William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Thanks to a super well-written piece from Emily Kaiser at Reuters, we can frame the discussion about the Chinese housing bubble as the difference between the US Savings and Loan/Bank debacle of the late 1980’s/early 1990’s and the US housing debacle from 2006 to today. Emily laid out the argument quite well. Many economists and experts believe that the large down payments by Chinese home buyers and the fact that their total mortgage debt is less than 20% of Chinese GDP is a reason for comfort. They argue that the Chinese government is in a position to deal with letting the air out of the bubble because of this big equity cushion. Here is how Reuters explains it:

“As housing bubbles go, China’s looks relatively benign. Unlike in the United States, Chinese home buyers typically put down at least 40 percent of the purchase price. That means they don’t have to worry about a modest decline wiping out all their equity, and banks have little reason to fear an influx of “jingle mail” from defaulting homeowners returning the keys.

Household debt amounts to less than 20 percent of China’s gross domestic product, according to the International Monetary Fund, one fifth of the U.S. ratio.

“In the United States, housing was a borrowing vehicle for households. In China, it’s a savings vehicle,” said Stephen Green, an economist with Standard Chartered in Hong Kong.”

By framing the analysis of China in the context of the US housing bubble, apologists are put in a perfect position to claim that it is not going to be a big problem to deal with for the Chinese government. The 2005 US housing bubble was about banks like Countrywide Credit lending money to people who couldn’t or shouldn’t have wanted to afford their big “dream” home. They made unbelievably large loans to millions of people who wouldn’t be able to pay it back. Countrywide’s President was Angelo Mozilo, who sported a great tan, a fat bank account and a fatter investment portfolio. His bank reported a ton of profit until all the bad loans came to roost. The China apologists are correct that China’s real estate bubble only has historically large price increases in common with Phoenix or Miami or Las Vegas in 2005 (even though China’s price increases are much more ridiculous). The Chinese end buyer puts a great deal of equity into a house purchase because owning a home is a “savings vehicle”.

What they should be putting China’s real estate bubble into the context of is the Bank and Savings & Loan debacle of the late 1980’s. China’s housing bubble is huge. In our opinion, it will cripple their financial system in several ways. The negative wealth effect, as their bubble gets unwound, will contribute to a deep recession/depression. For the most part, the impact of unwinding China’s real estate bubble will be felt in China, in the emerging markets surrounding it and the countries which have benefitted the most by selling them the inputs to massively over-build in the major cities.

Some review of the debacle in the late 1980’s is necessary. Savings and Loan institutions had huge deposits which were insured by the Federal government through an under-capitalized agency called FSLIC (Federal Saving & Loan Insurance Corporation). The leaders of these “Savings” organizations took the liberty to loan these deposits out to real estate developers to build both commercial and residential projects. These loans became a concentrated part of the assets of these companies and the tangible assets as a percentage of outstanding loans became dangerously low. The mortgage borrowers themselves had plenty of equity in their homes and the late 1980’s down cycle was not marked by high foreclosure statistics and “jingle mail”. Of the 3234 savings institutions in the US in 1987, 747 were eventually closed by the mid to late 1990’s.

The poster child was Lincoln Savings and Loan in Phoenix run by Charles Keating. His bank took in deposits through very high interest rates on Certificates of Deposit (CDs). The money was loaned to build projects like the Phoenician Hotel, which Keating just happened to have a financial interest in. Keating was constantly moving money back and forth between Lincoln Savings and Loan and his real estate development company, American Continental Corporation. The Phoenician was the most expensive hotel ever built in Phoenix.

