William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

In prior missives, we at Smead Capital Management have shared with you that there is a large group of money managers and investors who are counted as bullish, but are actually bearish. These investors own the reflation trade or what we like to refer to as “Peak Oil Mini-Me”. Their thesis says that the Federal Reserve and U.S. Treasury are flooding the world with dollars and “printing” money and the only way to take advantage of those facts is to be long oil, gold and other commodities. The current market correction is all about them and the truth behind their thesis.

We believe the truth is that if all that the government is doing causes a rapid improvement in the economy and quickly leads to very high levels of inflation, we’ve got even bigger problems later on to deal with. We sincerely believe these “Long Bears” are wrong. Their frustration is causing a significant and temporary pullback in the S&P 500 Index. We believe that the U.S. Economy will begin a long slow growth phase beginning in the fourth quarter of this year (Oct. 1-Dec. 31). A year ago the economy went into a coma in September. We have since reset our spending 10% lower than the prior year. This spending cut is much deeper than 10% appears because it is about half of the discretionary spending we do each month. The recovery doesn’t occur because of what the government does. Growth occurs because the economic benchmark has been lowered and economic activity is compared to how you were doing in the same quarter of the prior year.

The Federal Reserve’s actions and the government stimulus doesn’t scare us because of the banks need to replenish their capital. They will return to a good business of lending money to credit worthy people with sizeable down payments. A recent study by Stan Liebowitz in the Wall Street Journal has shown that the number one correlation to foreclosure was the lack of any down payment.

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

This return to normal banking will take three to five years. At the same time, individual households and businesses are going to be very hesitant for years and maybe decades to borrow money. Add it all up and you quickly decide that we will not recover by returning to the foolish lending and borrowing of the last ten years. In our minds this means that we won’t reflate the economy. If you don’t reflate the economy, the case for oil, gold and commodities go right out the window and will look foolish; especially after last year’s oil and commodity bubble burst. History shows that bubble markets are dead money for a long time after breaking, just look at the Nasdaq today compared to the peak of the tech bubble in early 2000.

So who wins in this scenario? The winners will be the “Long Bulls”. The “Long Bulls” believe that all the fear of the last 18 months has left the prices of many of the world’s best companies far below their intrinsic value. A long and slow economic recovery with an accommodative Federal Reserve could lay the groundwork for businesses with strong balance sheets and wide moats to gain market share. This would allow them to grow nicely from the “reset” of consumer spending levels. It could be a long period without excesses, which are usually created by too much leverage. As the debts of individuals and the government are paid back, an automatic restraint is put on the economy keeping it from overheating. Single-digit earnings growth in a slow economic era could produce price-to-earnings expansion. We believe large quality company shares will be the place to be for the next five to seven 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. 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:

I read an interesting book recently by Russell Napier called The Anatomy of a Bear Market. He sought to dispel myths about what happens at low points in the stock market. He examined the market based on the point in time when you would have done the best over the following twenty years. He focused on July of 1932, April of 1942 and August of 1982. His thesis wasn’t that buying at a major low point is all that mattered, but rather the best starting points produced forward success. For this reason he left out the market low in December of 1974.

Once he had identified the best points to enter the market over the last 108 years, he then researched what was going on in the economy. He wanted to dispel the myth that there wasn’t any good news at the bottom or best buying point. He found a few good clues to look at to see if the low point had forward looking merit. First, he found that commodity prices firm up around the bottom. Second, auto sales pick up. Third, major companies cut their dividends close to the bottom. For example, General Electric and AT&T cut their dividend within a month of the bottom in 1932. Lastly, overall business shows some life.

Where are we now? The decline in stocks of 53% from October of 2007 to March 9th 2009 is the worst decline since the 1930’s. Commodity prices have firmed as Oil and Copper prices have rebounded. Auto sales have not yet rebounded. General Electric, Alcoa, Wells Fargo and other major companies cut their dividend. Overall business conditions are showing signs of improvement. Durable goods orders were better than expected and retail sales were better in February than expected. Home sales were up on both new and existing homes. And the most active home sales are in California, Arizona, Nevada and Florida. We’ve had four of our clients buy a home in the Phoenix Valley in the last 60 days! Can you hear the rhyme?

