William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

Oppenheimer’s Chief Market Strategist, Brian Belski, put out a great piece of research last week (”US Strategy Weekly: Shifting Focus to Value Over Growth”) on the composition of the companies which make up the Value half of the market capitalization of the S&P 500 Index. The index is divided into growth and value partitions by the factors listed in the table below. High ratios in the growth factors show investor’s expect a bright or growing future. High yields in the value factors infer low future expectations on the part of investors.

The two accompanying charts appear to “paint a thousand words” in the opinion of Smead Capital Management. The first chart shows the number of companies in the value side of the index has grown immensely in the last 15 years. We believe it is not unusual for this to happen in the aftermath of a major market decline.

The second chart shows which sectors of the S&P 500 Value Index are the most over and under-represented in the S&P 500 Value Index today as compared to the average of the Value Index over the last 15 years.

We have only begun to decipher the “thousand words”, but here are a few. First, what would have caused the growth half of the index to require far fewer companies than before to equal 50 percent of the S&P 500 Index’s market capitalization? When the growth factors improved in the energy industry, investors moved massive amounts of capital into the sector. Energy is the most under-represented in the value side of the index (4.7%) compared to normal (12.6%). These energy companies tie up a massive amount of capital due to their capital intensive nature, taking money away from other sectors. Many other cyclical stocks hold above-average growth factors as the lemmings have overcrowded the BRIC trade, giving market premiums to capital and labor intensive companies. We have admired the stock picking of folks like FPA’s Robert Rodriguez and the sector analysis of Jimmy Rogers for 20 years, but they both need to consider that owning energy and living in Singapore is not lonely contrarianism today. If this was the course of action to take, we should move Smead Capital Management to the New York/New Jersey metropolitan area to be closer to the drug companies to show our bold contrarian spirit.

Second, what is over-represented in the Value half of the Index compared to normal? Consumer staples and healthcare, by a whopping margin! Consumer Staples represent 14.9% today versus the normal 4.4% in the value index while healthcare is 13.6% today versus its normal 4.5% weighting in the value half of the S&P 500 Index. Many of these companies have beautiful balance sheets, strong international brands, generate massive free cash flow and earn high returns on capital. We haven’t done the research yet, but we believe we will find that consumer staples and healthcare are normally as under-represented in the S&P 500 Value Index at this point in the cycle as energy is this time.

I heard Warren Buffett tell a story about raising money for his early partnership. We believe it does a great job of illustrating why we at SCM don’t want to own BRIC trade cyclical companies. He went to see the owner of the largest farm equipment dealer in Omaha when he was raising money for his partnership in the 1950’s. He asked the owner how he had done this year. The owner told him he had done great. Warren asked what he did with the profits. The owner went over to the office window and pulled open the drape. He told him that it was all sitting on the lot as he showed Warren the inventory for the coming year. In many cases, a great year in a capital intensive business leads to more capital expenditures and little free cash flow for investors. Consumer staple and healthcare companies have a history of producing consistent free cash flow which the owners/management of the company can use any way they see fit to enhance shareholder value.

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

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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.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

There are very good reasons to avoid investing in emerging markets. Below is a list of some of those reasons:

1. Political Instability (Russia, Honduras, Venezuela, etc.)
2. Small Markets (less liquid)
3. Poorly Regulated
4. Unusual Accounting
5. Currency Risk

However, I’d like to make the case for investing to make money from emerging markets. Five years ago my family and I took a trip to the Bay Islands of Honduras. While there I noticed that one of the only companies selling products to these Honduran Islanders was the Coca-Cola Company by way of the Fanta soda line. It reminded me of 1988 and Warren Buffett stepping outside of his usual proclivity to buy into the stock of a great company when the share price falls into some significant distress. Coke had gone up about five-fold since the bottom in 1982 and sported a trailing 12-month P/E ratio of 18. Buffett bought a major stake in the company and dumbfounded his fondest admirers in the process. Buffett said at that time that he “could go away for ten years” and he’d know that Coke would be doing well.

