The information contained in this tv appearance 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 tv appearance 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:

Mark Hulbert does a great job of explaining how sentiment works in bull and bear markets. He has examined market statistics and investment newsletter writers for the same 31 years that I have been in the investment business. His analysis shows that bull markets climb a wall of worry and that bear markets decline on stubborn bullishness. Investors buy the dips in bear markets and become more committed all the way down. It reminds me of the main characters in the movie, “Dumb and Dumber”. Lloyd Christmas (Played by Jim Carrey) and Harry Dunne (Played by Jeff Daniels) seemed to compound their mistakes in every pursuit they undertook.

What brought this to mind is the price action of the last week in the US stock market. Stocks have rebounded sharply from the lows of Monday, October 3rd. The rebound has been led by Energy and Basic Materials stocks like Apache (APA), Joy Global (JOYG), Freeport McMoran Copper and Gold (FCX), Schlumberger (SLB) and Caterpillar (CAT). These have been the heart and soul of the BRIC trade for the last 5 to 10 years. The theory is that the growth in China and India will cause immense demand for energy and basic materials. This in turn causes Brazil and Russia to prosper by providing China and India with the energy and basic materials they need. They are not in the BRIC acronym, but you can throw Australia and Canada into that mix.

If you read David Barboza’s columns in the New York Times, you’ll see that a major credit crunch in China is causing all hell to break loose in the world of small to medium size businesses. They are the entrepreneurs in China and they have not received loans from the four largest banks in China which are government owned. The Chinese government’s dictated lending spree of the last three years went to communist party officials at the municipal level, who formed special purpose vehicles to develop condo, office building and other infrastructure projects. Instead, a massive underground lending system has developed where risk takers with cash have sought higher interest rates than the government-controlled banks offer. This money was loaned to businessmen and developers who couldn’t get the cheap financing offered by the government. The borrowers wanted these loans to ride the boom. These small to medium-size businesses operate on fairly thin margins and the slowdown in the world economy of the last six months, triggered by supply chain problems in Japan, has put many of them over the edge.

Thousands of Chinese business owners are disappearing and walking away from their business because they can’t meet the demands of the high interest rates and the underground loans they have taken to fund their business. Here is how David Barboza describes the situation in his October 13th piece called, “As China’s Economy Cools, Loan Sharks Come Knocking”:

WENZHOU, China — The 300 employees of Aomi Fluid Equipment here were delighted recently when the owner offered an all-expenses-paid, two-day trip to a mountain resort three hours away.

The owner, Sun Fucai — or Boss Sun, as he’s known — was so insistent that his workers attend that he imposed a $30 fine on any employee who refused the getaway. Nearly everyone went.

Except Boss Sun.

When the employees returned from their holiday, they found that the factory had been stripped of its equipment and that Boss Sun had fled town. “It was entirely empty,” Li Heying, a former Aomi worker, said of the factory. “It was like what happens in wartime.”

The boss, as it turned out, was millions of dollars in debt to loan sharks — underground lenders of the sort that many private businesses in China routinely use because the government-run banks typically lend only to big state-run corporations.

As China’s economy has begun to slow slightly, more and more entrepreneurs are finding themselves in Mr. Sun’s straits — unable to meet debt payments on which interest rates often run as high as 70 percent in this nation’s thriving unregulated, underground loan system. Such illegal lending amounts to about $630 billion a year, or the equivalent of about 10 percent of China’s gross domestic product, according to estimates by the investment bank UBS.”

A major credit crunch for businesses is now occurring in China. Its economy, which was built on its businesses having a significant cost advantage over other competitors around the world, is losing its advantage to inflation. As that advantage dissipated over the last five years, China chose to go on the world’s biggest building spree. In the process, they have made fixed asset investment an unrepeatable 50-70% of the GDP of the second largest economy in the world, depending on whose estimates you use. Real estate transactions and development is estimated to be 74% of municipal revenue.

