William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

While China’s economy is hitting the wall and investors are beginning to deal with what we believe is a major bear market in commodities, it is time to stop and examine some of the bargains created by the recent correction.

We have said many times that valuation matters. We believe one of the biggest bargains currently is Aflac (AFL). They are the largest seller of supplemental health insurance in Japan and the US. Japan and the US are probably the two countries which would benefit more from a decline in commodity prices than any others in the world. Aflac sells at 7.5 times 2011 First Call consensus earnings estimates and has dropped from a high of $58 per share earlier in the year. It appears to us that Aflac’s stock price takes a dive every time that Greece and other PIG countries dominate the economic news cycle. Aflac has a huge international bond portfolio. A tiny percentage of that is in the weaker European countries. While investors mope about these concerns they are ignoring a powerful positive force in the US. As health insurance costs rise for businesses, deductibles will go up. As deductibles rise and the expense gets too great, companies will offer Aflac’s supplemental health policies in their benefits package. If Aflac has the same kind of success in the US they’ve had from rising deductibles in Japan, it could be huge.

We have argued for two years that Ebay continues to be the most underrated success story in the US. Marked improvements in their marketplace business are causing an acceleration in earnings. This is happening at the same time as PayPal is growing revenues at the rate of 20-25% year to year. We believe that the in-store payment system in the US is going to get revolutionized in the next five years. PayPal’s growth is yet to include being a major payment player at physical stores. With the experiences and technology advantages they have from the online world, we believe they will get their fair share. Ebay trades at 14.5 times operating earnings for calendar 2011 First Call consensus. This doesn’t include the $5 per share in cash on the balance sheet. They have wisely harvested Skype and gained further entry into the intersection of the virtual and real economy by purchasing GSI Commerce.

Our sum of the parts analysis of the company looks like this:

Disney’s First Call consensus estimates for fiscal 2011 and fiscal 2012 are around $2.56 and $2.99. Do you have any idea how many kids have had trips to Disneyworld and Disneyland postponed by the economic cleansing of the last three years? We believe oil prices will decline in the next year and lower gasoline prices could unleash pent-up demand for Disney vacations similar to what happened in the mid 1980’s. The stock has been under pressure as worries about a settlement between the NFL owners and players has been slow to happen. In our opinion, there is probably more certainty of where Disney is going in the next twenty years than any company in the US. This certainty should mean a premium multiple of 18 times the $2.99 per share earnings estimate or around $54 per share. We look for a big ramp up in dividends in Disney as well as many of our other companies.

After the original economic disappointment, we feel China’s slowdown will be the best non-government stimulus package ever invented. We believe the upcoming commodity bear market will usher in a great era for non-cyclical US companies and a sustained period of non-inflationary prosperity.

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:

In a Gallup Poll last week, 75 percent of Americans said the nation’s biggest problem in their mind was an economic problem. Precious metals and most commodities have hit records in the last six months. At an institutional investor conference we presented to last week, the participants championed risk reduction strategies using either highly illiquid, risky private equity, emerging market equity and debt offerings. Or they bragged about loading up on a commodity index, commodity ETFs and/or gold and silver. Some were puffed up about diversifying away from China by pursuing “Frontier” stock markets in Pakistan, Indonesia and other unsavory places. The pinnacle was my nephew telling me that he had purchased five ounces of silver recently at $50/ounce. He’s 19 and it was his first attempt at speculative risk.

We at Smead Capital Management feel compelled to make a US stock market bullish case which feels as good to this writer as avoiding tech stocks did in late 1999. It is so lonely that it is divine. Andy Grove, former Intel CEO, said that the best advice he ever got came from his City College of New York professor. He said, “When everyone knows that something is so, it means that nobody knows nothin’.” John Maynard Keynes said, “Investing is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.” We have travelled the country over the last two years, spoken at CFA Societies, presented to numerous institutional, consulting, RIA and financial advisor organizations. We believe the majority has put their assets into investments that will provide defeat, insecurity and failure. Out of this knowledge comes a very optimistic bull case which is available to those who have the courage to look foolish in the short run and avoid today’s popular asset allocation.