One of the main reasons that Buffett could have that kind of confidence was that the Berlin Wall was preparing to fall. Countries in Eastern Europe and Latin America were getting political freedom and adopting free-market capitalism. Any improvement in a third-world country’s circumstances was going to create a chance to sell something clean to drink. Nobody does that better than Coca Cola. With Coke he never had to take the risks listed above to make money from emerging markets. He only had to trust the brand, the balance sheet, the distribution system, the economies of scale and the management of the company.

A front page article in last week’s Wall Street Journal that discusses the distribution of drugs in emerging market countries tells you everything you need to know to make money investing in emerging markets in the next ten years. IMS Health reports that in 2003 there was $67.2 billion of prescription pharmaceuticals purchased in emerging market nations. In 2008 it had grown to $152 billion and IMS predicts it will hit $265 billion in 2013. How many companies in the world have the brands, balance sheets, patents, distribution, economies of scale and management to do this? Exporting health to the world will be an incredibly rewarding business both financially and ethically. It will help other businesses succeed by improving the quality and length of life for people in countries ranging from China and India to the smallest countries in Latin America and Africa. The difference this time is the companies that we are interested in like Merck and Pfizer are trading at distressed P/E levels as compared to the last twenty five years. Buffett did well on his investment in Coke, but the drug stocks start this cycle trading at distressed prices the way Buffett usually likes to buy shares.

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

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Dear Clients and Prospective Clients:

At the start of the year, we at Smead Capital Management predicted that 2009 would be like 1988. In the aftermath of the 1987 Stock Market Crash the market thrashed around violently in both directions before settling at the end of the year with about a 10% gain counting dividends. People had to put up with a great deal of volatility to earn that gain in 1988 and we felt that 2009 would look similar. We are halfway through the year and 2009 appears to be 1988 on steroids. The down swings and upswings have already been huge, but the stock market is about where it started the year.

We also have felt that the economy would begin to grow again once we got past the massive “reset” in consumer spending which started in September and October of 2008. Spending figures are typically measured against the prior year. We have continued to believe the year over year retail sales comparisons will be positive in the fourth quarter of this year as compared to the economic coma figures of late 2008. The stock market is an anticipatory vehicle and we expected that the market’s rally would begin six to nine months before the economy improved. It did in fact bottom around March 9th or six to seven months before the consumer spending reset turned one year old.

There have been some big surprises for us this year and those surprises are a big part of the market’s recent pullback. We believe that the economic “reset” is going to become the kickoff of an era of slower growth and unwillingness on the part of the average consumer to take on debt. In this slow and consistent era we expect a substantial premium to be placed on the companies which perform well despite the new environment and borrowing reluctance. In the prior era, investors basked in the belief that the growth in emerging market countries like Brazil, Russia, India and China would drive worldwide growth, thus placing a premium on the production and distribution of natural resources like oil, basic materials and fertilizer. These cyclical industries out-performed the market from 2004-2008, got clobbered from the second half of 2008 into the new year and came roaring back in the rally off of the March bottom.

If we are right and investors resign themselves at some point to the new environment, the normal premium for strong balance sheets, brand recognition and consistency of customer base should be reestablished. This means lower P/E ratios for cyclical businesses and higher P/E ratios for companies that meet our strict 8 criteria. What normally is highly valued by investors will take its usual place in the hierarchy of common stocks. We believe this current correction in the market is the beginning of a flow of money away from investor attempts to revive the BRIC trade. We expect to move toward a premium for large quality blue chip companies with relatively non-cyclical businesses. We wait patiently.

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

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Dear Clients and Prospective Clients:

When a market has been strong, there is no limit to the number of people who will tell you how good it is going to be for the foreseeable future. When a market has gone down for a long time, a multitude will tell you how far down it is going and how long the downtrend will last.

At Smead Capital Management we have developed a term for this that we call a “Well-Known Fact”. By definition (Smead Unabridged Dictionary), a “Well-Known Fact” is a body of economic information which is known by all market participants and has been acted upon by nearly everyone who could care or has the financial wherewithal to care to act. It is best understood through the comments of former Intel CEO, Andy Grove, who said that the best advice he ever got in business came from a professor at the City College of New York. The professor said, “When everyone knows that something is so, nobody knows nothin’.” By nothin’ the professor infers nothing that could do you any good. When everyone believes a fact and has acted on it to an extreme, nothing good can come to you from believing it from an investment standpoint.

