William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Charlie Munger, the Vice Chairman of Berkshire Hathaway, has said many times that psychology is the most under-utilized discipline in business. He compares the business person or investor, who doesn’t have an inter-disciplinary set of “mental models” including psychology, to a one-legged person in a kick-boxing competition. We believe that those using low consumer confidence as a reason to be bearish about US large cap stocks and consumer discretionary stocks are equivalent to one-legged kick boxers.

At the website, The Big Picture, Barry Ritholtz shared his thoughts (Nov. 4, 2011) on the US employment numbers. We have respected the thoughts and research of his firm because they were early in understanding how damaging the housing bubble was going to be on the US economy. However, this time we believe that the trap that the market has laid for investors in the area of unemployment and consumer confidence is well set. We believe that a number of savvy analysts are not “seeing the forest for the trees” when it comes to understanding the history, psychology and the accounting of consumer behavior.

We at Smead Capital Management believe two things about consumer spending and consumer behavior in the US. First, the income statement of US households tells you more about future spending than consumer confidence does. Second, we believe Andy Grove’s professor at the City College of New York was right when he said, “When everyone knows that something is so, nobody knows nothing!” In other words, is there an investor left in the world who has not anticipated that it will be years before the US consumer makes a comeback? Consumer confidence is a neutral indicator most of the time and a valuable contrary indicator at extremes.

Let me unpack these two ideas. The Federal Reserve Board has maintained statistics on US households since 1980 measuring the percentage of gross household income required to service household debt. You can view these stats by going to www.federalreserve.gov/releases/housedebt/. There you will see that the real estate and borrowing bubble of the 2000’s allowed US households to get to ridiculously high ratios of household debt service (around 14% of income at the peak). This was markedly higher than previous peaks of 12.4% in prior cycles. You will also see that US households have made huge strides since late 2007. These statistics are lagged by three months or more, but you can see that by June 30th of 2011 the ratio had fallen to 11.09%. Assuming that this trend of austerity continues through the next 12 months, the US Household Debt Service Ratio could fall to the low levels of the early 1980’s deep recession at 10.6% and in the job-less recovery of the early 1990’s.

Think of it like this. Who is likely to spend money and do it more consistently, someone who’s in very good shape on their income statement that lacks confidence or someone who is up to their eye-balls in payments but brims with confidence? The unconfident households with room in their income statement will ultimately be part of what we call “pent up demand” for goods and services. The car wears out or the fridge needs replacing or the kids are going to get too old to want to go to Disneyland, so you breakdown and do it. You don’t have much confidence, but you can afford the expense.

These facts have been baffling to most stock market participants for nearly three years. In the world of the supposed “new normal”, why is everything happening pretty normally among US consumers who are providing great business to McDonald’s (MCD), Starbucks (SBUX) and Nordstrom (JWN)? We believe the record-setting low consumer confidence numbers of 2009-2011 and the continuing high levels of unemployment that The Big Picture speaks of have been the reason that the money management community has avoided the consumer discretionary category.

We looked at the correlations between consumer confidence and the stock market between 1977 and 1996. What we found was that there was almost zero correlation and it was a neutral. If you look at the period since 1996, consumer confidence was a valuable contrary signal at extremes and the correlation is significant. Stocks were to be avoided on high consumer confidence and the stock market lows have coincided with low consumer confidence.

Going back to Andy Grove’s professor, the logical thing that everyone knows is that US households have a great deal of debt to work off over the next ten years and the US government has a very large amount to deal with itself. Everyone has assumed that the consumer wouldn’t be able to lead a meaningful economic recovery until those debt levels come back in line from a historical standpoint. This has resulted in significant under-ownership by professional money managers and asset allocators in the consumer discretionary category. We believe that until the money management community capitulates and buys into the consumer sector that it will out-perform the S&P 500 Index. And we believe that the capitulation will come at dramatically higher consumer confidence levels and we are about as far away from those statistics in early November of 2011 as you can be!

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

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

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

Here are examples from last weekend of these separating virtues:

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

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

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

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

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

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

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

In the midst of this historically poor start to the year 2009 in the stock market (S&P 500 year-to-date return), we thought it would be helpful to give you some reading in between the lines of the Berkshire Hathaway Annual Letter.