The difference between the US in the late 1980’s and China today is that the Chinese government is completely caught up in this debacle. They dictated to the four government-owned Chinese banks that they would provide the economic stimulus in China. The primary vehicle has been spurious loans made to real estate developers. Chinese Communist Party officials and Chinese Army leaders are in control of both the banks and the special purpose vehicles created at the municipal level to build these booming structures. In late 2008, China needed to avoid recession to prevent civil unrest. In the US version, Keating attempted to get the government involved to perpetuate his scheme. His problem was that in the US we have political and speech freedom. The Keating Five Senators got called to the carpet and our system came clean. Who is keeping China’s system clean? In case you are wondering, Phoenix has a history of booming and busting and one of those booms was in the 1980’s. The theory behind that boom was that retirees would move to Phoenix in droves and because of that fact, it didn’t matter how much the real estate you were buying was over-priced. The same logic about people moving from the rural areas to the cities dominates the real estate bubble in China and is used by the apologists all the time.

At the same time that real estate development was running wild from cheap deposits insured by the US government, major money center banks like Bank of America and Citigroup were recycling the massive wealth created by oil production in the late 1970’s and early 1980’s from Arab investors and Texas oil men. This money was turned into loans to fast growing countries like Brazil and Mexico. These were the hot emerging market nations of the time. These emerging-market loans became a large part of the loan portfolios of these money center banks and when these countries went through their business cycle, they were unable to meet their debt service obligations (if this sounds like today’s problem with Greece and other PIGS in Europe, you are starting to track with me properly).

Treasury Secretary Nicolas Brady from the George Bush Sr. administration ultimately came to the rescue with his bailout program called Brady Bonds. The Resolution Trust Corporation was formed by the US government to clean up the Savings and Loan debacle and the US economy languished for many years in a jobless recovery. The clean-up costs were in the hundreds of billions of dollars. The loans involved in these two institutional debacles were development loans and had an enormous impact on US economic growth from 1988-1993, costing President Bush Sr. his job and ushered in the era of the “jobless” recovery.

We believe the only way that the Chinese apologists can feel comfortable about a soft landing in China’s economy is if the development loans in the four largest government-owned banks are not a concentrated part of the loan portfolios. Second, they can be comfortable if the losses the banks will have to take from real estate developer failure don’t wipe out their tangible assets. Thirdly, they can be comfortable if the municipalities in China have a way to replace the 74% of their revenue that currently comes from taxing real estate transactions and creating money out of mid-air by capitalizing raw land much higher as it is developed. Lastly, they can be comfortable if the wealth effect of substantial price drops in the primary risk investments (savings vehicles) of their citizens don’t crush consumer spending. Consumer spending is estimated to be 30% of Chinese GDP. The apologists in Emily Kaiser’s article in Reuters are correct that this isn’t closely analogous to the US real estate bubble of 2005. Unfortunately, we believe they are very wrong about the magnitude of the damage to the economy that the real estate stimulus loans from 2008-2011 will ultimately have on China’s economy.

These loans were estimated to be $2.7 trillion and were originated from late 2008 to today to stimulate the Chinese economy via real estate development. We have seen estimates of loan losses ranging from 30 percent (Fitch) to 70 percent (Yin Zhongqing). The four largest lenders in China would likely have most of the $810 billion to $1.9 trillion in loan losses on their books. We believe this would devastate their tangible equity, force recapitalization and stop new development in its tracks. It would stop the ability of folks to move to the cities to get jobs, it would crush demand for commodities involved in construction and it would cut off surrounding Asian countries which have been suckling on the bounteous teat of China’s boom. The currency outflows and the bank recapitalization could vanquish China’s foreign currency reserves fairly quickly.

In our opinion, China has Angelo Mozilo’s price bubble going, but not his residential mortgages. They have Charles Keating’s development loans. These loans are in a quantity and magnitude relative to China’s $6 trillion economy that Jim Chanos described the potential fallout as “Dubai times 1000”. Let the games begin.

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

Dear Fellow Investors:

We have now seen the S&P 500 Index drop below 1150 five times since the first of August. The overriding reasons, listed in no particular order, are fears of another contraction in the US economy, European sovereign debt and bank problems, a lack of political leadership in Washington D.C. and persistent unemployment data. These problems have caused an 18% decline in the index from peak to trough and have given those of us who stay fully invested in high quality stocks another opportunity to examine our thesis.

