William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

At Smead Capital Management we have decades of investment experience starting as early as 1980, and have read the US economic history which we didn’t live through ourselves. In a recent research piece, Barry Bannister, Equity Investment Strategist at Stifel Nicolaus, has exposed the US economic history of speculative episodes in commodities over the last 200 years. Let me be the first one to tell you that we believe that this is a massive bubble and will end as badly for investors as the other speculative excesses have.

Bannister charted commodity performance by looking at trailing ten-year results. He found that this current episode is the best rolling ten-year performance in the 200-year history of commodity investing in the US. His charts also showed that if it follows history, this boom lays the groundwork for a bust even bigger than the busts that followed extremely high ten-year returns before.

Source: Stifel Nicolaus Macros & Portfolio Strategy, March 9, 2011

Mr. Bannister and his research cohorts were thinking clearly because they looked at long-term equity performance vs. long-term commodity investing performance and noticed that the 240-year trend clearly favors equities (see chart below). The longer the history, the more equities out-perform. This is despite occasional counter-secular trends like our current episode. Bannister shows that this episode is very similar to previous commodity investing infatuations. Here is how Bannister explained it:

“This “Paper Assets vs. Hard Assets” trade looks like it is reaching its outer limits, and may reverse direction in a typical long cycle, with stocks outperforming commodities. Centuries of data support the view that commodity production is a price-taking, high fixed cost, capital-intensive, cyclical industry, and that stocks, in contrast, magnify the intellectual capital of human ingenuity.”

Source: Stifel Nicolaus Macros & Portfolio Strategy, March 9, 2011

Allow us at Smead Capital Management to rephrase this in simpler terms. We believe owning common stocks with long holding periods is a positive sum game where economic growth leads patient investors to a profit well above frictional costs. Commodities at their best are a zero-sum game where a loser is matched evenly with a winner. At worst, and most of the time, high frictional costs make it a highly negative-sum game. At best, commodity investing is a poker game at home. At worst, it is being played at a casino where the rake is substantial. We believe it is not a coincidence that the world’s largest commodity trading firm (betting casino), Glencore, is attempting to go public this month.

How did Bannister explain the devotion to commodities which has been established with investors? It is the same explanation at the rabid stage of any speculative episode: the rearview mirror. Investment committees and momentum investors look at what has done well and what it would have meant to have been invested earlier in the hot category. Late in the cycle the feverish urge is met with Wall Street’s open arms to provide the adoring masses with simple and direct participation in the hot category. In the late 1990′s Tech Bubble it was sector mutual funds and Initial Public Offerings (IPO’s) of Dot-Com companies. This time it is IPO’s like Glencore, Youku and DangDang. It is also a completely pervasive binge on Exchange-Traded Funds (ETF’s) which give you direct exposure to all the hottest momentum trades in commodities and all things BRIC-trade related.

What is the end game to all this? We believe it all dies when there are no bigger fools and there is nobody left to buy. We will be the first to admit that we can’t know when this fever breaks, although we believe that it has a great deal to do with the US ending its emergency-oriented monetary policy. At the point when there are no more “bigger fools”, things not only stop going up, but there is virtually no bid going forward on the way down. Just check the charts of everything from Cisco and Juniper Networks to Amazon and F5 Networks from March 10, 2000 to the end of 2002 to see what the misery could be like in these commodity markets, in our opinion, when they break.

Therefore, copper, cotton, coffee and gold are no different today, in our eyes, to a dot-com company with a great story surrounding it in 1999. The Internet was going to change our lives and so is uninterrupted growth in China. However, dot-com companies did have some possibility of being a positive sum game, while these “dot-commodities” we feel can only benefit from someone else’s misery or by making the receiver of the frictional costs wealthy. You are officially warned!

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:

After 31 years in the investment business, I have come to the conclusion recently that we have become a nation of risk adverse people being led by a risk adverse group of financial industry professionals. What would the US have been like if many of the best minds in the country had always been devoted to reducing risk or risk mitigation?