In other words, if China doesn’t keep on building at the same pace as the last three years, their economy will contract. Therefore, the two-pronged economy of China, exports and infrastructure construction, are both threatened at the same time. Exports are threatened by the underground markets ability to over-leverage small to medium sized businesses and the construction world is over-leveraged on cheap money force-fed into an economy that doesn’t need what is being built. There is nobody to rent the condos and too few citizens who can afford a train ticket.

This brings us back to the US. Most of the US economy’s recovery has been held hostage by incredibly high commodity prices. We have had the worst and deepest recession since 1981 and the deepest depression in construction since the 1930’s. On a per capita basis, home building is at 70-year lows! This means that demand for copper, steel, iron ore, cement, coal and oil are way down from four years ago. We are using the least amount of gasoline since 2000 and the least oil since 1996.

We have been struggling to recover against a back drop that includes record high input prices. At the same time, energy costs and demand for food in China and India have made Americans pay much higher prices for food and other goods. All of these facts stem from the demand coming from China and the faith that has been placed in the idea that their economy is not subject to normal business cycles. David Barboza’s article is proving them wrong:

“That tycoons in a city known for its savvy entrepreneurs are running scared has raised concerns that private business, a vibrant part of China’s economy, may be losing steam — while exposing the high-risk, unregulated financial system on which so many of the nation’s small and medium-size businesses have come to depend.

“There have always been people running away because they couldn’t pay their debts,” said Wang Yuecai, general manager at Wenzhou Yinfeng Investment & Guarantee, which guarantees state bank loans when small businesses are lucky enough to get them. “But recently, the situation here has gotten much worse.”

Last week, Prime Minister Wen Jiabao and a delegation of top officials, including the head of the nation’s central bank, visited Wenzhou, promising to get official banks to lend more to small companies and to crack down on underground lenders that charge high interest rates.

And on Wednesday, China’s state council, or cabinet, announced a series of measures aimed at helping small businesses with tax breaks and new lines of credit.

Beijing no doubt worries that similar problems could surface in other parts of the country.

“This is not just happening in Wenzhou,” said Chang Chun, who teaches at the Shanghai Advanced Institute of Finance. “Some companies borrow from the state banks and then lend into the underground market. Many are doing this type of arbitrage.”

Thanks to research done by Kynikos Associates LP and its founder, Jim Chanos, we believe that many of the premises used to create faith in the idea that China’s economy won’t suffer normal business cycles is unfounded. For example, many China apologists argue that 25-30 million people will move each year to the cities from rural areas and support the added infrastructure. I don’t know how to say, “If they build it, they will come” in Chinese, but that is the theory. Chanos argues that Kynikos research found 8.5 million people migrated in 2009 and a total of 118.7 million since 1998. However, all that movement is predicated on jobs being available in the cities and that is predicated on the building boom continuing along with those entrepreneurial businesses surviving. It sounds so much like the retiree migration that was anticipated in Miami, Phoenix and Las Vegas in 2005 and we all know how that myth worked out.

Michael Pettis has provided us statistics that which show what an unusually large part of the world’s commodities have been used in China in recent years. This was backed up this week by a report which puts China as having 1.9 million metric tons of copper stockpiled at the end of 2010. This is equal to all the copper used each year in America. The credit crunch for small to medium sized manufacturers included them using copper as collateral for loans.

We have argued for three years that commodities are ridiculously over-priced and have argued that China has to have a deep recession/depression if it wants to become a major and sustainable world economic power. We believe this is all unfolding before our eyes, yet US hedge fund, institutional and individual investors are buying every dip in the commodity markets and playing the same risk-on trade that worked in 2009. Hulbert would say that their dogged bullishness is a bad sign for contrarians.

Wenzhou is one of China’s many manufacturing metro areas. Barboza relied on research from Wang Tao, a UBS economist based in Hong Kong. Here is how Tao and Barboza show the current circumstance:

“As long as China’s economy was racing along at an 11 percent growth rate, small companies could hope for enough business to stay a step or two ahead of their underground creditors. But there was little room for error.

