William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

At Smead Capital Management we have made it a high priority to pay attention to the investors who have proven over decades that their work proves worthy of great respect and admiration. In baseball, you can make the All-Star team with one great season, but to make the Hall of Fame, you need a long career at very high levels of success to be inducted. Our industry is wonderful because we can look very closely at the investments and writing of these people we have great respect for.

All great money managers reach a point in their career where adulation and self confidence detracts from their better judgment. This interruption in judgment usually coincides with the discipline in use becoming the most popular discipline in the marketplace or the investing style being overdue for a three to five-year correction. Studies of the equity managers with the best long term records show that the best underperform the S&P 500 Index 35% of the time. The pride associated with multi-decade success and the reinforcement of an army of folks enjoying your work is probably the most dangerous thing that can happen in the money management business.

To understand these phenomena, we will review the work of Warren Buffett, Bill Miller and Kenneth Heebner on a backward-looking basis. Then we will examine Jeremy Grantham and Bill Gross looking forward. Our supposition is the following. These men make up a short list of five of the best money managers of all time! However, there is a point in their career when their pride can get in the way of their better judgment and capital can get destroyed.

Warren Buffett is the most successful money manager of all time, in our opinion. His long-term compounding of book value at a rate in excess of 20% is legendary. To this day, I’d rather be a fly on the wall in his office than one in anybody else’s office in money management. In 1998, he was uniformly admired by the media, by a slew of book writers and by a huge army of professional and individual investors. He wrote in his 1996 annual shareholder letter that stocks like Coke (KO) and Gillette (now part of Proctor and Gamble) were the “inevitables”. In Buffett’s eyes, these companies had such dominant moats, sustainable profit margins, strong balance sheets and other strengths that he could ignore the fact that they reached PE multiples of as high as 57 times trailing earnings. These stocks were “maniacal” and were trading at PE multiples which doomed their stock prices for ten years. Coke peaked at around $88 in 1998 and bottomed in 2009 around $38 per share. Warren’s big mistake list is so small that you need a magnifying glass to read it. I believe that everything going on around him in 1998, the adulation and the uninterrupted success got the better of him. His popularity dropped in 1999 as the Tech Bubble went into its highest gear. By early 2000, many writers were asking if Warren Buffett’s investment discipline was old-fashioned and out-dated.

Bill Miller beat the S & P 500 Index for 15 years from 1991-2005. He has the unusual ability to recognize deeply out of favor stocks in widely diverse industries and then has the constitution to hold his winners for many years. He specializes in high reward and volatile positions and is unafraid to average down far longer than most admirable money managers. By the end of those 15 years his streak was followed heavily by the media, his parent company (Legg Mason) boomed and financial advisors nationwide poured billions of dollars into the two funds that he manages. We at SCM believe that he is as brilliant a thinker and money manager today as he was in 2005. He’s only out-performed the market once since 2005 in the year 2009. His five-year numbers are 99th percentile in his category. We assume that the circumstances brought pride into the picture and that these last five years have been incredibly humbling.

Kenneth Heebner manages money in a way that is unfathomable to this writer. He takes concentrated positions based on strong opinions and analysis. He had the best 15-year track record among mutual fund managers in 2008. He produced stunning results in the first eight years of the decade of the 2000’s. However, he turns his portfolio over aggressively and constantly. In May of 2008, he was called “the best money manager around” and featured on the cover of Fortune magazine. Enormous adulation was heaped on him by the media and billions flowed into his mutual funds. At the top of the commodity markets in the late spring of 2008, Ken Heebner was massively over-weighted in energy, basic materials and heavy industrial companies. He immediately went from there to an aggressive over-weighted position in financials. His performance over the three years since the overwhelming adulation has been dismal. He is one of the most talented managers of money, but pride temporarily got the best of him.

Jeremy Grantham and Bill Gross are Hall of Fame money managers. Grantham leads the firm of Grantham Mayo Van Otterloo (GMO) which is a leading strategic wide-asset allocation firm. He has been unusually accurate in his long-term predictions in everything from lumber to large caps and emerging markets to energy. His firm is drowning in new money and his specialty area, asset allocation, is the darling of institutions, registered investment advisors, consulting firms and financial advisors. Even stock pickers like us pay attention to Grantham’s thoughts on asset allocation and GMO’s 7-year prediction for inflation-adjusted forward performance expectations. He has been spot on and his research director, Ben Inker, has done some of the best investment research in the marketplace. Grantham is currently known for his “7 lean years” thesis and in his latest quarterly letter titled “Danger: Children at Play” he nearly exhausted himself taking victory laps around the nine pages and an addendum. This comes just three months after Grantham boldly predicted that commodities were in a “paradigm shift” and had , in effect, reached a “permanently” higher plateau!

