William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

At Smead Capital Management (SCM) our contrarianism and urge to purchase stocks with low PE ratios has led us to own what we think are the finest and most recession resistant companies in the world. To understand our portfolio and where we are in history you must read Randall Forsyth’s column in Barron’s dated June 21, 2010, an article written by Jason Zweig in the Wall Street Journal over the weekend called “So that’s why investors can’t think for themselves” and Brian Belski’s research note at OPCO yesterday (June 21st, 2010). Randall quotes work by Jason Trennert on “The New Lords of Finance: Policy’s Long Shadow Over the Markets”. In it Trennert argues that a small group of policy makers in places like Washington D.C., Brussels and Beijing (whether elected or not) are “exerting enormous influence over the economic cycle”. He says and Forsyth reiterates, “All of this has led to a certain sclerosis when it comes to the behavior of certain large companies. Among the symptoms is that these companies sit on record levels of cash.” Forsyth points out that it wouldn’t be so bad if the cash was being used to raise dividends and do stock buybacks instead of hoarding it in t-bills earning virtually zilch. He also goes on to show how investor behavior has been led around by reaction to the policy makers and the inaction on the part of the leaders of large US corporations:

“Leaving aside the philosophical implications, the practical investment effect is that investors appear willing to hold cash earning 0% or 10-year Treasuries yielding 3.25% “and yet remain unwilling to buy large-cap growth stocks with fortress balance sheets and decent dividend yields trading at low double-digit earnings multiples,” Trennert says.

Jason Zweig’s article cuts to the core of the current opportunity in Large Cap Non-Cyclical US stocks. Here is his thesis:

“Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear. In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn’t just give investors a sense of “safety in numbers.” It also gives them pleasure. That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the “consensus view” on Wall Street.”

Therefore, at the “basic human level” it is unnatural to be a lonely contrarian and what could be more lonely than owning large quality companies which have not been the place to be since they peaked in popularity back in 1999. Throw in the worldwide policy elites publicly dressing down your industry and demonizing large profitable companies in general and you have what we believe is a prescription for historically extreme undervaluation and absolute low PE’s. This makes us at SCM just drool and lays the groundwork for what we believe will be 7 to 10 years of above average performance.

People say things like, “small to mid-cap stocks are still doing way better”, even though they are dramatically more expensive on a trailing and estimated PE ratio basis. The smaller your company is the less chance that the policy makers are going to use you as a populist punching bag. We believe the biology study proves what John Templeton clearly understood in creating an incredibly good track record in the Templeton Growth Fund from 1950-1990. He said, “The time of maximum pessimism is the best time to buy”. The price you get without any reinforcement from the crowd is the price that will generate the most future success with the least amount of risk.

In a report out yesterday called “Dividends and Buybacks Increasing”, Brian Belski and his folks at OPCO show that despite the coma that the circumstances of the last three years have put companies and investors in, that the dividend increases and stock buybacks are coming anyway. Templeton might have called that the first light at the end of the tunnel. Belski also shows that it bodes well for overall stock market returns. Rejuvenation phases in dividend and stock buyback activity in the past has coincided with very solid and positive results in the S&P 500 Index. Our portfolios are loaded with recent dividend increases and massive added stock buyback activity because our companies have strong balance sheets for the most part and generate way above average free cash flow. From all of this we believe there can be only one conclusion for the patient investor.

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.