managers in the last ten years. The amount of US equity assets which are indexed grew from 12% to 22% of the total pie. Theoretically the more that investors or their advisors index, the more likely active managers would be to gain the upper hand over passive investments in the S&P 500 Index (scarcity creates value). Unfortunately for the active managers, this was not the case as only 20% of active managers beat the market over the ten years. In the article, Hulbert concluded that all the added advantage that active managers might have received from greater passive participation was dissipated or offset by the increased portfolio activity (turnover) of stock mutual fund managers. At Smead Capital Management, we think these results and information are important to contemplate because it sheds light on what it means to be a wise contrarian investor in early 2010 and in the future.

The S&P 500 Index has obvious built in advantages over active funds. As a benchmark it has no management fee. Therefore, throughout the year the index will gain the advantage of not paying a management fee of .50%-1.00%. The active managers automatically have to overcome this difference through better performance. Second, there are no operational costs associated with the index. In the actively managed US equity fund universe this adds up to an average of 1.31% per year including the management fee. Third, the index has very low turnover historically. This means that trading costs and bid and asked spreads do little to reduce the returns of the index. Lastly, the S&P 500 Index is a market-capitalization weighted index. It means that the S&P 500 Index holds its winners to a fault while allowing the duds (like General Motors) to run their stock price into the ground. At SCM, we believe this is one of the index’s biggest built in advantages over active managers. The math is that you can make 10 times your money on a big winner, but you can never lose more than 100% of your money on a stock going bankrupt.

Academic research has shown repeatedly that long time periods allow value to get recognized in the marketplace. Eugene Fama’s work on efficient markets at the University of Chicago focused on low price to book value. Others like Bauman, Conover and Miller as well as David Dreman have shown clearly that buying the lowest P/E ratio stocks has soundly beaten the market averages if measured over a ten year or longer time frame. This shows that long durations produce better results for both passive and active investors.

Ben Inker, research director at Grantham, Mayo and Van Otterloo (GMO), exposed what is wrong with the high level of activity and portfolio turnover at the average actively managed fund. His work shows that 75 per cent of the current intrinsic value of a stock comes from cash flows earned more than 11 years from now. Why are short term business prospects receiving most of the professional investor attention when company durational success should be their focus? Ironically, in 2009 the average holding period for a stock on the New York Stock Exchange dropped below a year for the first time in 70 plus years. Not only have fund managers been more impatient, but individual and institutional investors have been as well! On top of all this is the fact that dividends and dividend increases make up a substantial part of long-term returns produced by participating in US equity investments. The average investor doesn’t stay around long enough to collect an entire year of dividend payments.

Let’s put this wonderful band of players together and see what we come up with. When stocks do poorly for a decade, investors are motivated to try to compact duration or holdings periods on stocks to gain an advantage. In the process they cede success to the S&P 500 Index. And by being impatient and too active they fail to take advantage of the kinds of under valuations provided by cheap stocks. We believe these advantages include dividends, dividend growth and companies with long duration business characteristics (wide moats and strong balance sheets).

It appears that good stock selection, with an eye on low PE’s and long duration business characteristics could be very successful for the patient US equity fund manager. It also appears to be quite contrary to the popular view and methodology of active managers in 2010.

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.