British citizens moved to the American colonies in the 1700’s. After an extended period of time, these pioneers became frustrated by taxation without representation. Good risk mitigation would have argued for seeking political representation in England and possibly going long an exchange traded fund (ETF) which would appreciate if taxes rose. Why on earth would you want to give up the protection of the most powerful nation in the world with the most powerful navy? Instead, we fought the Revolutionary War with an undermanned army led by a General (Washington) who had wooden teeth and wore a wig full of lice.

Once the US gained its independence, people were fool hardy and began to settle in the wilderness of America. My great-great-great-great grandfather and grandmother settled in Southeastern Indiana in 1796. It was called Indiana because it was controlled by Indians. They were allowed to buy property soon after for $3 per acre by an Act of Congress in 1805 called the Dufour Act. In other words, anyone foolish enough to risk their lives to settle there was given favorable terms. Today’s advisors would point out that the Case-Schiller Index of property prices indicated that prices can fall lower and that settling Indiana wasn’t a good idea because of the risk they were taking.

In the 1850’s, strategic asset allocation would have argued the virtue of having one area of the country with legal slavery (the south) and one slave free (the north). The best financial move was to live in the North and stay long cotton futures in case slavery ended up being a bad business proposition. Why fight about it in the Civil War (1861-1865) and kill roughly one out of every twenty US males in the process? An ETF could have been created to be long the part of the country you disagreed with to reduce overall risk.

Germany and Austria declared war on Europe in the summer of 1914. It became a World War. The US sent its “Dough Boys” over in 1917 and the Allied Armies defeated Germany to the tune of millions of dead soldiers. When Pearl Harbor was bombed in December of 1941, we entered World War II. We sat by for years and watched a totalitarian dictator (Adolf Hitler) oppress millions of innocent people and left our strongest allies (Britain and France) hanging on the edge of destruction. To reduce risk and save our soldiers lives we could have invested in the German stock market double long ETF. Imagine how much more profitable German companies would have been had they held control of Europe! Why would you want to risk American lives in those situations?

Today, investors mitigate risk by investing in a country with a totalitarian communist political regime which prevents political, intellectual and religious freedom. This regime must present the façade that the GDP growth in their country is uninterrupted. In the process, China’s strategy has driven the price of commodities like Oil, Copper and Cotton through the roof. Investors hedge their risk by owning commodity index ETFs. If the 1.1 billion people in China who aren’t benefitting from “Red Capitalism” get exposed to the downside of capitalism (bouts of recession and depression), they might realize that there isn’t opportunity for those outside the political and military ruling class! Good risk management argues that we shouldn’t be the ones to tell them. Who cares if the myth the Chinese are perpetuating and the massive over-capitalization of the BRIC trade is probably the biggest hindrance to US economic recovery?

Almost three trillion dollars sit in money market funds and US investors are over-weighted in bond funds at the lowest interest rates in fifty years. Sophisticated investors and institutions screen constantly for minor statistical advantages with trillions of dollars. They also go the extra mile to avoid the possibility of the next 2008 stock market meltdown. We are very excited about the fact that our country was made great by taking risks and betting on the future. We are even more excited about taking risks on outstanding companies and avoiding ones that would appear to be popular due to the current risk aversion. At Smead Capital Management, we think folks should be excited to take good risks, just like our ancestors did and spend a little less time, money and energy on risk mitigation.

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 Fellow Investors:

At a recent institutional investor conference one of the speakers was the economist and chief investment officer of a major institutional investment consulting firm. He recounted that in late 2008 his firm recommended that institutions overweight commodities. This was based on all of the liquidity provided to the financial system around the world by governments seeking to combat the deflationary affects of the deep recession. He went on to say that his firm was staying with that over-weighted position as of December of 2010 despite how successful the strategy has been. From there he described how anemic this economic recovery in the US is compared to past recovery periods following deep recessions. Slow GDP growth, persistently high unemployment rates and virtually no contribution from home building led him to believe the economic recovery would remain anemic. Why would this respected firm stay with the commodity over-weight position?

