William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

As the chart below shows, correlations among the S&P 500 Index companies was the highest on October 10th of 2011 as it has been for 25 years.

In the opinion of Smead Capital Management, this means that more investors are participating in market directional strategies, macro-economic strategies and tactical portfolio strategies than at any time in US history. John Maynard Keynes was a great investor, as well as a famous economist, and he said, “Investing is the only sphere of life where victory, security and success go to the minority, and never to the majority”! As it does every time, Wall Street creates new instruments to satisfy the demand that comes from individual and institutional clients to pursue what was successful in the prior five years. These directional investments come mostly in the form of Exchange Traded Funds (ETFs). The tactical portfolios come from go anywhere mutual funds, which have become immensely popular and the macro-economic investments have been the domain of the hedge fund world. They are all designed to fit into the wide asset allocation models which are being employed by almost everyone in the wealth management world.

Wayne Gretsky, when asked why he was such a good hockey player said, “I skate to where the puck is going to be”. We believe that the correlation chart is screaming for reversion to the mean. It tells us that stock picking will never get more out of favor in the investment business than it was on October 10th. In other words, there is an over-capacity of asset allocation and a scarcity of stock picking. Large-cap stocks in the US have done poorly since 1998.Those who moved away from US large-cap stocks between 1998 and 2003 to other asset classes took advantage of inexpensive asset classes and made a smart shift. By 2007, the shift was nearly complete and has only been exacerbated by 2008′s cataclysmic decline in stocks. After two 40% or greater stock declines in one decade, stock picking became overwhelmingly out of favor. The assets under management gravitated from the large cap US funds to the directional, macro -economic and tactical strategies, where we stand today.

Alas, all of this came to a peak in 2011. The asset classes like commodities and emerging/global markets ended up with a massive amount of money and US large cap suffered record setting net liquidation. We believe the commodity and emerging market asset classes have entered a terrible bear market for the next five to ten years. Fortunately, two of the best stock pickers have rung the bell for everyone. Warren Buffett announced that he is an aggressive open-market buyer of individual large-cap stocks and Legg Mason punctuated the cycle by nudging Bill Miller out the door as CIO and lead manager of the Value Trust Fund. (see link)

As large-cap value managers and stock pickers, we are very excited about the next three to five years as all the chips have moved to the other side of the table and stock picking has become a scarce resource.

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:

Two watershed events were announced in the last two weeks. First, Warren Buffett disclosed a massive amount of open market purchases of US large-cap stocks. Second, Legg Mason announced that Bill Miller is “stepping down” as Chief Investment Officer of his firm and as manager of the Value Trust. These are two of the greatest stock pickers of all time and the change in direction for both men is driven by who they answer to and how favorable investing could be in the US large-cap space going forward.

In 1999, at the Allen and Co. event in Sun Valley, Buffett warned how poorly technology stock investments would do going forward and how muted US large-cap returns would be from 1999 to 2016. He explained how the Fortune 500 companies were trading at 30 times profits and that profit margins were at the high end of historical ranges. Therefore, he laid out an incredibly difficult road for those who pick large-cap US equities.

Buffett runs a holding company in which he is the largest shareholder. In effect, he answers to no one. When publicly traded US large-cap stocks got way over-priced in the late 1990′s, Buffett shifted to private equity purchases of entire companies. He bought all the outstanding shares of General Reinsurance and Geico. He made numerous smaller acquisitions like Mid-American Energy. Buffett got his investments away from having the prices quoted every day and allowed his publicly traded portfolio to become a minority of Berkshire’s assets. He continued that approach in 2009 by buying all of Burlington Northern and recently bought Lubrizol.

Bill Miller beat the S&P 500 index for 15 straight years making his shareholders, his parent company and himself very wealthy. The last five of those years included much less spectacular returns between 2000 and 2005. He ran relatively concentrated portfolios and was adored by the media. The index has gone nowhere for 12 years and Miller answers to shareholders. They have expressed their disappointment by driving Value Trust’s assets down to $2.8 billion from a peak of $20 billion. Bill stepped down voluntarily or was asked to. Either way, it is exactly what happens at the end of a stretch where investors have been massive net liquidators of US Large-Cap stocks.

Buffett has no career risk and no one to answer to. He told Becky Quick on TV that he feels US large-cap stocks are undervalued relative to other asset classes. He bought $10.7 billion of IBM (IBM) and added to Wells Fargo (WFC). His underling, Todd Combs, bought shares of numerous US large-caps for Berkshire as well. Buffett is happy at these prices to get back into public shares priced every day.

