William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

moat/mōt/
Noun:   A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.

At Smead Capital Management our investment committee talks and thinks about the moat of a business a great deal. Based on the definition above, we believe that a wide moat is provided by the aspects of the company and their business which prevent competition from damaging highly sustainable profitability. Wide moat is one of our eight proprietary criteria for selecting common stocks. We have seen a number of organizations begin to include logic associated with moats into their equity research formats. Unfortunately, we believe many market participants confuse the by-products of a moat with the actual moat itself. We think this spells opportunity. Looking for stocks with a wide moat that are priced as if they don’t have one adds to the advantage of the long-duration common stock investor.

I read recently that after years of trying and millions of dollars invested, Google (GOOG) is considering folding Google Wallet and Google Checkout together. When it was announced five years ago, Google Checkout was thought by some to be a potential “PayPal killer”. PayPal appears to have successfully defeated one of the largest cash-rich, wide-moat companies in the world from getting into its secure, online payment castle. PayPal’s moat includes over 100 million existing customers, consumer brand recognition and nearly a decade of statistical information on transactions. Google has the same kind of moat in search that PayPal has in payments. The economic need that PayPal meets is identification privacy and ease of transaction facilitation. It’s a huge market and will grow tremendously in the next ten years. We believe as Google admits defeat, it will mean that the moat at PayPal is so strong that it can’t be overcome by massive financial resources and tech savvy. Google had both of those merits.

PayPal is a wholly-owned subsidiary of Ebay (EBAY). Ebay has a wide moat in its core marketplace business. Ebay is one of the most recognized brands in the world and most of its advertising is free thanks to the lock it has on market share for pre-owned items. When an athletic milestone is reached, the ball or puck or jersey is expected to immediately be offered on Ebay. Sportswriter’s frequently mention this fact in their writing. When Michael Jackson dies, his memorabilia becomes an instant hit on Ebay. This moat makes the low-risk, high free-cash flow nature of Ebay’s original business nearly impregnable. After backing out the cash net of long term debt, Ebay trades for 11 to 12 times the 2012 consensus earnings estimate. It is very unusual to see a fast-growing, wide-moat business trade for anything short of a premium to the S&P 500 Index multiple.

The symptoms of a wide moat are things like high, sustainable profit margins, huge market share, pricing flexibility and long histories of these identifying characteristics. However, the symptoms are not the moat. The moat causes the symptoms. Walgreens (WAG) is one of the two largest drugstore companies in America. Their properties dominate the best locations in the US, their brand recognition is the highest in the industry, their real estate ties up very little of the company capital and they have decades of experience in customer needs and satisfaction. Their financial muscle puts them in position to buy Duane Reade and walk away from Express Scripts. A college buddy who did extensive research on the subject told me that one out of every two Americans will never get a prescription filled outside of the walls of a drugstore. Walgreens castle is being attacked by a disagreement over pricing with Express Scripts and their moat is very busy defending the company. We think it will succeed.

HR Block (HRB) has spent the last ten years fighting off the attacks of Jackson Hewitt and Liberty, two tax prep companies started by former HR Block employees. My favorite test for a moat is putting 100 people through a survey. You ask them, “What is the first thing that comes into your mind when the surveyor says tax preparation”? Almost everyone will say, “HR Block”. If the question was online payments, it’s PayPal. If it is, “where do I find pre-owned items, or sporting event tickets?” the answer is Ebay. If the question is, “who do I trust to entertain my children and spouse?” it is Disney/ESPN (DIS). If the topic is coffee the answer is Starbucks (SBUX), burgers it’s McDonalds (MCD), retail service and selection it’s Nordstrom (JWN). The moat in business is about deeply, rooted competitive advantages which business cycles can’t uproot. It is about a love affair between a company and an addicted customer base which grows as population grows.

Warren Buffett was asked by the Financial Crisis Commission what one single characteristic he looks for in a business. He referred to the stickiness of the customer and the company’s ability to raise prices without affecting unit sales. We feel the moat of the business is what protects the ongoing success of a business even when legitimate competition comes along. It is what is behind wonderful long-term profitability and high levels of free cash flow. Moat analysis is not about number crunching, it is about mind-space control and forces which block or kill competition.