This got us thinking about other times in history when there was a big disconnect between commodity prices and US economic activity. Commodity prices boomed in the late 1970’s as the US wrestled with stagflation in the presidential term of Jimmy Carter. Back then an army of baby boomers were forming households and having children. The demand for real estate and most other product categories far exceeded the supply. The US economy could not provide jobs fast enough to the waves of high school and college graduates to prevent high levels of unemployment. The industrial revolution was dying (Allentown) and the information technology revolution had not yet replaced it. Inflation was the national bugaboo and investors adapted by spending the decade of the 1970’s moving out of stocks into “inflation beneficiary” investments like gold, real estate and other commodities. Most historians believe it came to an end when Fed Chairman Paul Volcker tightened credit enough to produce a 21.5% prime interest rate and President Ronald Reagan stood up to the Air Traffic Controllers Union in 1981.

Why does the US have late stage economic boom commodity prices with an anemic economic recovery? At the margin, commodity prices are where they are because of the uninterrupted economic boom in China and the non-economic asset allocation decisions of institutional and individual investors. China has grown at very high rates for over a decade and they have convinced otherwise sensible investors that they are the first capitalist economy in history which can figure everything out ahead of time. Most institutions have invested in commodity indexes as a passive way to participate in commodities. In this way, they are adding capital to this asset class without regard for any differentiation among the individual commodities. It reminds me of the faith in indexing executed through the S&P 500 Index back in late 1999. It was over-weighted in Technology back then in much the same way that most of the commodity indexes are over-weighted Oil today.

Since it is China’s boom driving the psychology of the investor attitudes about commodity investing, you have to look at where China is in their business cycle. They have moved from an export driven economic growth model to an infrastructure/real estate building model. They have accelerating inflation, 40% year over year housing price increases in its largest cities, unaffordable housing in relation to average annual household income and universities pumping out graduates moving to the cities to find no jobs to match their skills. They’ve built so much infrastructure already that they have the world’s largest and emptiest mall and a number of ghost cities sprinkled across the country.

It so much reminds me of Phoenix, Arizona back in 2005. The Chinese economy is strong because residential real estate is smoking hot and the residential real estate market is doing well because the economy is doing well. Real estate market participants in Phoenix, who had the most to gain from housing prices moving up as much as 47% in 2004-2005, told us not to worry. They could see what they thought was a never ending stream of retirees moving there from cold weather states. In China, it is the peasants moving from rural farms to the major metropolitan areas. The theory is they will move there to get jobs in manufacturing and continue to provide their economy with cheap labor.

China’s economy is like a game of musical chairs. First, you remove the export growth chair. Then you remove the real estate chair and finally economic growth has no place to sit down.

All of this wouldn’t matter if China wasn’t already tightening credit to deal with the potential social unrest from rising inflation. They have been raising reserve requirements and central bank interest rates, but trying to do it in a mild enough fashion to attempt to engineer a soft landing. The average price of residential real estate in China was 8.2 times average household income at the end of 2009 before 2010’s big run up. At the peak in 1990, Japan’s housing bubble burst at 8 times household income and peaked in the US at 6 times. History would argue that the bigger the bubble, the harder the landing. China’s real estate bubble looks like five-year old children playing musical chairs with tall bar stools.

When it comes to over-extended markets and economies, our job as value investors is to determine whether something will happen and not be as concerned with when. Despite not knowing when, in our minds, it is only a question of how many months before the credit tightening becomes aggressive in China. This puts us closer and closer to a Paul Volcker style replay in commodity markets. Gold and Oil dropped 70% from the 1980 peak to the 1999 low. It was the definition of a bad long-duration asset allocation.

Therefore, here is our recommendation: Avoid all China-related stocks, commodities, basic materials, emerging markets and countries which have benefitted the most from China’s uninterrupted growth. Prepare for the US economy to benefit from lower commodity prices over the next 3-5 years as those essential ingredient prices match up with our slow economic recovery. Lastly, always remember to flee investment momentum which divorces itself from underlying economic fundamentals.

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
Subscribe to the Missives Podcast
Click here to listen to this Missive

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

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