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.

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:

In an article in Saturday’s Wall Street Journal, Jason Zweig asked the question, “What will it take for companies to unlock their cash hoards”? At Smead Capital Management, we’d like to expound on his thoughts and examine our own portfolio under the magnifying glass presented.

Zweig dealt with the key facts. First, companies with large cash balances are adding to them. Second, payouts are historically low as he showed through this research:

“Meanwhile, the payout ratio—the proportion of earnings paid out as dividend income to shareholders—fell to 28.9% for the past four quarters. That, says S&P senior index analyst Howard Silverblatt, is the lowest level since 1936.”

Third, the point has probably come where the best interests of corporate management and the shareholders are at odds. Zweig zeroed in on Ben Graham’s thoughts in regards to why big companies that generate high levels of free-cash flow are hesitant to return cash to shareholders. He intimates that larger business managers seem to think that their slowing growth can be dealt with by acquisitions. With depressed stock prices, the cheap currency is cash. Just look at the money market fund interest rates at major investment firms and banks. The rate is almost zero. Why would you want to make an acquisition with stock at a 6-10% earnings yield when you can give up .01% return on cash?

Graham provided three solutions to this problem. He said that shareholders must pressure management to return the cash to shareholders. He urged companies to set up a formal dividend policy. This would be a certain percentage of profits to be paid out in the form of dividends. Lastly, Graham urged companies to pay out 67% of earnings in dividends. Here is how Zweig explained it:

“Finally, Graham advocated that leading companies should pay out two-thirds of their earnings as dividends. That rate isn’t as radical as it might sound, even though it would amount to more than a doubling from today’s levels. The dividend payout, as a percentage of total profits, has averaged 52.3% since 1936 and 46% over the past two decades, according to Standard & Poor’s.”

Silverblatt estimated for Zweig that a 50% payout ratio would put an additional $207 billion into investor’s pockets and raise taxable income for the US Treasury. It would be a stimulus package without government intervention and it would happen every year going forward.

How would Zweig’s thesis affect our portfolios and some of our individual companies? At the end of the first quarter of 2011, we concluded that 23% of our company’s after-tax income was being paid out in dividends. We have three criteria among our eight proprietary criteria which speak directly to this issue. Our companies must generate high levels of free-cash flow, be protected by wide moats for long duration business consistency and have strong balance sheets. Therefore, we believe our companies are in a much better position to raise dividends than the average company. On a portfolio basis, a growth in dividend pay-out ratios to 46% would mean an immediate doubling of our dividends. If our earnings grew by 7% per year for 10 years and our pay-out ratio was 46% at the end of the 10 years, our dividends would quadruple. This is only something to think about in a relatively low turnover portfolio where an investor could be likely to own many of the current holdings for a decade.

We are involved in a number of companies which should be pestered by shareholders. Some have shown improvement by starting a dividend for the first time like Amgen or by raising their dividend significantly like Microsoft or Franklin Resources. One of our portfolio companies, Ebay, was kind enough to take 30% of the $8.5 billion paid to buy Skype that came from Microsoft’s balance sheet. In our opinion Ebay could easily pay a dividend with their massive free-cash flow, but so far has chosen to not pay a dividend. Microsoft has been much more interested in pouring our dividends out through losses they manufacture in their online division. They lost more money last quarter in that division ($726 million) than they had in revenue ($648 million). Microsoft tells us dividend hungry investors that they will make those losses up on volume.

We have been impressed by how Starbucks has handled the subject of dividends. When the company’s restructuring and slower store growth exposed their massive free-cash flow in 2009-10, Howard Schultz set a substantial initial dividend. He also announced an ongoing dividend policy of a 35-40% payout ratio going forward. Ben Graham would love that kind of attitude toward shareholders.

We believe that our eight proprietary criteria finds companies with the kind of cash hoards that Jason Zweig described. They are in a position to follow Ben Graham’s advice. We also believe that income hungry investors have been too scared to trust the attractive income possibilities created by rising pay-out ratios. As this phenomena plays out and pressure to disgorge these cash hoards occurs, we’d like to think that our portfolios will get an above average share of these rising income streams.

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.

The information contained in this article 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 article 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.