Lastly, we at SCM are value investors. Something very difficult has usually had to happen to open the door for us to get a good entry price on common shares of a wide-moat company. Ironically, in many cases, the temporary reason for the disfavor actually increases the size of the wide moat. Big pharmaceutical companies have had the most hostile political, regulatory and legal environment in the industry’s history the last four years. Major drug stocks have seen blockbuster products lose their patent and the combination of the aforementioned forces have brought many drug stocks down to the lowest PE quintile (bottom 20%) in the S&P 500 index. Instead of doing permanent damage to companies like Merck (MRK), Pfizer (PFE) and Bristol Myers (BMY), these circumstances have increased the depth and width of their moat. It is estimated that a new drug costs over one billion dollars to create and bring to market. Nobody besides these large pharma giants can afford to fight the battle. This high original investment threshold has turned the biotech industry into mostly farm teams feeding the major leagues. Smaller drug and biotech firms do research for creating wonderful new health science and are forced to hand it off to someone with deep pockets and an international manufacturing and sales force. Now that companies like Merck and Amgen (AMGN) are having great success with new products, the naysayers can begin to recognize how incredibly well defended these companies are from competition going forward. We believe they have wide moats.

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 are owners of both EBay (EBAY) and Amgen (AMGN). We believe the dividend policy and price action in the shares of these two companies can teach us about stock price performance over the next three to five years.

History shows that for a few decades after terrible stock price performance (like we’ve seen from 1999 to 2011) investors demand more of their return from cash dividends because they do not trust appreciation. In the 1940’s and early 1950’s, investors demanded a higher cash dividend from stocks than they demanded from Treasury and Corporate Bonds. Treasuries yielded around 2% in 1950 and the Dow had around a 6% yield from dividends. However, in the aftermath of the 1929-32 crushing bear market in stocks and massive bank failures which followed, public companies hoarded cash. Howard Silverblatt at S&P reports that the payout ratio in 1936 of US public companies was 29%. Ironically, in our opinion, we are in the same kind of circumstance and have the same kind of payout ratios today. See our June 1st, 2011 missive called “Cash Hoards” to understand the history more fully. Click here for missive.

Last summer, Amgen was trading in the low $50’s on a per share basis and had never paid a dividend as a public company. Amgen declared their first ever cash dividend at $.28 quarterly last summer. Since then, they did a Dutch auction, buying back 9% of their shares and raised the dividend to $.36 per quarter. Amgen’s first ever dividend was a higher yield on share price than the 10-year Treasury bond yield! I have been in the investment business for 31 years and can’t ever remember an initial dividend offering more than the 10-year Treasury interest rate. We believe it is no coincidence that Amgen is trading above $64 per share on December 29, 2011. At the $1.44 annualized dividend rate, it yields around 2.23%, still significantly above the Treasury bond yield.

Amgen still has a payout ratio below 30% and has massive free-cash flow. They could be an aggressive dividend growth company going forward as we believe their balance sheet is strong and the future earnings look bright. Their newest product Denosumab is selling briskly in the form of Prolia for Osteoporosis and Xgeva for treating cancerous tumors. Management seems to have learned what scared investors want from a company.

At the end of June in 2011, EBay closed at $32.27 per share. We believe they have a fortress balance sheet. Their PayPal division is growing like weeds and throwing off massive free-cash flow. Their legacy Marketplace business has turned the corner and is growing nicely, while continuing to throw off over a billion dollars in free cash flow. EBay is buying back stock, but they don’t pay a dividend. The stock was trading between $30 and $31 per share in the last week of 2011. Investors can’t help but like the operating results of EBay’s management team, but they are too scared from the last 12 years of non-existent price appreciation to bet on it alone.

Silverblatt pointed out that the historical payout ratio over the last 50 years is 52.6% and over the last 20 years it was 46%. At Smead Capital Management, we believe that the companies which raise their dividend payout ratio towards the historical averages from the position of strong balance sheets, wide moats and relatively non-cyclical earnings performance will enjoy the kind of outsized price gains that Amgen has seen in the second half of 2011. Hopefully, EBay will get the memo.