We continue to believe that there has never been a better time for investors with a three to five-year outlook to buy quality common stocks. Be careful. If you wait for auto sales to improve, you could get caught in a melt up. Remember, there is more money on the sidelines than at past bottoms on both an absolute and relative basis. Did I forget to mention that the cash on the sidelines pays very little in interest?

Warmest Regards,

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:

Before the next ten years of successful stock market investing gets away from us, we at Smead Capital Management would like to remind everyone that the purpose for investing is to build wealth to enhance future purchasing power. If you watch investment shows on T.V. or read investment magazines, newspapers or websites, you’d think that the object of the game is to be smart. However, let’s look at some of today’s key topics to see what is currently considered dumb and smart in the investment world. Then, let’s ask if they build wealth over long periods of time.

Ultra-Smart—Sitting in Cash, preferably U.S. Treasuries.
Those who were smart in 2008 held inordinate parts of their assets in cash or treasuries and missed some part of the stock market’s horrendous decline. They earned anywhere from 3% interest to as low as 0% toward the end of the year. It can be a very smart strategy in the short run, but has always been blown away as soon as everything returns to something more normal. We believe when normality returns those who sat in cash will have to stare longingly at the portfolios of their “dumb” friends who sat through abusive declines in the value of their blue chip stocks to get long-term returns averaging 10%.

Smart—Trading in and out of stocks.
Wade Cook hasn’t been out of business that long, but it is hard for you all to remember his advertisements which told people to “cash flow” their stocks. He said, “Buy a stock at $1 and sell it at $2, wait for it to go back down to $1 and do it again.” Wade spent time in jail for his misrepresentations, but the “Fast Money” people or Jim Cramer’s followers won’t. You’d have to be pretty “dumb” to sit through last year’s volatility when you could have been trading the enormous market swings (mostly down swings, they fail to mention). I think that if you add up the gains and losses, commissions taxes and you find that trading almost never builds wealth (unless your Charles Schwab).

Smart—Participating in highly sophisticated and esoteric asset classes.
Commodities, hedge funds, private equity, emerging international markets, short selling and the like always look and sound smart because of the exclusivity and complexity. The exclusivity and complexity contributes to dramatically higher participation costs (a leading cause of wealth destruction) and who knows if anyone ends up building wealth (see Bernard Madoff).

Smart—Gold.
Gold was $1000 an ounce when I was in college 30 years ago. It is $870 today. Am I missing something?

Dumb—Buy and Hold Blue Chip Stocks.
How could anyone be so dumb as to buy and hold the finest companies in the world like Disney or Microsoft or Nordstrom? Don’t they know that we have the worst recession since the 1930’s? Don’t they know what Professor Roubini says? Haven’t they been in China with Jimmy Rogers? Didn’t they see how bad it was last year?

Dumb—Buy American Stocks
Everyone knows that the smart people are investing in China and emerging markets! They must know that Warren Buffett will be wrong this time (NY Times Op-Ed Oct. 16, 2008—Buy American, I did). Didn’t he get wealthy?

Dumb—Leaving your stocks to your alma-mater.
I love reading the stories of the elderly man or woman who leaves their stock certificates to their favorite charity. A schoolmarm who left the school millions or the guy who left the Union Gospel Mission thousands and thousands of dollars of utility stocks buried under his mobile home. It was never gold or trading techniques or complex investments they left, it was common stocks.

At any given time the best investments can look smart or dumb depending on when you look and where we are in the market. However when traditionally solid wealth creation disciplines are challenged, it could be time to get excited. We love what we do at SCM and we hope you all join us in this worthy and hopefully wealth building endeavor.

Happy New Year!

William Smead

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

Andy Grove was the CEO of Intel for many years and was asked what the best advice was that he’d ever been given in business. His answer was that a professor at the City College of New York taught him that “When everyone knows that something is so, nobody knows nothing”. It means that when the crowd of market participants reach more than 80% agreement on matters of business or investng, you have to disagree with them and do the opposite of what the crowd is doing.

A few examples for newer readers. When everyone thought in 1998-1999 that the profit to be made from tech investments was unlimited, you had to flee the area. A year ago when investors were rabid for international stocks (especially emerging markets), you had to assume the bubble would burst. Last summer when Oil hit $145 per barrel and commodities were flying high, we warned everyone who would listen to get clear and forget you’d ever heard of BHP Billiton, Transocean, Mosaic and Freeport McMoran.