Now, businesses here and elsewhere in China are being caught short because the national economy has begun to moderate a bit, to a projected 9 percent rate by year’s end, in response to government-imposed measures to fight inflation and let air out of the real estate bubble.

Ms. Wang, at UBS, said the slowing economy and weakening exports would hurt many small Chinese businesses. Already, according to a recent survey by the city’s small-business council, one in five of Wenzhou’s 360,000 small and medium-size businesses have recently stopped operating because of cash shortages.”

This means that 72,000 businesses have recently been shut down in just one city in China. A major credit crisis and recession/depression is in the offing, in our opinion. Yet US investors continue to pursue the BRIC trade all the way down. This is why the investor behavior reminds me of the movie, “Dumb and Dumber”. We believe the next great bull market in US stocks will not be led by the best performing sectors of the last ten years, because leadership in energy, basic materials and heavy industrial can only come from uninterrupted growth in China. If China can continue its charade, we believe the US economy will continue to suffer. If not, the seeds of US prosperity will be watered and fertilized by lower commodity prices.

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:

Everything you need to know about today’s circumstance in the US stock market is covered in the theme song to the movie, Grease.

          I solve my problems and I see the light
          We got a lovin’ thing, we gotta feed it right
          There ain’t no danger we can go too far
          We start believing now that we can be what we are
          Grease is the word

You might think that the countries in Europe like Portugal, Ireland, Greece and Spain are the source of the current consternation in the US stock market. We believe that Europe is peripheral to the core issue. American investors have spent the last ten years falling in love with the BRIC trade and feeding an infatuation with the “global synchronized” economy and the “emerging consensus” surrounding global stocks/bonds. They have felt that there is “no danger we can go too far” and they haven’t just started believing, they have swallowed this meal hook, line and sinker.

          They think our love is just a growing pain
          Why don’t they understand, it’s just a crying shame
          Their lips are lying only real is real
          We stop the fight right now, we got to be what feel
          Grease is the word

We at Smead Capital Management think that the love for all things BRIC is a “growing pain”. China experts say that we “don’t understand” and that “it’s just a crying shame”. The yield curve is inverting in Brazil and India. China is tightening credit as they deal with all of the usual fallout from acting like you can’t “go too far”. Inflation, economic inequalities, trouble handling debt and civil unrest are the products of “believing now that we can be what we are”.

In our opinion, China’s massive stimulus effectively suckered US investors into thinking that their command economy is not subject to the discipline of economics. Instead of participating in the global recession in 2008-09 they shoved $2.7 trillion of real estate development lending into the system. It certainly made it look like they were still growing 9-10% per year and caused them to keep absorbing a massive part of all the commodities used in the world. This in turn has caused over-confidence in commodity-based countries and currencies like Australia, Canada and Brazil. The Chinese lenders even started using copper as collateral for loans. “Their lips are lying” because they don’t want to deal with the political fallout of an economic contraction in a country with no freedom of speech, religion and voting. Here is how Standard & Poor’s explained China’s predicament on September 26th, 2011:

“Chinese developers face an ‘increasingly severe’ credit outlook, which may force them to cut prices and turn to costlier funding sources as sales weaken, Standard & Poor’s said.

A 30 percent decline in sales may leave many developers facing a liquidity squeeze, S&P said after conducting stress tests of the nation’s real estate companies. Most developers would be able to “absorb” a 10 percent sales drop next year, the credit rating company said.

“The worst isn’t over for China’s real estate developers,” S&P analysts led by Frank Lu wrote in a report today. “Developers are bracing themselves for slower sales and lower property prices ahead.”

We’ve seen loss estimates ranging from 30-70% on those stimulus loans. This could set a recapitalization of the Chinese banking system into “motion”. Those development loan losses could stop economic growth in China the way a flat tire stopped a jalopy back in 1960.