In 1999, Buffett felt that two things beside market levels could affect overall stock prices. He said that a drop in government interest rates from 6 percent to 3 percent would double the value of stocks. He also said that high sustained profit margins would positively impact stock prices. Both of those have happened. Lastly, stocks have done worse than Buffett expected despite these facts.

We believe putting this all together for us as contrarians means one thing. The time to net liquidate US large- cap equity is over because Bill Miller is being given up on and Warren Buffett believes the risk reward in these stocks is very favorable. In our opinion, it is time to buy a concentrated portfolio of US large-cap stocks. We suggest you do this while avoiding the BRIC trade, in case you have someone to answer 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

Printable Version

 Dear Fellow Investors:

At the annual meeting of Berkshire Hathaway in May of 2006, Warren Buffett was asked to comment on the commodity markets in the US and here is what he said:

“I don’t think there’s a bubble in agricultural commodities like wheat, corn and soybeans. But in metals and oil there’s been a terrific [price] move. It’s like most trends: At the beginning, it’s driven by fundamentals, and then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end. With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.”

As we now know, the commodity bubble lasted until July of 2008 and ended up including agricultural commodities like wheat, corn and soybeans. I was in Walla Walla, Washington on July 15th in 2008 when wheat peaked out at around $10 per bushel. This coincided with oil hitting an intra-day high of $147 per barrel that same week. The folks who live around the area were benefitting from the fact that Southeastern Washington produces some of the best wheat crops in the nation. Even though the nation was in its deepest recession since 1981-82, you wouldn’t have known it by what was happening in Walla Walla. Speculation in commodities ran rampant in the spring of 2008 and drew special notice from the government’s main regulatory body, the Commodity Futures Trading Commission (CFTC).

In 1999, a limited number of very smart people invested in the oil business and gold. Oil bottomed at around $11 per barrel and gold bottomed below $250 per ounce. With all the gas guzzlers which were being driven in the US, it was easy to see that at some point we would pay the price. I remember seeing an automobile industry survey at the time which had gas mileage listed nearly last on a list of the 25 most important factors to a car buyer in the US. At the same time, countries were selling gold holdings by necessity or choice. The wise men were buyers in the beginning during the time period between 1999 and 2004.

Buffett’s thoughts appeared to have played out when the commodity markets broke in the summer of 2008. Oil dropped to $32 by March of 2009, wheat fell to $2.46 per bushel in October of 2009, and gold peaked at $1003 around March 14th of 2008 and bottomed at $712 in October of 2008. In the past when markets have boomed and busted in that kind of spectacular fashion it took as long as 5 to 10 years or more for those markets to get interesting again. Look at how long it took stocks to recover in the US after the depression and in Japan over the last 20 years. Commodities were hot in the 1970’s, but were incredibly dead from 1981 to 1999. It is usually hard to put Humpty Dumpty back together again.

However, there has been an unusual and once in a lifetime phenomena at work in China. It started in late 2008 and it has caused this speculative phase to continue. The Totalitarian Communist Government of China recognized the politically unacceptable downside risk of going through a deep recession. China has the vast majority of its citizens in a position of not yet benefitting from the prosperity of “limited” capitalism. It is one thing to go through a recession when you can vote to “throw the bums out”, but it is entirely another one too go through economic contraction when your citizens have no voting power, free speech and freedom of religion.

Once the decision was made to not run the risk of letting the Chinese economy cleanse itself, the government decided to massively increase the money supply and produce GDP growth through legendary construction stimulus..Residential real estate prices soared in China as a result of the confidence and the “easy money” this stimulus created. More than $2 trillion in loans for real estate development was made to special purpose entities at the municipal level to build condos, office buildings and even immense sports stadiums. These loans are equal to one third of the $6 trillion Chinese economy. A Communist Party Official, Yin Zhongqing, and other credible sources have estimated that as much as 70% of these loans will never be repaid. As a result of growing in an uninterrupted way, commodity use in China equals close to 40% of all the commodities consumed in the world each year, even though it is only 9.4% of the world’s GDP and 19% of the world’s population.

With interest rates low and US investors trained for years to like commodities and trust the growth of emerging markets, the speculative fervor of 2008 was reborn in 2009-11. Speculative positions in major commodities like oil have exceeded those taken in 2008 by more than 50% as reported by the CFTC. We have described this explosive move since 2009 in commodities as “the greatest bear market rally” we’ve ever seen. Here is how Bloomberg reported the recent speculative activity on July 17th, 2011 in an article titled, Investors Boost Bullish Commodity Bets as Gold Demand Jumped on Debt Woes:

“Speculators raised their net-long positions in 18 commodities by 15 percent to 1.09 million futures and options contracts in the week ended July 12, government data compiled by Bloomberg show. That’s the biggest gain since early August. Gold holdings surged the most since September 2009 as prices climbed to a record last week. A measure of bullish agriculture bets climbed the most in 11 months.”

