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.

The information contained in this tv appearance 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 tv appearance 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:

Stock market participants seem to be having a great deal of difficulty handling temporary economic weakness. This weakness is highly likely to be a combination of higher gasoline prices and the disruptions that supply chains suffered at the hands of the Japanese Tsunami. We are not surprised by this temporary weakness and if it hadn’t been caused by this combination it would have come to pass anyway.

In our opinion, 2011 is the year that the US economy will move away from export-led growth in manufactured goods. US manufacturers have been the biggest beneficiary of the weak dollar. The Federal Reserve’s policy of keeping short-term rates at nearly zero has made capital intensive manufacturing companies the darling of growth in the US economy. These low interest rates have triggered dramatically higher commodity prices in both soft and hard commodities and provided the ammunition to financial advisors, RIA firms and institutional investors to chase emerging market growth. Ironically, most of the emerging market growth of the last three years has been due to higher commodity prices and China’s massive construction spending.

China’s massive construction spending has caused hard commodities to rise in price. Professor Michael Pettis has provided a list of major commodity inputs and showed that many of them saw the Chinese economy use around 40% of what was used in the world in 2010! In turn, US manufacturers of construction equipment, mining equipment and oil-producing machinery have never seen better sales growth and profit margins. Higher soft commodities have produced a “nirvana” environment for US farmers and farm equipment manufacturers. In parts of the Midwest and the farm belts of states like California and Washington, this is the best of times.

The problem for the US economy is that the vast majority of Americans live in states like Ohio, Pennsylvania, New York and Florida. The folks in those states are seeing their gas and food budgets get busted and don’t have enough manufacturing or farming prosperity to offset the misery. Or they live in California where the long commutes and debilitated housing market outweigh the farming boom between Redding and Bakersfield in the central part of the state.

Where are we going and where does this transition lead us? First, Barry Bannister from Stifel Nicolaus showed us the chart of rolling ten-year commodity returns over the last 200 years. Commodity prices have never been hotter than in the last 10 years and a glance at the chart helps you see what a statistically freakish point this is! These circumstances have been perfect for commodities. The largest populated nations (China and India) in the world have grown uninterrupted for the last 10 years. Thanks to the massive lending binge in 2009-2010, China skipped the “great reset” recession and their confidence and political necessity have led them to the limits of what an investment-driven economy can do. Even as most of the developed world shrank, the commodity inputs they use in their economy rose to boom levels.

Source: Stifel Nicolaus March 9, 2011 report “World Energy Price, Economic Growth, and the
Financial Setting of Agri-Business”

Second, the major credit analysis firms (Fitch, S&P and Moody’s) are reviewing China’s credit rating for downgrades. They are doing this because history has shown that the transition from an export-led economy to an investment-led economy never ends in a consumer-led economy without some recessions and depressions occurring in the process. The US was the most successful emerging economy in history. It grew 9% per year on average from 1800-1900 and we had 15 recessions and 4 depressions during that stretch. It means that the US economy contracted regularly for 100 years and created a consumer economy in the process. It is the opinion of Smead Capital Management that China’s economy will contract in the next two years. For all anyone knows, it could be contracting right now! When China hits the wall, the entire game and worldwide asset allocation will be turned on its head.

According to Standard and Poor’s Analyst, Scott Sprinzen , “A ‘sudden’ slowdown in China may lead commodity prices to fall as much as 75 percent from current levels.” He theorizes that commodities would trade close to their cost of production, which is 25% of the current prices on average. The commodity price decline would be less, Sprinzen says, depending how much the Chinese economy slows down.

All this leads us to a transition to the pent-up demand for everything from cars to homes to travel in the wealthiest nation in the world. The US has 310 million people who have enormous incomes and still are the largest economic engine in the world. These folks have postponed forming households, buying homes and getting on with their life waiting for this commodity boom and religious belief in emerging markets to come to a miserable conclusion. They have worked hard to get their income statements and balance sheets in order and paid for the banking system to get recapitalized. Commodity prices coming down and investments being repatriated could cause a booming domestic stock market and one of the best eras the US dollar has ever had!

How can we say these things and do so with confidence? We will quote the Scottish investor, Hugh Hendry, who said this recently:

“If you want a definition of safe harbour, safe investment, I think it only has safety if it has a degree of contentious nature to it. That’s why I worried, there’s nothing contentious in wanting to short treasury bonds, there’s nothing contentious in wanting to short the dollar… Religion is a function of repetition and a passage of many many years. 10 years is effectively sufficient to create a cult, a cult of belief, in capital markets. And we’ve had 10 years where the dollar has sucked. And the opposite of that, is antithesis: gold has been phenomenal. You have, 10, count them, 10, 10, 10 consecutive up years in gold… it’s not contentious. Emerging market is not contentious. The formidable strength of the Chinese is not contentious.”

Therefore, our discomfort and enthusiasm for US consumer discretionary companies, high-quality financials and major medicine makers could lead us to unusual performance relative to other stock market participants over the next 3 to 5 years. It will be because we went to where the tough transition is taking us, regardless of what goes on in the short run.