Large cap growth stocks received the highest PE ratios in US history in the late 1990′s as the world crowded into the 25 most popular tech stocks. As large cap fund managers got deluged with money pulled from every other asset class, they attempted to reduce risk by bloating the PE ratios of large-cap growth names like Pfizer, Merck, Colgate and Clorox. At 40-50 times earnings and with the majority piled in for the ride, these mature company stocks were doomed for 10 years. Other asset classes were starved for capital and you could have thrown darts at them back then. Only a small minority had the courage to flee the crowd and widely diversify into other asset classes. Harvard’s endowment did, as did Warren Buffett. He stopped buying individual US stocks and sought to protect his capital by buying whole businesses and removing his large capital base from the judgment of public markets.

The investments which were wise in 1999 and were owned only by the small minority of investors, brought victory, security and success. Unfortunately, it is 12 years later, and the same asset allocation that was wise in 1999 is now the majority, and is unwise today. These trades are so crowded that it has reached the deserts of Africa, the jungles of Indonesia and the Westfield Mall near my hometown of Washougal, Washington. To understand the bull case, you need first to believe that today’s popular asset classes are doomed to ten years of misery and those companies, sectors and countries which benefit from their misery could produce immense relative and solid absolute performance.

I am very fortunate to have been taught by my Econ professor that economics is a lot like physics. For every action there is an equal and opposite reaction. What will happen to make emerging markets, precious metals, oil, farm commodities, natural resource based countries, and US stocks in the energy, basic materials and heavy industrial areas turn incredibly sour? Lipper reported last week that April 2011 was the 23rd consecutive month of net liquidation of US equity mutual funds. This occurred in one of the biggest up moves in 23 months in US stock market history. What could reverse the direction of these flows?

The linchpin of the bull case is the violent economic contraction about to occur in China. We will not bore you with a rehash of prior missives, but let it be said that they have deceived investors into massively over-capitalizing these popular asset classes. China’s growth is behind all the over-confidence in every market I’ve mentioned. When the fact that China is hitting the wall becomes more clear, wide asset allocators who don’t take what I’ve written seriously will sit for ten years in misery, in our opinion.

Out of this comes the bull case. The US economy has spent four years cleansing itself. We’ve recapitalized our banking system by recognizing over $1 trillion in losses. We are foreclosing and short selling billions of dollars of real estate. Housing is the most affordable in 60 years. We are learning to live inside our means and US households are close to Household Debt Service Ratios similar to 1982 and 1992. These were the start of five-year prosperity periods where the Gallup Polls showed numbers like they are today. We are in control of the keys to the virtual reality economy and have all the best companies who are helping us to maximize interactions between the virtual and real economy. Think Ebay/PayPal, Apple, Facebook, Linkedin, Groupon, Fedex, UPS, Amazon, etc. We feed the world, keep it secure, invent a large part of the best medical science and share productivity/higher living standards with anyone who wants to interact honestly with us. Our greatest days are ahead of us.

We are all frustrated by how long this cleansing is taking. What will trigger our next great prosperity period is a collapse in commodity prices and a reversal of all the misery which asset allocators are set to profit from, but missed by ten years ago. Less money leaving to pay for oil and the repatriation of emerging market money will set off a bull market in the American dollar, in our opinion. The rising confidence will force short-term interest rates up. Businesses will be rewarded for how they participate in our bright future and how well the business throws off free cash flow. Capital intensive industries and countries will see profit margins plunge as they are in no position to produce free cash flow unless commodities are soaring and China is building projects which have no rental income!

We are playing the bull case by over-weighting consumer discretionary powerhouses like Disney, Nordstrom and Cabela’s, domestic financial heavy weights like Franklin Resources, Wells Fargo and Berkshire Hathaway and over-weighting the geniuses of medical science like Merck, Amgen and Mylan Labs. We at SCM can’t wait to get to the future because we are in a lonely minority and making the bull case nobody wants to even admit to.

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:

I’ve seen West Virginia’s Men’s Basketball team play four times in the last two weeks. The first time was live at the Big East Tournament and the last three in the NCAA Tourney on TV. Close observance of them has helped us at Smead Capital Management to be even more excited about our investment discipline.

West Virginia has quality players. These players are molded into a team by a hard driving coach, Bob Huggins. But what got them to the final four is that they run their offense. They not only run it, but they actually set the screens that are required. I have been a rabid basketball fan for over forty years and can’t remember better picks being set. They are wearing out the other teams physically and getting much easier shots in the process.

To us at SCM, this speaks to the fundamentals of successful investing. Buy quality common stocks and do it inside your circle of competency. Let the businesses operate for years, executing the kind of business plans which can be built on for decades. Do it in businesses which sell products and services again and again and again.