Buffett continued explaining speculative phases at the 2006 Annual Meeting this way:

“Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we’re seeing that in commodities and housing…Orgies tend to be wildest toward the end. It’s like being Cinderella at the ball. You know that at midnight everything’s going to turn back to pumpkins & mice. But you look around and say, ‘one more dance,’ and so does everyone else. The party does get to be more fun — and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice.”

Therefore, the huge peak in commodity prices in July of 2008 occurred with a few hours left in Cinderella’s Ball. The long and spectacular move in commodity prices has turned into an institutional investment orgy in commodity indexes, while gold is the commodity of choice for the speculation of the individual investor masses. Commodities are being taken for “one more dance”, very much like college students who keep drinking beer at a party long after intoxication has set in.

At Smead Capital Management, we believe that the clock is very close to striking 12 midnight in commodity prices for three main reasons. First, China’s effort to manipulate history and economics with construction spending is being exposed. The inflation occurring in China and the complete recapitalization of the Chinese banking system coming from a real estate crash will cause a deep economic contraction, in our opinion. Second, it has taken so much more speculative firepower to get oil back up to this year’s peak at $115 per barrel, compared to how much was required to go to $147 per barrel in 2008. Any good technical analyst would tell you that a lower peak on much higher volume is a “death knell” for a market. Lastly, China must tighten credit aggressively to slow inflation or they are going to see a protest the size of a province, not one contained in a square (Tiananmen 1989).

Commodity over-indulgence, like other out of control circumstances, get the most exciting towards the end and this one is no different from the others in that respect. We think the end of this one will usher in huge revaluations in the capital markets in the US and abroad. Scott Sprinzen, an analyst at S&P, pointed out in a recent report that a significant slowdown in China could cause commodities to fall as much as 75%. His research shows that commodities decline to their cost of production when they fall out of favor. If he is right, they would certainly qualify as “pumpkins and mice”. It all looks to us like time is running short.

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:

It appears that the sharp increase in Oil prices occurring in reaction to the unwinding of dictatorships in the Middle East has possibly triggered a correction in the US stock market. The theory holds that higher energy costs could cause lower consumer spending and possibly inhibit consumer confidence. Those of us that have been around for decades expect a 10% correction in the stock market yearly and a bear market (a 20% or greater decline) every five years. Considering that the S&P 500 Index rose sharply since last summer’s low and has made a big comeback since March of 2009, is it any surprise that some folks might want to take profits? How do effective portfolio managers deal with market corrections if they are interested in creating wealth by holding outstanding businesses for a long time?

First, we will deal with what we know. In a recent white paper, RS Investments points out that low portfolio turnover promotes better results. Using Morningstar data, RS screened actively manage funds between the end of 1999 and the end of 2009. They found that funds in the lowest turnover quartile outperformed in all three capitalization categories (Large, Mid and Small). The study found that risk adjusted returns were also better for those portfolios which were in the least active quartile. What is especially attractive about this study is that the stock market performed poorly during the decade and confirmed that the benefit of low turnover is not just a bull market phenomenon.

Second, we are reminded of Ben Inker’s research at GMO in February of 2009 which concluded that 75% of the intrinsic value of a business comes from cash flows more than 11 years from now and 50% from cash flows more than 25 years out. In his study, he pointed out that the minor differences in earnings during the next two years make up a tiny part of the intrinsic value of a business. Think of it like this. Starbucks announced that higher coffee prices will probably cost the company $.20 of their earnings in the current fiscal year. If those coffee prices stay elevated forever and aren’t offset with retail level price increases by Starbucks, it is meaningful to today’s intrinsic value. If it is temporary or matched by price increases, it means 20 cents less value in a present value calculation.

Warren Buffett recently told the Financial Crisis Commission what he thought was the most important aspect of the businesses he likes to own. His answer was that he likes companies which have such a strong hold on customers that they can raise their prices. In effect, he is saying that he likes companies which you can hold through thick and thin because they have the ability to prevent exogenous variables from affecting long-term intrinsic value. Wall Street research firms, active traders and hedge fund managers treat these short-term variables as important whether their implications are long term or not. As the New York Stock Exchange statistics show, holding periods for stocks have fallen below one year for the last three years. Poor equity performance from the end of 1999 to the end of 2009 has modified the behavior of most market participants. After all, why would you want a low turnover portfolio in a market going nowhere?