Here is a series of “Well-Known Facts” from recent history. Also noted are the assets that were purchased to act on the fact and the end result of the extreme:

Fact 1: The Internet will change our lives. — Asset Purchased: Tech Stocks — Result: From the peak of early 2000, tech stocks fell 80% in 2.5 years.

Fact 2: Residential Real Estate only goes up. — Asset Purchased: Homes in sunshine states of Arizona, Florida, Nevada and California. — Result: 40-50% price drops and a majority of the nation’s foreclosures.

Fact 3: Brazil, Russia, India and China (BRIC) will grow faster than the industrialized world. — Assets Purchased: Commodities and Emerging Market Mutual Funds. — Result: Commodities drop 60-80% and Emerging Markets fall 50-70%.

At the extreme, whatever value that is connected to the assets involved with the “well-known fact” doesn’t matter in either direction and there is no shortage of both expert and non-expert opinion on how high or low the asset prices will go. Henry Blodgett saw the moon for Qualcomm and internet stocks in 1999. No shortage of cable shows taught you to “Flip this House” in 2005. And in 2008, Goldman Sachs’ Oil analyst put a $200-250 price possibility on a barrel of oil. Not to mention T. Boone Pickens, who has been attempting to talk oil prices up since it peaked at $147 per barrel last year.

In the opinion of SCM, here is the new “Well-Known Fact”.

Fact 4: The massive amount of borrowing attached to homes and personal finances in the U.S. over the last ten years dooms us to a three to four-year recession/depression which is not treatable by policy makers and could ultimately cause a total collapse of our financial system. — Assets Purchased: U.S. Treasury Bills, Notes and Bonds; Gold and “virtuous non-U.S. currencies”. — Assets Sold: Common Stocks including the finest companies in America. – Experts: Nouriel Roubini, Jimmy Rogers, Marc Faber, etc., etc. etc.

The T-bills and gold are easy for us to see through. There is a bubble of fear and uncertainty. Therefore, any asset which seems to give protection against fear should get way over-priced at the height of the fear. We wonder how people are going to feel about earning little or no interest for years. I drove by a guy on Pima Road in North Scottsdale today selling Safes on the side of the road. Gun sales are through the roof. These actually make more sense to me than the money-market funds, savings accounts, CD’s and T-bills. If the premier U.S. companies don’t survive and prosper, there will be no tax revenue to insure deposits, back money-market funds and redeem government debt. If our Disney, Abbott Labs and WalMart don’t make it, you need a one-acre garden, a nearby water supply and a set of big guns and lots of ammo.

As bad as this decline has beaten our stocks in the short-run, you’d think that we wouldn’t love it just as much as the other “well-known facts”. You’d be wrong. This one is possibly setting up faithful and persevering blue-chip stock investors for the positive ride of their lifetime. First, today’s Wall Street Journal is talking about an additional decline of more than 20% off a stock market which has been pummeled more than any market other than the 1929-32 “Great Depression” decline. Second, sentiment polls from the American Association of Individual Investors and Bespoke Research show that a MAJORITY of market participants believe that the stock market will fall more than 20% from here. Third, our wonderful and well-trained clients have called me more times in the last two weeks to tell me that the market is going down more and is going down for another one to two years. All these prognostications coming from folks we’ve worked for for years and have n ever had an personal opinion about the short-term stock market direction prior to this year.Fourth, there is more cash on the sidelines in money-market funds relative to total U.S. stock market capitalization than any time in the last 60 years.

We could go on all day with additional evidence, but we think you get the picture. We believe there has probably never been a better day to buy quality U.S. stocks (for a two to three-year holding period) in our lifetime than today. The reason is that everyone knows that the opposite is so and, therefore, “nobody knows nothin’.”

BUY-BUY-BUY

Warm Regards,

William Smead

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.