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:

Louis Zamperini was an Olympic distance runner who finished eighth in the 5000 meter race at the 1936 Olympics. His story is chronicled by Lauren Hillenbrand in her book, Unbroken-A Story of WWII Survival, Resilience and Redemption. Zamperini’s promising athletic career was interrupted by the Japanese attack on Pearl Harbor on the seventh day of December in 1941. What happened to Louis can give us some perspective on the endurance and perseverance needed to succeed in what have been very difficult investment markets.

Louis was a B-24 bombardier. In 1943 his plane was shot down on a mission south of Hawaii. He and two other crew members survived against long odds floating on a life raft for 47 days. When they drifted 2000 miles west, they were captured by the Japanese Navy and shipped to a prison camp on the Island of Kwajalein. It was the beginning of a 30-month ordeal in numerous prison camps where he and his mates withstood horrendous torture. The most outlandish punishment came from an officer named Watanabe who the prisoners called, “The Bird”.

The Bird knew that Louis was a famous athlete and that he was very disciplined and well trained. He singled him out for especially egregious beatings in hope that it would affect the entire group of prisoners. By the time the war was over, Louis was emaciated, deeply wounded and suffering from post traumatic stress disorder. He woke up every night dreaming about being hit with the belt buckle or bat held by Watanabe. Zamperini was miserable.

At Smead Capital Management (SCM), we feel like we’ve been in an investment prison camp. First, we were shot down by the 2007-2009 Bear Market and held on to our companies like they were a life raft. We survived, but our portfolios were in pretty rough shape when the bottom came in March of 2009. Since then our portfolios have recovered. Unfortunately, few investors, either individual, professional or institutional, can find the courage to buy these wonderful companies when there could be the most to gain longer-term from employing our eight proprietary criteria for stock selection.

It is not unusual for our contrarian stance to be shunned, we’ve been in this position many times. However, in the spring of 2010 and the summer of 2011, we have been beaten indiscriminately and unmercifully by the Flash Crash and Sovereign Debt Crisis, respectively. About the tenth time you’ve been punched in the face by the “risk on, risk off” trade or beaten with an algorithm bat through “high frequency” trading you begin to lose some of your dignity like Louis Zamperini did in the prison camps.

As a 31-year veteran of Wall Street, I am well adjusted to regular temporary stock market corrections and occasional bear markets. History shows that most years include at least one decline of 10 percent or greater and that a 20 percent or greater decline happens about one out of every five years. What frustrates us as long-term holders of businesses like Disney, EBay, Merck and Franklin Resources is that there is virtually no respect shown to their superior attributes in these declines of the last two years. The result is that our companies are exceedingly cheap, in our opinion, compared to other stocks and other asset classes.

As if being punished in the investment prison camp isn’t enough torture, we have to stand by and watch the love affair investors are having with Treasury bonds and gold. It is as if a group of war prisoners are being put up at the Ritz Carlton while we join Louis eating seaweed and bug-infested rice. If two percent interest on Ten-Year Treasury Bonds and $1900 ounce gold succeed as investments these next ten years, we believe we’ll have much bigger problems than stock market performance. Grab your guns, ammo, rations and water.

Our wonderful companies already average a higher dividend percentage than the rate of interest on the Ten-Year Treasury did at the close of trading on September 6th, 2011. They trade at very low multiples of earnings and free cash flow. The dividend growth over the next ten years could provide adequate comparative returns to other asset classes without much capital appreciation. In today’s investment prison camp the dividend payout ratio on the S&P 500 Index is the lowest since 1936 at around 29 percent. As people and companies get out of the investment prison over time, we believe those payout ratios will gravitate toward historical norms around 50 percent. This means that a portfolio trading at ten times after-tax profits could easily pay a five percent dividend in the not very distant future.

By now you are probably wondering what happened to Louis. After three years of struggling with alcoholism and PTSD, Louis was dragged to a Billy Graham Revival in 1949 by his wife, Cynthia. He remembered that he’d promised God on the life raft that if He saved them he would devote his life to God. Louis started a major ministry to wayward teens and spoke all over the world about endurance and perseverance. He also forgave The Bird and his other tormentors. The PTSD miraculously went away.

We at SCM are prepared to forgive the hedge fund whiz kids, ETF flippers, algorithm traders and doomsday gold bugs who are making our investment life temporarily miserable. We expect to lead a large group of wayward investors over the next ten years to enjoy long-term ownership of high quality common stocks. All this is possible if we remain “unbroken”.

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:

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.