Our thesis is that by owning the companies which fit our proprietary eight criteria and making changes very sparingly, we can garner the historically superior returns which come from equity ownership and exceed the return of the index over long-term time periods. This comes from a combination of dividends, dividend increases and capital appreciation.

Even though we are not traders or short-term oriented, we at Smead Capital Management would like to throw out a few opinions which cause us to be very positive about the stock market over the next one to two years.

1) While market participants look to the US government and the Federal Reserve Board for answers, US Households are doing remarkable and historical work of getting their finances in order. The Household Debt Service Ratio dropped to 11.09% at the end of June after being as high as 14% in late 2007. This is the ratio of how much of the average family’s gross income is dedicated to debt service. The statistics are reported on a 90-day lag, which means that the ratio is probably below 11% by now. At the pace that households are improving their income statements, we could see a ratio of 10.6% in the next year. Numbers below 11% existed in 1982 and 1992 at the beginning of extended periods of prosperity. What this means is that households could take on monthly payments comfortably and that bodes well for the employment rich automobile and housing industries.

2) Usually bearish firm, Grantham, Mayo, Van Otterloo (GMO), recently put out an extensive research piece indicating that US housing participants are making the “Error of Pessimism”. They are arguing that US housing is in position to become a bright spot in the US economy.

3) Commodity prices are plunging. In the same piece, GMO argued that China is making the “Error of Optimism” in residential real estate. If real estate activity falls off in China, commodities will continue to decline. No politician could duplicate the incredibly simulative effect of lower gasoline prices, not to mention the enormous psychological benefits in a mobile society like ours.

4) Pretty much all stock market participants are bearish. Mutual funds specializing in US Large-Cap equities have suffered huge net liquidations for months. Sentiment polls look similar to the spring of 2009, right before a huge gain in the following two years. Stock correlations are running at highs only seen in the 1987 crash period. This means that the professional traders are selling baskets of stocks simultaneously without regard to their quality. When low correlations come back in the future there is a lot of wheat to separate from the chaff.

5) We believe our companies have performed well in a less than stellar environment. The dividend growth the next five to ten years could set records as these lean powerhouses gush free cash flow. Howard Schultz pointed out, as an example, that Starbucks has $2 billion in cash on their balance sheet and might be interested in strategic acquisitions.

6) Insiders (officers and directors of public companies) have been as aggressive in their purchases of their own company’s stock as they were in early in 2009.

We believe many of our stocks have held up quite well in this environment, but some of them look especially attractive at this point. Financial stocks seem to be in a capitulation phase and Wells Fargo (WFC) and Aflac (AFL) look particularly attractive. The household debt ratio inspires us about Disney (DIS), Cabela’s (CAB) and H&R Block (HRB) in what we call our “staple” consumer discretionary category. In healthcare, Mylan Labs (MYL) is retesting its August low and saw significant insider buying at these price levels last month. We would be remiss to not mention that PayPal/ Ebay (EBAY) is preparing to become a major payment force in stores for the first time. It is nice to start a business with 100 million existing customers.

In conclusion, we have reasons for being the optimistic contrarians, even over the next one to two years.

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 was a bank based in Seattle, Washington called Washington Mutual. The bank grew by acquisitions in the 1990’s and enjoyed the prosperity of the United States of America. It raised its common stock dividend every year from 1989 to 2006 and on April 18th of 2006 reported their 1st quarter 2006 earnings. Profits grew 15% in the first quarter of 2006 as compared to the prior quarter ended December 31st of 2005. Here is how Washington Mutual’s Chairman and CEO, Kerry Killinger, described the results:

“We are very pleased with our first quarter results,” said Kerry Killinger, Washington Mutual chairman and chief executive officer. “The company’s strong performance demonstrates the benefits of our continued diversification and enhanced operational focus. This past quarter we had particularly strong results in Retail Banking and Card Services.”

