William Smead
Chief Executive Officer
Chief Investment Officer

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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

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Dear Fellow Investors:

For a long-term multi-year bull market to exist in stocks in the US, a number of things need to fall into place. Since we at Smead Capital Management enjoy owning high quality large cap US equities for long holding periods and seek to find “Hall of Fame Companies”, we would like to see a long bull run play out over the next 3-5 years. We thought it would be helpful to line up the current “ducks” to see if the markets have done what they need to do for this bull market to last for a long time.

Duck No. 1—Negative Sentiment

When this market sneezes, investors get a cold. A recent 7.5% pullback in the S&P 500 Index caused individual investor sentiment and professional investor sentiment to plunge. Mark Hulbert covered this in a column called “A mid-winter night’s gloom” in which he showed that short-term professional market timer’s had reduced their equity exposure in a short time by 45%. Both the Investor’s Intelligence and American Association of Individual Investor’s (AAII) surveys saw the number of bulls plummet and the number of bears or people looking for a correction soar.

Duck No. 2—Insider’s Positive

The recent pullback in the market saw a big drop off in insider selling (Officers and Directors and Substantial Stockholders of public companies). When the Insider’s are big sellers of dips, beware.

Duck No. 3—Favorable Supply and Demand for Shares

Every week another major acquisition announcement is made. Most are all cash (Terra Industries $4.1 billion) or mostly cash purchases (Berkshire Hathaway’s buy of Burlington Northern). When shares of stock are bought out for cash, the supply of shares outstanding decline. Major stock buyback announcements have been fairly constant (Merck and Amgen in our stable are recent examples) and are being executed, wiping out more supply. In more normal times this supply elimination would be offset by Initial Public Offerings (IPO’s) and Secondary Common Stock offerings. Ask any investment banker, IPO issuance is almost non-existent.

Duck No. 4—Massive Cash on the Sidelines

US households ($7 Trillion), Banks ($1.2 Trillion) And Non-Financial Corporations ($1.8 Trillion ) are holding record levels of cash on their balance sheets. When confidence comes back a significant piece of this amount will either participate in business growth or stock purchases.

Duck No. 5—Negative “Nabobs” have Credibility

Any two-bit economist or market strategist who foresaw the sub-prime meltdown is treated like a god/guru and like they have a crystal ball. They all say the same thing about the US economy in one way or another. The US has seen its best days and we are in for a long deleveraging phase. In their mind commodities and emerging markets are a better place to invest than the best companies in the world domiciled in the USA.

Duck No. 6—The Public Can’t See the Ducks

We believe US household investors and many institutional investors are looking in the rearview mirror at the horrid decline of October 2007-March 2009 and can’t see the ducks lined up. Remember, US households were net liquidators of US common stock last year.

We are very excited to own the companies which fit our eight criteria and look to enjoy the ride as we believe investors will slowly recognize that the “ducks are lined up”.

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
Click here to listen to this Missive

Dear Clients and Prospective Clients:

I believe that an individual’s income is close to the average of their ten best friends. This could be why an estimated 35,000 people sought to make friends with Warren Buffett and Charlie Munger in Omaha on Saturday at the Berkshire Hathaway Annual Meeting. Buffett is the Chairman and Chief Investment Officer of Berkshire and is the world’s third wealthiest man, while Charlie is Vice-Chairman and has a $1.5 Billion net worth (which is not chump change). Even at the ages of 78 and 85, respectively, these two billionaire investors can hand out the wisdom.

What I find the most interesting about what these men say about investing is the clarity and simplicity of their investment decisions. Unfortunately for most investors, the part that holds most people back from imitating these great investors is the patience, contrarianism and humility associated with executing a non-widely diversified buy and hold common stock investing style. At Smead Capital Management we seek to practice these virtues.

Here are examples from last weekend of these separating virtues:

On the subject of patience, Charlie Munger said Friday, “I think the reality is that if you hold a stock for a long long term even though it’s screamingly successful as an investment, you will have huge declines in the value of that stock two or three times in half a century. And I don’t think that should bother long term holders all that much.”

While everyone is scared to death of banks, the ultra contrary Buffett said, “I would love to buy all of US Bancorp or I would love to buy all of Wells Fargo, if we were allowed to do it.” Buffett spoke again about Wells Fargo and the $9 price it had earlier this year. “If I had put all my net worth in one stock, that would be the stock.” This is a stock he started buying in the last major financial crisis in 1991.

On the search for a Chief Investment Officer to replace him in the future, Buffett shared that he has found four good potential replacements. Instead of chasing recent out-performance (like most investors do), he shared that none of them had beaten the S&P 500 Index last year (which means they lost more than 37% of their beginning year value). He and Munger also added that sitting on large amounts of cash to avoid last year’s decline did not impress them or influence their decision.

On another note of humility, Warren had to eat some humble pie. “Buffett said Saturday that he was ‘disappointed’ when Moody’s cut its Berkshire ratings, though he said the decision was lamentable mostly because it led to a 1oss of ‘bragging rights’ – not because it will materially raise Berkshire’s borrowing costs.” Maybe it is God’s way of getting him back for undercutting the municipal bond insurance companies and then using information they had shared with him to compete in the bond insurance business in the middle of the panic and the credit crisis last year. Warren needs to relearn the Mike Milken lesson of the junk bond era of the 1980′s. Leave some business for everyone else and not just crumbs.

On simplicity, both men reiterated that if you need a calculator for making an investment decision or if your investment relies on computing some sophisticated mathematical formula, in their minds it is a bad idea. I always told my kids that all the math you need to learn to make a great deal of money in investing or in business is learned by the end of 7th grade.

Reading and listening to these two great investors over the weekend makes those of us at SCM that much more excited about the great companies we own, the investors who are along with us for the ride and how much money we could make in the aftermath of the recent fire sale in the stock market. You supply the patience and we’ll supply what we think are the great companies because the stock market has already handed out the humility!

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.