Setting a good screen is 90 per cent effort and 10 per cent talent. Finding a coach and players willing to do it is unusual, but could be done by anyone truly committed.

Think of companies we own like Starbucks, Disney, McDonalds and Walgreens. They provide products and services in the same clean and consistent way all over the US and around the world. They wear out the competition through branding, balance sheet strength and scale in the same way the Mountaineers have done through well-placed screens and consistent defense in this tournament. We at SCM like those kind of fundamentals on our side.

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:

The floating bridge between Seattle and Bellevue in Washington State is being rebuilt and will be paid for by tolls. The Narrows Bridge between Tacoma and Gig Harbor crossing Puget Sound has been rebuilt and folks are paying a toll to cross back and forth. I paid for toll privileges in the rental car when I was in New York in May visiting clients. You can’t pass back and forth without using these roads and, therefore, the lock you have on the customer and your pricing power are immense. Warren Buffett used to talk a great deal about toll bridges among companies and why it makes for a great business.

A toll bridge company is one which everyone or a great number of people must cross or do business with and the best ones require very little labor and additional capital investment to maintain. It can be a utility in nature like electricity, phone, prescription drugs or cable service. Or in today’s world it can be ESPN or internet search or an internet payment system. At Smead Capital Management we believe that toll bridge companies are being underestimated in the current market. The primary reason for this underestimation is the time frame which most investors operate, the worldwide scope of today’s toll bridges and their connection to technologies/futuristic nature.

Toll bridge companies typically involve receiving a small amount of money from millions or billions of people for a long time. They are most rewarding to investors with long holding periods. Since the New York Stock Exchange reported recently that the average holding period for stocks traded on its exchange had fallen below one year and since that is the lowest figure since the late 1920’s, we can safely assume there are very few real long-term buy and hold investors out there today. Since there are few long-term investors and very little money demanding these types of investments, we can also assume there are very few people analyzing toll bridge aspects of a business which would lead to long duration success. Under those assumptions, it is safe to assume that there is drastically less than normal demand for the common stock of these companies. Toll bridge companies have a tendency to produce very high levels of free cash flow, have wide moats (barriers to competition) and are shareholder friendly (stock buybacks and dividend increases). It means the supply of common stock shares have a strong possibility of declining. If anything happens to cause a normal or higher level of demand for longer-term investment in common stock, higher prices could follow.

Toll Bridge companies are underestimated because of their worldwide scope. PayPal serves the world as the most popular payment system on the internet. Billions of transactions will pay them a small toll. Most humans have only had 5 to 10 years experience buying and selling online. It is safe to assume that as the population ages and today’s tech savvy twenty something’s become the Mom’s and Dad’s of the future that online transactions could grow exponentially around the world. It is hard for even me to wrap my mind around that fact. It is even harder for investors with 6 to 12 month time frames in mind to even care about considering this. ESPN (80% owned by Disney) controls almost every fan of US sports in one way or another. They have Monday Night Football, the World Series of Poker and mountains and mountains of College sports programming. And they don’t have to pay most of the actors and actresses. In the World Series of Poker the actors and actresses pay $10,000 each to act for free! ESPN then rebroadcasts the main event over and over and over much like Disney resells cartoon movies made by artists from decades gone by without any additional production expense. Like Jack Nicholson’s character said in As Good as It Gets, “the fact that I understand this makes me feel good about myself.”

The best toll bridges might be passing people my age (51) by because they have emerged in the last ten years and have new technologies connected to them. Most of the respected value investors in this country are over the age of 50 and more than likely are not regular users of the future’s best toll bridges. I have never personally bought or sold anything on Ebay. Cloud computing sounds to me like something that requires use of psychedelic mushrooms. Ordering whatever you want to watch on TV at exactly the time you want to watch it probably makes a great deal of sense to Brian Roberts, CEO of Comcast, but matters very little to multibillion dollar money managers who read annual reports for a living and live and die by how they do each quarter. Roberts is buying what we believe are deeply undervalued entertainment assets to add to his toll bridge in cable service and high-speed internet access. Short-term oriented money managers and investors think he is a fool for doing it.

In conclusion, we are excited about the long-term potential of investing in toll bridge companies and believe that underestimation equates to undervaluation.

Holiday 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 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.