“These businesses added customers at a record pace and delivered significant revenue and earnings even in this difficult interest rate environment,” Killinger added.

Today there is a bank called China Construction Bank. It is the third-biggest commercial lender in China. On August the 22nd of 2011, China Construction Bank reported that its first half profits rose 31% to $14.5 billion, buoyed by higher income from fees and interest. Here is how the web site mystockmarketnews.com described the bank’s results:

“Like other Chinese lenders, the bank has benefited from rising interest rates and higher fees and commissions as it diversifies its revenue sources.

Interest income in the first half of the year rose 24 percent, while income from fees and commissions jumped 42 percent to 47.7 billion yuan ($7.5 billion).”

Unfortunately, Washington Mutual is no longer in existence. The reason they no longer exist was actually shown in the 1st quarter report in 2006. Despite reporting an operating profit of $985 million dollars in the quarter, Washington Mutual and its executives were preparing it to run headlong into the realities of the conflict between the income statement of a bank and its balance sheet. The bank was lending a massive amount of money to people who were buying homes with no money down under the premise that home prices would never drop nationwide. Many of those loans were made to people whose incomes were never verified and logically would never have the income to afford what they bought.

On page two of their earnings report, Washington Mutual reported tangible equity as 5.85% of tangible assets and non-performing assets as .59% of total assets. The provision for loan and lease losses was $82 million and net charge offs were $105 million. Remember, this was in the first quarter of 2006. Residential real estate prices in the most popular markets in America like Southern California, Arizona, Nevada and Miami were already starting to crater. Washington Mutual was a major player in those markets on the West Coast of the US. Washington Mutual had $26.156 billion of shareholders equity at the end of March in 2006, total loans of $240 billion. The percentage of these loans which would default wiped out the bank and put them into the hands of JP Morgan with FDIC assistance.

China Construction Bank was one of the main institutions that the government of China has used between late 2008 and early 2011 to stimulate the Chinese economy through lending to special purpose vehicles for building condos, office buildings and infrastructure. The purpose behind the speculative development loans was to avoid the economic contraction happening around the world which Chinese policy makers correctly foresaw in 2008. The average citizen in China can’t afford to buy the condo residences which are being built by these quick buck speculators. China Construction Bank’s activities are described in the mystockmarketnews.com article this way:

“The bank said it was strictly controlling lending to industries designated by the government as having excess capacity, such as iron and steel, coal and plate glass. Meanwhile, it boosted lending to small and medium-size companies.

Smaller businesses have usually struggled to get bank financing. Such lending increased 9.5 percent by the end of June over December of last year, compared with a 6.8 percent increase in total corporate lending.

Construction Bank, which is relatively heavily exposed to the property sector, also said it was limiting lending to local government investment entities, whose debts have ballooned in the wake of a binge of recession-fighting construction investments.”

It is estimated by Fitch and other reliable sources that more than $2.7 trillion in loans were made to real estate developers at the municipal level on spec developments. We have seen estimates of loan losses ranging from 30% to 70% and reports show that interest payments of as much as $140 billion are due this year alone. The Chinese government has already allocated $464 billion to their version of a TARP program to deal with the capital which these loans are beginning to destroy. Here is how Bloomberg explains these circumstances recently:

“Chinese lenders expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. The surge in loans exceeded credit expansions in the U.S. before its financial crisis, in Japan before its stock and property bubbles collapsed in 1990 and in South Korea before the Asian financial crisis of the late 1990s, according to Fitch.”