1) “Book Value fell 9.6% and the stock price fell 32%”

Translation: This was the worst year out of 44 on an absolute basis for Berkshire Hathaway. Book value has grown at 20.3% on average over 44 years!

2) “By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Translation: What we at SCM describe as an “economic coma” has been as swift and violent as any Warren Buffett has seen in his adult business life.

3) “Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

Translation: It has been a long time since we had a major and painful economic contraction. We have grown soft because of it and the steep decline in stocks has every intention of robbing all of us of our optimism. It won’t rob Warren’s and it won’t rob ours at SCM.

4) “Take a look again at the 44-year table on page 2. In 75% of those years, the S&P stocks recorded again. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’ t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”

Translation: Don’t extrapolate forward the recent down trend. Picture where you are as an owner of common stocks and where you want to be in five years and stick with your discipline.

5) “I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

Translation: Warren got caught in the “Peak Oil” Bubble last year and believes that oil will rise in price in the future. Too many investment people agree with Warren and we believe that he will need a great deal of time to get even on Conoco.

6) “I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 m illion for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

Translation: Warren’s existing holdings in Wells Fargo, American Express axp and US Bank usb punished him in the last year and he got burned badly by dabbling in a few new financial institutions. There is grace for us at SCM in his difficulties!

7) “The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

Translation: Good quality stocks and bonds are underpriced and U.S. Treasuries, money market funds, CD’s and savings accounts are overpriced! However, to gain the benefit from this investment discrepancy you must deal with the possibility that the markets continue to deepen the underpricing and raise the overpricing!

We know we have given you a great deal to consider, but in these trying times in investing we hope we are serving you well by modeling the behavior of the greatest investor of all time.

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.

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

In his wonderful book A Short History of Financial Euphoria, John Kenneth Galbraith wrote that human beings ascribe higher and higher levels of intelligence to people based on how much money they make and business success they have. The opposite would be that a lower and lower level of intelligence are ascribe to investors and business people as difficult economic and stock market circumstances dominate the news. Charlie Munger, who is the vice-chairman of Berkshire Hathaway, told Stanford Business School MBA candidates a few years ago that psychology is the most undervalued discipline in business. I’d like to combine the wisdom of the timeless academic Galbraith and the respect for psychology from the super-successful investor Munger to ponder our current market conditions.

The stock market in the U.S. has already fallen 50% from peak to trough since October of 2007 to today. Among many admirable money managers and stock pickers, we at Smead Capital Management appear to have very little intelligence and our IQ seems to get lower by the week. This decline ranks as the worst bear market by magnitude since the 1929-32 market, which lost over 80% of its value from peak to trough.

Perma-bear, Jeremy Grantham, who because of his negative stance on the stock market over the last 10 years is ascribed a great deal of intelligence. He has written extensively recently that he believes “high quality” U.S. stocks provide good long-term value at these levels, but strongly cautions investors that these kind of psychological business crises can overshoot to the downside. He therefore urges consistent buying, but warns that the S&P 500 Index could drop as low as 600 (around 770 today) before it makes a bottom. His main reason for the concern about the downside is that negative psychology and a negative feedback loop can dictate a great deal of panic through human behavior.

It is our view that additional major downside movement in the U.S. stock market could only be justified by a much greater economic contraction than the one we have seen so far (5% contraction year to year) or a substantial increase in U.S. Treasury bond interest rates. Many of the most negative stock market prognosticators look at the market bottoms in 1932, 1974 and 1982. Those market bottoms averaged price-to-earnings ratios of 6-8 and dividends yields of 6%. The 1932 bottom included 25% unemployment and was part of four years averaging 12% year to year contraction in the economy. The economy was chopped in half in four years. The other two bottoms at those historically low average P/E ratios (1974 and 1982) saw Treasury interest rate peaks of 9 to 10% and 13 to 15%, respectively. Therefore, without a near complete collapse in the economy or dramatically higher Treasury interest rates, we don’t see those worst-case scenarios being realized.

None of this makes the bullets we are all sweating fit through our pores any better. However, Grantham points out that his quantitative models show above average returns the next seven years on the S&P 500 Index. Bargain prices on outstanding companies with bright futures outweigh the negative psychology around us and the low level of intelligence ascribed to us for saying so.

Best Wishes,

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.