Bill Gross is the most successful bond mutual fund manager in history. His company, PIMCO, manages over $1 trillion for institutions and individual investors. During the bull market in bonds from 1981 to today, he has handled every environment well and produced a market beating track record. His monthly missives are followed closely by the same crowd which feasts on Grantham’s quarterly letter. The bond bull market in the US has culminated the last three years in an avalanche of money drowning bond managers like Bill Gross. Those investors, advisors and institutions will recite statistics about how much better bonds have done than stocks the last 10 and 20-year periods. Bill Gross even has a very similar forward thesis to Grantham’s which he calls the “New Normal”. It is a relatively negative belief that the US has more than a decade of penance to pay for the financial and real estate sins of the decade from 1998-2008. His firm travels around the world explaining how they are looking for bonds in countries which benefit from emerging market growth to protect against both currency declines and to get a decent rate of interest. When Bill Gross and other major players at PIMCO are on CNBC, the world seems to stop to find out what the markets wisest players have to say. The adulation from all corners is thick enough to cut with a knife and the pride in PIMCO’s opinion continues to rise.

If this piece were a trial rather than a missive, it is safe to say that Jeremy Grantham and Bill Gross are in a very similar and guilty position compared to the Hall of Famers we mentioned in the beginning. Buffett stumbled when his favorite kind of stocks (large-cap/wide moat/strong balance sheet/powerful brands) were wildly popular. Bill Miller became the most respected equity mutual fund manager at the height of eclectic stock picking. Kenneth Heebner headed into the tank right after he got unusual media attention and his “go anywhere” discipline squeezed every dollar out of the marketplace it could. They have been in Jeremy and Bill’s shoes.

Therefore, what could happen to ruin the party for these two great money managers? They would have to have a very rough three to five years of performance and the thesis they are operating on would have to be wrong. We believe bonds will never be more popular in the next thirty years than they are now. We believe that so many people are practicing wide asset allocation that it will be a “nightmare” the next five to ten years. We believe that a bear market has started in oil and commodity indexes which will embarrass today’s bulls. Lastly, we believe that the ability of the US economy to heal itself is being badly underestimated by these two great money managers.

As contrarians, we can’t run away from the opinion of these great money managers fast enough. This is not because they aren’t deserving of Hall of Fame status, but because they are trapped in today’s two most popular disciplines with all the same adulation and pride that our other great managers had before them. Both favor emerging markets over the US, have confidence in commodities, assume China’s economy will grow uninterrupted; both think the US consumer is dead for years and both think that the US is a political disaster area. We will still admire them when those who fawn over them today no longer have respect for them. This will be after the “pride that leads to destruction” turns into humility in the marketplace.

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.

Gentlemen Prefer Bonds

» Sign up for Smead Capital Management’s Quarterly Newsletters

Marilyn Monroe was a physically beautiful woman who figured out early in her career that coloring her hair blonde would draw attention. Not only did it further her career, but it led her to make a movie called “Gentlemen Prefer Blondes”. We at Smead Capital Management are sure that women, who are intelligent and beautiful without being blonde, are dumbfounded by the attraction men have to platinum hair. It doesn’t surprise us, however, because we have been seeing the same kind of visual and emotional attraction work in the investment markets over the last 29 years. As we look out into the fourth quarter of 2009, we will look at one of those eye-catchers today because “Gentlemen Prefer Bonds”.

Click Here to Read On

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version
Subscribe to the Missives Podcast

Dear Fellow Investors:

We are witnessing one of the greatest battles to control the hearts and minds of investors that we at Smead Capital Management have just about ever seen. In one corner you have PIMCO and their fearless leader Bill Gross, buying longer-term Treasury bonds. They see the world as a giant game of deleveraging as the large U.S. government and household debt is worked off in a muted economic recovery. They see a “new normal” set of spending patterns and higher savings rates leading to slow growth rates and low levels of inflation or possibly deflation. It is our opinion that PIMCO and Gross have been super successful, outperforming other bond market participants for years in one of the best bond investing eras in U.S. history. The amount of money they manage has reached legendary proportions and they have huge influence in the debt markets in which they maneuver.

In the other corner are such heavyweights as Warren Buffett, James Grant and Julian Robertson. Buffett is actively buying stocks in the U.S. He fears that inflation is a natural by-product of all the efforts of the Federal Reserve Board and U.S. Government to stimulate the economy. James Grant, one of the best writers and contrary thinkers in the money world, recently shared his opinions in an op-ed piece in the New York Times. Looking back at history, Grant surmises that the deeper the recession the more explosive and powerful the two to three-year economic rebound has been. He sees the large camp of economists assuming a poor/jobless recovery as a good psychological signal. Julian Robertson, one of the deans of Hedge Fund investing, is short U.S. Treasuries across the board and sees very high interest and inflation rates coming as a consequence of quantitative easing and Federal stimulus efforts. Who should you/we believe?

First, I’d like to give you our SCM caveats. We believe that the merits of the companies we invest in based on our Eight Criteria are the most important factor in how we will do over the next ten years. Second, we don’t believe we can predict the stock market or the economy. We like the fact that our criteria has the tendency to find strong balance sheets, powerful brands, high free cash flow generators and wide moats, because they are more likely to withstand whatever environment plays out.