If China Construction Bank has its fair share of these massive loans and the default rate runs 30%, $300-500 billion in bad loan write-offs wouldn’t look very impressive in comparison to a $14.5 billion dollar profit on the income statement. The grave difficulties which are hiding in the capital structure of this bank are showing up the same way they did with Washington Mutual in 2006. The stock market kept giving Washington Mutual a lower and lower price-to-earnings ratio and the stock lagged performance benchmarks in 2006. Here is how Bloomberg describes what is going on recently with the Chinese Bank stocks:

“Investors are cutting their estimates for the value of Chinese bank assets. The MSCI China Financials Index’s price-to- book ratio, a measure of share prices relative to net assets, tumbled to 1.8 on July 29, the lowest level since February 2009, from 2.8 two years ago, according to monthly data compiled by Bloomberg. The ratio for Chinese lenders slipped below that of the MSCI Emerging Markets Index on June 21 for the first time since January 2006, data compiled by Bloomberg show.

Industrial & Commercial Bank of China (601398) Ltd., the world’s largest lender by market value, slumped 8.2 percent from the end of March through July 29 even after saying bad loans dropped almost 4 percent in the first quarter. The stock gained 1 percent today.

Credit-default swaps on Bank of China Ltd. (3988), the nation’s third-largest lender by assets, jumped to 153 basis points from 106 on March 31, according to data compiled by Bloomberg and CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in privately negotiated markets.”

The bottom line is that Washington Mutual is only in existence in the world of litigation. For those of you out there who like to avoid these kinds of risks, we at Smead Capital Management recommend you avoid China, avoid the commodities which are used most heavily in construction, avoid the makers of construction and mining equipment, avoid the countries which have benefitted the most from China’s uninterrupted growth, and avoid the vehicles used for financing all of this growth. Economist Gary Shilling said it this way:

“‘China isn’t this juggernaut that’s going to grow forever without any interruption,’ Shilling said in a July 14 interview with Bloomberg Television’s Betty Liu, adding that the government may be forced to bail out banks as bad debts grow.”

With the capital they use to recapitalize banks like China Construction Bank, we believe China won’t be able to continue their non-economic building spree. The inevitable economic recession/depression in China which we expect to follow will turn the asset allocation world upside down, in our opinion. Buyers beware!

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:

They say that to make significant improvements or permanently change behavior you have to hit bottom. Once you hit bottom, you have to want to change. There is a special blessing in hitting bottom in the business world earlier than your competitors. This is true for companies and it is also true for national economies.

Home Depot was created by Arthur Blank, Bernie Marcus, Ron Brill and Pat Farrah. The leader of the company for years was Bernie Marcus. He had a passion for the business and for employees which was infectious. When he stepped back from the company in the year 2000, a former GE executive named Robert Nardelli became the CEO and attempted to improve the company through financial engineering. The attention to merchandising detail and customer service suffered once Bernie’s enthusiasm was removed from operational management of the company. Frank Blake was hired in 2007 with the morale and the performance of the company in a deep struggle. Home Depot’s number one competitor, Lowe’s, was running rings around them.

Frank Blake went to work on a company which in many ways hit bottom in 2007. By the time the “Great Recession” was in full force in 2008, Home Depot was already working on improvements which other businesses would make at the depth of the recession. In the most recent quarter of 2011, Lowe’s and Home Depot reported results which effectively were the reverse of 2007. Lowe’s earnings stagnated and Home Depot is growing again and appears to be gaining market share. Hitting bottom early was a competitive blessing for Home Depot.

Another example of this occurred in 2007 when it became obvious to Howard Schultz that he needed to retake the reins as CEO of Starbucks. The company had over-expanded and lost the attention to detail and efficiency, which was one of its hallmarks. Soon after taking over in mid-2008, Schultz announced that 600 stores would be closed and that earnings would be damaged by charges and lower sales. Starbucks corporate performance hit bottom in late 2007 and early 2008.

By 2008, Starbucks was well on its way to improving almost every aspect of their business. Then the “Great Recession” hit with full force. This caused all the businesses around Starbucks to deal with some of the same forces that their own stumble had forced them to address. In the fiscal year 2011 ended September 30th; Starbucks will have nearly doubled its peak fiscal earnings record prior to the great “reset”. Hitting bottom before most all the other businesses was a blessing.