          We take the pressure and we throw away
          Conventionality belongs to yesterday
          There is a chance that we can make it so far
          We start believing now but we can be who we are

          Grease is the word
          It’s got groove it’s got meaning
          Grease is the time, is the place is the motion
          Grease is the way we are feeling

The US economy grew 9% per year on average from 1800 to 1900. This included 18 recessions, 3 panics and 3 depressions. We even took time out for a Civil War. Our critics say that our belief in business cycles is “conventionality” and that it “belongs to yesterday”. They say that each year 25-30 million people will move to the cities of China from the rural areas and that all the empty condos and office buildings will be filled with highly-educated Chinese workers. They argue that the Chinese people will make fantastic consumers and they will ride on high-speed trains and use the world’s best infrastructure. They argue that their argument is not over-capitalized.

We argue that this bubble mentality has “got groove and got meaning”. It is the same kind of “groove” in 1999 that said, “The internet will change our lives.” The internet bubble in Tech stocks chopped common stock investors to bits. It is the same “meaning” as in 2005 that said, “Phoenix and Miami will see a never ending stream of retirees moving down there.” Those are two of the nation’s worst performing real estate markets over the last 6 years.

Grease was the way teenagers were feeling in the late 1950’s and early 1960’s. By the 1970’s it was a dry, afro hairdo at the discotheque in Saturday Night Fever. Greece is the poster child for how investors are “feeling” in late 2011. We believe the BRIC trade and US investor infatuation with international and commodity-oriented stocks and bonds is in the process of dying. In our opinion, it is time to go back to “conventionality” and leave the BRIC trade before its “time” is gone and investors put their capital in “motion” towards the next great theme in investing.

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
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Dear Fellow Investors:

In the short run, psychology and entrenched beliefs can drive a market or the price of a commodity. In the long run, the laws surrounding supply and demand win out. No current market shows that better than in the market for a barrel of oil. We at Smead Capital Management (SCM) believe today’s price of oil is driven by belief in the “Peak Oil” theory, the perception of a very long-term transition to electric/hybrids cars and Oil’s use as a trading or investment vehicle to pursue international economic growth and diversification. At SCM we think the day is coming when supply and demand take over. The folks from Cameron Hanover, led by President Peter Beutel, shared on CNBC recently why that is.

The price of a barrel of oil would be closer to $10 if the commodity wasn’t traded as an investment instrument, given the record-high levels of U.S. oil inventories, Peter Beutel, president of Cameron Hanover, told CNBC Monday. “I honestly think that if there were no investors using oil as an asset that the price of oil right now would be $10 or $15 or $18, but it wouldn’t be anywhere near where it is,” Beutel said. “We have so much oil right now, more than we’ve had in 27 years. Why is it 27 years? Because that’s how far our records go back. It’s probably the most in 50 or 100 years,” he added. Part of the reason the price of oil is currently above $74 a barrel is because of a belief in the economic recovery, Beutel said.

I have been in the investment business for 30 years. Oil peaked at monthly average prices around $40 per barrel in 1980-81. It bottomed around $11/barrel in 1999. Oil peaked in 2008 at a monthly average around $126/ barrel and stands today somewhere around $73/barrel. Like many other investors we at Smead Capital Management have been conscious of “Peak Oil” theory. In his book, “The Prize”, Daniel Yergin points out that “Peak Oil” theory has popped up every ten to twenty years since oil was first discovered in Pennsylvania in 1855. Whether “it’s different this time” doesn’t matter to us because we see a dramatically quicker transition away from gasoline to electric and hybrid automobiles than the average portfolio management firm does. We believe the transition to electric/hybrid vehicles is a 10-15 year process. If you spend much time in Los Angeles or Seattle, you can see the speed of the transition with your own eyes. If you cut demand for gasoline by 25-50% in twenty years, you chop off the “lack of supply” argument which “Peak Oil” is all about.