With caveats in hand, here is SCM’s feeling about the arguments from these titans. Bond mutual funds have been receiving $20 of inflows for every $1 received by equity funds since the beginning of March. In our 29 years, we have virtually never seen that kind of overwhelming popularity get rewarded over the next three years. Therefore, Bill Gross and PIMCO look due to have the markets they dominate become more difficult. Since 1984 we have had a huge bull market in Treasury bonds as they peaked at 14% interest rate. At 3.4% today, PIMCO has mathematics working against them. Near the end of the 1982 to 1999 era, Warren Buffett and common stocks were enormously popular. Buffett spoke in Sun Valley to a group of business owners and executives who had been made mega-wealthy by the bull market in stocks. He told them that stocks would do poorly from then to 2016, if history was any guide. He was spot on, as the next ten years proved to be one of the worst decades in U.S. history for stocks. I don’t hear PIMCO saying anything vaguely similar about bonds today.

We don’t agree with Julian Robertson, primarily because of the speed and magnitude of interest rate increases he is advertising. He looked on T.V. the other day like someone who had a big position going and wants to by-pass the normal holding period to see it succeed. There is little evidence that the over-capitalization of the banks in the U.S. is resulting in any meaningful lending and debt monetization (read “Monopoly Money”). We believe the inflation he fears appears to be years away, not months.

Last, but not least, is James Grant. We believe that he has a few powerful forces working in his favor. The economic coma we entered last year in September lasted until the end of March of 2009. Any discretionary economic activity which occurs in the next six months could cause fairly sizable economic growth numbers and possibly boost consumer confidence and hiring. Maybe as important is how unequivocally negative most market participants are about the long-term future of the U.S. economy. I was around in 1982. There was as much disbelief in the possibility of a rousing long-term comeback in the U.S. economy then as there is now. As fellow contrarians, we believe he must be taken seriously. We should harken our thoughts to some of the widespread belief on the part of investors who may be adding more smoke to the “Mythical Argument.”

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
Subscribe to the Missives Podcast
Click here to listen to this Missive

Dear Clients and Prospective Clients:

In a recent interview on CNBC, Morgan Stanley Smith Barney Chief Market Strategist Tobias Levkovich talked about the “Mythical Argument” that consumers are never going to spend again. The thesis is that the behavior of consumers will be permanently changed as a result of the depth and length of this recession. In turn, high levels of unemployment could decline doggedly. High sustained levels of unemployment and large over-hanging consumer and government debt could serve as a force field, preventing meaningful real economic growth for years. Leading proponents of this argument are Bill Gross (PIMCO) and Jeremy Grantham (GMO). Tobias argued that their argument is so ingrained in existing portfolio management actions that it just might be a myth. At Smead Capital Management, we believe we are positioned to do well in that environment. We believe our large-cap recession-resistant brand name companies could thrive if that argument holds water.

However, we must constantly harken back to the idea that “When everyone knows’ something to be true, nobody knows nothin’”. Belief in the “weak economy for years” argument has caused a huge amount of U.S. investor capital to chase commodities and worldwide infrastructure investments. These investors are going where they think the economic growth is going to be and want to protect themselves from whatever inflation comes from the policy decisions made to avert an economic depression and come out of this recession. There are some big problems with their approach. First, the BRIC trade or idea that the economic world will be led by the emerging markets of the world peaked last year (2008) in a bubble. Bubbles take a minimum of 5 to 7 years to correct and many times take as long as 10 years or more to return as a profitable concept. Therefore, if history is any guide, Oil, commodities and emerging markets could be dead money for a number of years.

Second, even if emerging market economies do lead us out of this recession and into a period of prosperity, they may not be a good place to invest. Franklin-Templeton’s emerging market strategist Mark Mobius said on Bloomberg recently that an enormous amount of new shares of common stock will be issued as Chinese companies go public in the next five years. Fast growing nations and their economies can be capital absorbers, rather than capital multipliers. How can this be so? When our nation’s residential real estate markets and economy boomed between 2002 and 2006, capital was drawn away from most stock market sectors. Basic materials, commodities and heavy industrial stocks gained capital and affection, while most other sectors suffered capital withdrawals. Individuals have been massive net sellers of U.S. equities since the peak of the market in early 2000 when they held $10 trillion of individually owned shares. At the recent March of 2009 lows, that figure was close to $5 trillion. The economic growth absorbed the capital and the same thing could happen in China. It happened in the U.S. as we built the railroad system in the second half of the 1800’s. Our nation grew immensely and spread westward, but we absorbed massive capital and much of it never got paid back to the countries like Britain and France which loaned it to us.

I will say the unspeakable. From the “reset” levels of the 2008-09 contraction, consumers could make a consistent comeback as they become convinced that our system will continue to succeed and gasoline isn’t going to cost $4 per gallon or higher. If the idea that American consumers won’t make a comeback is a “Mythical Argument”, what could happen the next few years? Unbelievable profits could come out of the income statements of lean and mean corporations. What would a year-to-year sales gain of 5% do for the profits of Nordstrom, Starbucks or WalMart? How much money could Home Depot make if people quit worrying about their job and the price of gas and started fixing everything that is wrong with the home they want to live their life in? What if all the kids who want to go to Disneyland and DisneyWorld get to go next year? What if you could have a good economy for years without building up debts in the process? What if this cleansing of the last two years really worked and we ended up with one of the best long-term economies we’ve ever had?

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.