This is not only true for companies, but it is also true for countries. It was obvious to our firm in late 2005 that residential real estate prices were nuts. We wrote endlessly about this topic during that time. The residential real estate market started to crash in the hottest markets in the US in late 2005 and in the rest of the country in 2006 and 2007. In turn, the market for mortgage loans blew up in 2007 and 2008 leading to the financial crisis of 2008 and early-2009. The US hit bottom in the economy in the first quarter of 2009 and the stock market bottomed on March 9th of 2009.

The US economy has been attempting to cleanse itself of these over-priced properties and bad loans for five years. We’ve had to recapitalize our banks through the TARP program. Businesses had to right-size their employment levels and get their balance sheets in order. Households had to aggressively attack their over-spending ways, turning Dave Ramsey into the high priest of debt reduction and have made massive improvement in their household debt service ratio.

While the US economy has hit bottom and has been cleansing itself for five years, Europe and Japan have been slow to get their act together. Japan never has cleaned their system of the loan problems of their late 1980’s bubble. Europe has a common currency and uncommon problems which they have been hesitant and reluctant to address.

Brazil, Russia, India and China have boomed and caused Australia and Canada to boom with them. The economies of Brazil and India are already showing severe cracks. Australia’s housing market is crashing. Lower oil prices could lead to major problems for Canada and its hot residential real estate markets. Bank loans that are going bad are haunting the economies of the BRIC nations. Here is how Bloomberg Business Week’s Michael Patterson explained what is going on in the emerging market world in their August 15th-28th issue:

“Loans to Brazilian shoppers, Chinese infrastructure projects, and Indian property developers have fueled the global economic recovery and turned emerging-market banks into some of the world’s biggest firms by market value. The party may be ending. Worrisome inflation rates in Brazil, Russia, India, and China have local monetary authorities raising interest rates and tightening credit conditions. That, plus evidence nonperforming loans are on the rise, has investors rethinking their enthusiasm for BRIC bank stocks.”

China has an even nuttier residential real estate bubble than we had in the US, in our opinion. China has more bad real estate and infrastructure development loans in their banking system today than the US did back in the late 1980’s, when we had the Savings & Loan debacle. The US banking crisis in the late 1980’s ended in the Resolution Trust Corporation handling bad development loans at taxpayer expense. It looks to us like a $1.5 trillion black hole waiting to be filled by the Chinese government. In other words, these other countries like China are at the beginning of their skid and nowhere near the bottom as yet.

Fraser Howie, the co-author of “Red Capitalism”, expounds on China specifically in a piece in Barron’s August 29th. He sees, “more problem loans ahead for China’s big banks, with negative consequences for global economic growth.” Here is how he details the problem loans:

“China’s banks issued a record $2.8 trillion in new loans, of which $1.7 trillion went to local governments. While the big four banks— Industrial & Commercial Bank of China (ticker: 1398.Hong Kong), Agricultural Bank of China (1288.Hong Kong), China Construction Bank (939.Hong Kong) and Bank of China (3988.Hong Kong)—reported nice first-half earnings gains last week, as well as limited impact from local-government lending, fresh problem loans are likely to surface in the future, says Howie, a Singapore-based executive at the investment bank CLSA Asia Pacific Markets.

Worse, the banks are ill-equipped to handle them, he said in an interview last week.”

Summing up the investment landscape from the angle of banking weakness in the BRIC countries Howie said:

“But weakness in China and the knock-on effects will surely hit a raft of investments premised on breakneck growth, among them mining stocks, commodities, construction plays and retailers. China ultimately has an unsustainable banking system.”

We believe that the first country to hit bottom, the first to confess its mistakes the way Frank Blake and Howard Schultz did for their companies, and the first to cleanse the banks, corporations and households will lead to lasting prosperity long before any other country in the world does. We also believe that the investment rewards of US non-cyclical large cap common stock investing has rarely looked more attractive because of the willingness of investors to underestimate the benefit of hitting the skids before everyone else does.

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.