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:

Kairos (καιρός) is an ancient Greek word meaning the right or opportune moment (the supreme moment).

The world of value investing and portfolio management includes mean reversion and patience. Speculative episodes typically go on for much longer than expected. This fact forces us at Smead Capital Management to take a stand by avoiding overvalued common stocks and owning undervalued shares for a period of time before the marketplace chooses to recognize capital misallocation. Everyone would love to make their adjustments at the “Kairos” or supreme moment when that which is over-priced begins to tumble and that which is undervalued starts catching a bid.

We believe that the greatest existing misallocation of capital in the world today is based on over-confidence in the uninterrupted growth of emerging markets. The BRIC trade, as it is affectionately known, has impacted a speculative episode in emerging markets (debt and equity), currencies, precious metals, oil and other commodities, exchange-traded-funds (ETFs), cyclical companies in the heavy industrial and basic material sectors and small/mid cap outperformance. China is 9.4% of world GDP and 19% of the world’s population, but as China Business Professor Michael Pettis shared recently, here is China’s share of global demand for various commodities:

• Cement demand represents 53.2% of global demand
• Iron ore = 47.7%
• Coal = 46.9%
• Pigs = 46.4%
• Steel = 45.4%
• Lead = 44.6%
• Zinc = 41.3%
• Aluminum = 40.6%
• Copper = 38.9%
• Eggs = 37.2%
• Nickel = 36.3%

Since most equity portfolio managers are all too familiar with career risk, they hesitate to walk away from owning the popular parts of the marketplace. Think of how difficult it has been for us in the last year to be heavily under-weighted energy stocks as they rose 40% in the six months ended Feb. 23, 2011. This was only the sixth time in 70 years that the energy stocks had done that well. How do you indentify the “Kairos” or supreme moment for pursuing the mean reversion that the statistics tell you are inevitably coming?

We use watershed events and the writing/public pronouncements of smart people. In this way we pay attention to the kinds of things which have happened or have been communicated at other major change points. Below is a partial list of recent watershed events:

• Caterpillar bought Bucyrus International
• Glencore (the world’s largest commodity trader) is attempting to go public in May
• The Texas State University System announced massive physical gold holdings
• Silver prices went parabolic with the silver ETF trading exceeding the trading on the SPY (S&P 500 Index)
• Cargill is spinning off Mosaic (maker of fertilizer)
• Massive inflows into emerging market mutual funds in 2009-10
• ETF trading dominates exchange volume
• Open interest on US commodity exchanges is higher than at the 2008 commodity peak
• CNBC and Bloomberg devote their TV time to commodities and macro-economic news and thought

We could go on, but you get the idea. On the smart people side of the ledger has been famous short-seller, Jim Chanos, who calls China’s use of infrastructure investments as the “Treadmill to Hell”. Maintaining economic growth by over-investing in unneeded buildings and infrastructure ultimately leads to the recognition of bad loans and a poisoned banking system. Chanos is no longer alone in his opinions.

The Financial Times has brought forth the ideas of UBS Economist Robert Magnus and Deutsche Bank Strategist John-Paul Smith. Magnus refers to China’s investment-intensive growth model and exogenous circumstances as pushing it toward what Magnus calls a “Minsky moment”. Minsky warned that the process of leverage always culminates in instability. Magnus asks, “Could China be flirting with a similar outcome?” Here is how he (Magnus) describes what has been going on there:

“What China calls ‘total social financing’ – conventional bank loans and most other external sources of finance – was still 38 per cent of GDP in the first quarter of 2011, almost as high as in 2009 when China implemented a credit-centric stimulus programme. The credit intensity of growth, or the amount of new credit generated for each unit of CGDP growth, has risen from 1-1.3 before 2009 to 4.3 in 2011.”

 In other words, it is taking nearly four times as much borrowed money to fuel GDP growth in China in 2011 as it did in 2009. The “Treadmill” has sped up, to use Chanos’ metaphor.

John-Paul Smith is more focused on emerging markets in general. He argues that inflation and how it is dealt with in emerging market countries like China will lead to grief. He explains that they are very slow to deal with the inflation problem and are more prone to use government interference in industry. In Smith’s view, this will cause US companies to be much more nimble going forward. Magnus backs up Smith by examining where China is in the credit cycle. He argues on an inflation-adjusted basis that China’s “real” interest rates are the lowest in 13 years. They are way behind the curve and their catching up process could coincide with the ramp-down of their capital intensive real property binge.

Here is the irony of where we are today. We can’t say that this is the Kairos moment or the Minsky moment. We believe that we are seeing the kind of watershed events and comments from smart people which have been seen at other pivotal times in capital markets. Magnus says, “A Chinese Minsky moment would hit global growth and resource markets and shock the consensus.” In our opinion, the risk-reward relationship has worked its way to favoring those of us who are betting that the “Kairos” or “Supreme Moment” is not far off.

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.

The information contained in this tv appearance 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 tv appearance 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.