Third, the RS Investment study also looked at portfolio concentration. The Morningstar database shows that those actively managed portfolios with less than 50 stocks outperformed those which held more than 50 as well as the average of all actively managed funds in each capitalization category! We believe in owning no more than 30 stocks in our portfolios at Smead Capital Management.

Lastly, the RS Investment study showed that combining high concentration with low turnover gives you what they call “High Conviction Investing”. The outperformance in the large-cap category was about 1.25% annualized over the ten-year period. It was higher in the mid-cap and small-cap categories, but it appears to have been affected by a much better decade for the mid and small-cap indexes. In other words, the more money made in the decade, the greater the benefit to concentrating and keeping turnover down.

We are two years removed from the most difficult bear market in the US stock market since the 1930’s and the deepest recession since 1982. Economic recoveries coming off of deep recessions have lasted more than five years on average, which means we are in the early innings. Higher oil prices would be a negative to GDP growth and earnings if the move higher holds for an extended period of time. However, those portfolio managers who sell long-term holdings for market timing reasons or to capture small discrepancies in intrinsic value to avoid short-term pain have proven to underperform those who don’t. At Smead Capital Management we don’t think it is going to be any different this time.

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:

Once upon a time there were institutional and individual investors named Dorothy. She was hit by two financial tornados and knocked unconscious. These tornados fell on the Wicked Witch of the East (Alan Greenspan) and Dorothy ended these crises wearing Alan’s ruby slippers (massive liquidity in the US financial system). All she wanted was to reach home (her financial goals).

Fortunately for Dorothy, numerous good witches in the media told her that there is a place called the Emerald Country (China). At the heart of the Emerald Country is a Wizard (Centralized Government), who can not only successfully run a planned economy in a capitalistic way, but could help Dorothy reach her financial dreams. One of the good witches told her that to get to the Emerald Country she should follow the “Yellow Brick Road” (buy gold).

Along her way to see the Wizard of Oz, Dorothy made three friends. First, she met a Scarecrow (Bill Gross). He told Dorothy to invest in the one thing that didn’t require a brain, his bond fund (Pimco Total Return). Then she ran into a Tin Man (Jimmy Rogers) who had no heart. He told her to invest in commodities so that she could take advantage of other people’s misery and be heartless like the Tin Man. Lastly, she made friends with a Cowardly Lion (David Rosenberg). He told her to invest in fear. The Cowardly Lion was precluded from participating in investment markets which require courage.

Along the way to the Emerald Country (China) to see the Wizard, Dorothy ran into the Wicked Witch of the West (Meredith Whitney). The wicked witch told Dorothy she would be captured and her financial goals would be ruined because the US banking system would never repair itself. The wicked witch sent in flying monkeys (hedge funds and high frequency traders) to try and scare Dorothy away from going to see the Wizard. Other flying monkeys urged Dorothy to own the “reflation trade” and over-emphasize all sectors and companies which benefit directly from uninterrupted growth in the Emerald Country (China). All the flying monkeys kept one foot out the door at all times and turnover in investments hit record highs. She also ventured into Munchkin Land and had the leader of the Lollipop Guild (Peter Schiff) remind her to “follow the yellow brick road” (buy gold) and to own it outside the US to insure financial survival.

All along the way, Dorothy had her dog Toto (the media), coaching her. In the fall of 2010, Toto had a good witch (Becky Quick) take an entourage to the Emerald Country. In this entourage was the Oracle of Omaha (Warren Buffett) and the expectation was that this would be the coronation of the success of the Emerald Country and its leader the Wizard of Oz. As Dorothy approached the Wizard with her cowardly friends behind her, Toto had one of his own, (See David Barboza from the New York Times) pull the curtain back to reveal that there was no Wizard. A bunch of old Communists were behind the curtain funding the building of infrastructure that nobody wants or needs. They had artificially inflated the price of all commodities related to construction and created temporary demand for everything from Oil to Earth Movers. These old communists didn’t have any more chance of running a planned economy than their Soviet brethren did between 1950 and 1990. However, they knew if the truth came out and their construction-based economy was about to melt like Las Vegas and Phoenix did between 2006 and 2009, that massive social unrest would arise in the land.

Dorothy was incredibly disappointed that wide asset allocation and Emerald Country related sectors like basic materials, heavy industrial, commodities, emerging markets and natural resource export countries couldn’t meet her financial needs. Fortunately, Smead Capital Management came by and told Dorothy that all she had to do was click her heals together, buy recession resistant large cap US common stocks and chant, “there’s no place like home, there’s no place like home”. We believe that Dorothy will wake up to find Auntie Em (Jeremy Grantham) telling her that if she stuck to large cap US quality the next seven years she will live happily ever after.

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.