At Smead Capital Management we crave the opportunities created by this phenomena we call a ”Well-Known Fact”, which is a body of economic information which is known by all participants and has been acted on by the 80% majority. Unfortunately, for the last 10 years, most of the “Well-Known Facts” were things to avoid as opposed to sectors made attractive for new investments. Avoiding overvalued areas saves you money while pursuing undevalued sectors could make us wealthy.

I’m pleased to report the latest “Well-Known Fact”. The “new” fact is that the recession which started a year ago is going to be the longest and deepest since the 1930’s. Therefore, the crowd of investors assume that the most violent decline since the 1930’s in the U.S. stock market (from October of 2007 to November 20th of 2008) is not good enough to discount all the bad news which will come for however many months that the recession lasts. Individual investors are approaching having 2.5 times as much of their aggregate household assets in treasury bills, checking, savings and certificates of deposit as they own directly in common stock. It is almost the exact opposite of the top of the market at the end of 1999 when they owned $10 trillion of common stock directly and had $4 trillion in the safest and historically lowest paying instruments. Warren Buffett says, “Uncertainty is the friend of the buyer of long-term values” and “So if you wait for the robins, spring will be over”.

Here is our opinion based on the current “Well-Known Fact”:

Buy quality U.S. stocks with balance sheet strength and powerful brands.

Assume that Treasury interest rates will rise dramatically in the next two years.

Assume that recently hot sectors like commodities, oil, international/emerging market and gold will be dead money in the “Next Great U.S. Stock Market.”

Assume the largest self-help and psychological counseling group in the U.S. in 2010 will be made up of the folks who sat on low interest rate money market and “cash is king” investments at the end of 2008 and watched a once in a lifetime fire sale in America’s finest companies pass them by.

Lastly, if we don’t currently manage money for you and your portfolio doesn’t line up well with this advice, don’t waste time getting the dust off your feet before you call us.

Best Wishes,

William Smead

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

Stocks

As we saw from June 30th to now in the price of Oil, price is a great regulator of price. Stocks are way down, having dropped the most in October since the crash of 1987. An abundance of selling supply coming from hedge fund liquidations, margin calls, mutual fund redemptions and individual stock owners (reaching their pain threshold) has overwhelmed the few lonely buyers. Most of the selling is being done in panic. The lonely buyers are people like corporate insiders and value-oriented, patient investors like Warren Buffett, John Neff, Marty Whitman and us at Smead Capital Management. Supply is high, demand is nil and prices are low.

Treasury Bonds

Demand is the highest since the 1930’s as investors want U.S. Government assurance of payment of principle and interest. Sellers are lonely and prices are high. Watch out though, because the Federal Reserve and Treasury are looking to massively increase supply as they trade Treasuries at high prices for preferred stock in depressed banks and out-of-favor mortgage loans.

Real Estate

Lonely buyers are coming out of the woodwork at lower prices to snatch up bargains in California, Nevada, Arizona and Florida on short sales and foreclosures in an ocean of supply. This bubble, which broke at the end of 2005, is now being bottomed as the media misses the law of supply and demand. The media rails about huge drops in housing permits, starts and sales. These are a big supply reducer and leaves buyers shopping among the existing supply.

Corporate and Municipal Bonds

Investors are so scared that they don’t trust state and municipalities. Lonely buyers are seeing the biggest spreads to treasury bonds since the 1930’s and supply is contracting fast.

Money markets/Cash/T-bills

These are the world’s most popular investments. There are hardly any lonely sellers and there is currently the world’s biggest army of buyers. Money-market prices are at record highs and interest rates at or near 70-years lows.

Commodities

This asset class was hotter than a pistol from 2003 to four months ago. However, price regulates price and that rule is no exception in the price of oil, grains, basic materials and other commodities. Supply comes out of the woodwork and alternatives become very attractive. I would expect this asset class to be dead money in the “Next Great U.S. Stock Market.”

I remember being a lonely seller of Tech stocks in late 1999 and feeling incredibly foolish as I talked to unhappy clients who were watching their rabid neighbors get wealthy overnight on the latest Initial Public Offering (IPO) of common stock. Supply was exploding and buying was frenzied. We are at the exact opposite today. Sellers are dumping the best companies with the brightest futures and there are virtually no IPO’s. As the “Motels” sang in 1982, “It’s like I told you, only the lonely can play.”

William Smead