Much more important to the price of oil today is its use as a way to participate in international economic growth and as a way for asset allocators to use commodities as a way to diversify one’s investment portfolio among “non-correlated” asset classes. The “BRIC trade” is a Wall Street slang term for exceptional growth in the world coming from developing nations. The BRIC part of it stands for Brazil, Russia, India and China. Brazil and Russia have been growing because they are major oil exporters. India and China have become large consumers of oil and gas. China’s boom was originally led by exports, but more recently has been led by Commercial and Residential Real Estate construction. It has had one of the longest stretches of uninterrupted growth in modern economic history. The US economy grew from a Gross Domestic Product (GDP) of $476 million in 1800 to $20.56 Billion in 1900, but that growth was interrupted by numerous recessions and depressions/panics in 1807, 1819, 1837, 1873 and 1893. We took time out in 1861-65 to kill 500,000 Americans in the Civil War as well.

Therefore, the Chinese economy is due for a slowdown and recent reports indicate that loan losses at Chinese banks are about to sky-rocket. We believe that as the China economy slows down it will cripple the emerging market demand argument and reduce demand and demand expectations for oil around the world. Brazil and Russia’s growth would be immediately called into question since it has been driven by oil exports.

Lastly, the price of oil has moved the opposite direction to the S & P 500 Index from the beginning of the year 2000 to today. By investing in oil and gas common stocks and limited partnerships, natural resource heavy mutual funds, commodity funds and exchange traded funds (ETFs), asset allocators and hedge fund managers have dramatically increased their exposure to oil as an investment vehicle during the last 10 years. In today’s highly volatile markets where 3 to 6-month holding periods are considered an eternity, oil is an easy and liquid way to play an economic rebound in the US and world economy. We have one big problem with this approach. THE PROBLEM IS THAT THE DEEPEST RECESSIONS SINCE 1946 WERE PRECEDED BY OIL PRICE INCREASES (1973-74, 1981-82 and 2008-09) AND STRONG ECONOMIC GROWTH IS USUALLY TRIGGERED OR ENHANCED BY LOWER ENERGY PRICES! The US economy grew really well from 1995-1999 and Oil fell significantly during that stretch. We believe that gasoline’s importance will be reduced by electric/hybrid cars and that lower oil prices will follow. Those lower oil and gasoline prices will drive consumer confidence in the US. Most of the money we spend on oil and gasoline leaves the country. In the process it damages our balance of payments and weakens our currency. Peter Beutel said it best:

From a historical perspective, Beutel pointed out that the current level of inventories is even higher than when the price of oil was below $20 a barrel. “We’ve got 50 million barrels of crude more than we had two years ago. We have 176 million of distillate,” Beutel said. “When I started in the business back in 1980 we used to think to ourselves: “Gee, we would love it if we had 140 million barrels of distillates to start the winter.”

We vote for the law of supply and demand as always.

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.

Printable Version

Dear Fellow Investors:

When I was 5 years old I got a life saver stuck in my throat while grocery shopping with my parents. My Dad grabbed me by the ankles and turned me upside down. He shook me a couple of times until the sweet lozenge dislodged. We just did the same thing in the US stock market in the last week.

We at Smead Capital Management believe that the market has an uninterrupted BRIC trade lozenge stuck in its throat. This lozenge causes the US stock market to choke on over-priced oil, basic materials and industrial shares. While we are seeing a textbook economic recovery, we are using much less gasoline than a year ago. We are also embarking into the world of electric cars. Why is the price of a commodity going up when its best customer is using less?

In our opinion, the answer is that the capital market participants believe as deeply in uninterrupted growth in China as I believed in the good flavor of orange and cherry flavored life savers at age five. The only way to get it out of me was to shake me and the only way to change the investment trend is to shake it with high volatility. The Chinese stock market, as represented by the Shanghai Composite, fell 1.9% last night in overseas trading. That’s a decline of 20% in the last nine months, qualifying for bear market territory. Stock markets have a tendency to look out one year on economic activity.

Ignore the noise and enjoy owning America’s fine companies in areas like consumer, banking and healthcare. When we get this BRIC trade out of our throats, we believe under-priced non-cyclicals will take over market leadership.

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.