William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

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

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

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

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

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

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

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

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

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

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

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

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

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

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

The information contained in this tv appearance represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this tv appearance do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

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

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Dear Clients and Prospective Clients:

In a recent interview on CNBC, Morgan Stanley Smith Barney Chief Market Strategist Tobias Levkovich talked about the “Mythical Argument” that consumers are never going to spend again. The thesis is that the behavior of consumers will be permanently changed as a result of the depth and length of this recession. In turn, high levels of unemployment could decline doggedly. High sustained levels of unemployment and large over-hanging consumer and government debt could serve as a force field, preventing meaningful real economic growth for years. Leading proponents of this argument are Bill Gross (PIMCO) and Jeremy Grantham (GMO). Tobias argued that their argument is so ingrained in existing portfolio management actions that it just might be a myth. At Smead Capital Management, we believe we are positioned to do well in that environment. We believe our large-cap recession-resistant brand name companies could thrive if that argument holds water.

However, we must constantly harken back to the idea that “When everyone knows’ something to be true, nobody knows nothin’”. Belief in the “weak economy for years” argument has caused a huge amount of U.S. investor capital to chase commodities and worldwide infrastructure investments. These investors are going where they think the economic growth is going to be and want to protect themselves from whatever inflation comes from the policy decisions made to avert an economic depression and come out of this recession. There are some big problems with their approach. First, the BRIC trade or idea that the economic world will be led by the emerging markets of the world peaked last year (2008) in a bubble. Bubbles take a minimum of 5 to 7 years to correct and many times take as long as 10 years or more to return as a profitable concept. Therefore, if history is any guide, Oil, commodities and emerging markets could be dead money for a number of years.

Second, even if emerging market economies do lead us out of this recession and into a period of prosperity, they may not be a good place to invest. Franklin-Templeton’s emerging market strategist Mark Mobius said on Bloomberg recently that an enormous amount of new shares of common stock will be issued as Chinese companies go public in the next five years. Fast growing nations and their economies can be capital absorbers, rather than capital multipliers. How can this be so? When our nation’s residential real estate markets and economy boomed between 2002 and 2006, capital was drawn away from most stock market sectors. Basic materials, commodities and heavy industrial stocks gained capital and affection, while most other sectors suffered capital withdrawals. Individuals have been massive net sellers of U.S. equities since the peak of the market in early 2000 when they held $10 trillion of individually owned shares. At the recent March of 2009 lows, that figure was close to $5 trillion. The economic growth absorbed the capital and the same thing could happen in China. It happened in the U.S. as we built the railroad system in the second half of the 1800’s. Our nation grew immensely and spread westward, but we absorbed massive capital and much of it never got paid back to the countries like Britain and France which loaned it to us.

I will say the unspeakable. From the “reset” levels of the 2008-09 contraction, consumers could make a consistent comeback as they become convinced that our system will continue to succeed and gasoline isn’t going to cost $4 per gallon or higher. If the idea that American consumers won’t make a comeback is a “Mythical Argument”, what could happen the next few years? Unbelievable profits could come out of the income statements of lean and mean corporations. What would a year-to-year sales gain of 5% do for the profits of Nordstrom, Starbucks or WalMart? How much money could Home Depot make if people quit worrying about their job and the price of gas and started fixing everything that is wrong with the home they want to live their life in? What if all the kids who want to go to Disneyland and DisneyWorld get to go next year? What if you could have a good economy for years without building up debts in the process? What if this cleansing of the last two years really worked and we ended up with one of the best long-term economies we’ve ever had?

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

Printable Version
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Click here to listen to this Missive

Dear Clients and Prospective Clients:

Paul Lim is a business writer for the New York Times and he had an interesting thesis in his article on July 19th entitled, “Picking Winners in the Next Bull Market”. He correctly acknowledged that it would be highly unusual for the leading sector of the previous Bull Market to lead the next one. For this reason, he advised hesitation on an urge to chase the emerging markets and those companies (like oil) which benefitted most from the last bull market. We can give you numerous examples from our 29 years in the investment business which back up his thesis.

From the 1974 low of 550 on the Dow Jones Industrial Average to the 1983 high around 1200, technology companies with fast earnings growth were popular. This wave crested soon after Apple and Genentech went public. Investors wanted fast growth to offset double-digit inflation rates and handed out high P/E ratios to those fast growers. When Paul Volker broke the back of inflation through tight credit and President Reagan stood down the Air-Traffic Controllers in late 1981, the game changed. Inflation began to decelerate and investor interest moved away from these popular names. Technology stocks spent seven to eight years in the dumper during a Roaring Bull Market which took the Dow to 3000 by 1990. The high P/E ratios came back to haunt investors.

Paul used the example of the Tech stocks leading the Bull Market which peaked in early 2000. The next Bull Market started in late 2002 and just like today, some of the best early gains came from the last Bull Market’s leaders—Technology. It was a head fake. Energy and emerging markets turned out to be the big winners. Microsoft, Cisco and Intel skipped the last Bull Market for the most part.

More important to us is who could lead the next Bull Market in U.S. stocks. To understand which groups might be the best place to be you have to ask what were the characteristics at the bottom of prior market lows of the leading sector. First, they were out of favor. This is primarily from poor stock price performance, but also usually because of bad news incorporated in their stock prices which they have no control over. The sector to buy at the 1982 low was consumer staples. The stocks were depressed and they were about to gain the economic benefit of commodity prices dropping dramatically. Lower input prices expanded profit margins and earnings. Coke, Pepsi, Kraft, General Mills, General Foods and Beatrice Foods were some of the names that lead that 1980’s Bull Market.

Second, to be the leading sector of the next Bull Market it helps to be the center of attention of the worst things that happened in the prior Bear Market. Banks and Savings and Loan institutions couldn’t have been any more out of favor coming out of our national financial crisis between 1988 and 1992. They were despised for being the heart of the problem which caused the first President Bush to not get re-elected because it was “the economy, stupid”. With Enron and the collapse of energy trading in 2001 and 2002 leading the Bear Market down, it was only natural that energy-related stocks bottomed at such depressed prices that they were a powerhouse for stock buyers from 2002 to 2007.

Third, and most importantly, the Bull Market’s leading sector offered its future success at a huge discount to the future success of other sectors and the market itself. We measure this by comparing P/E ratios and dividend payout ratios to the market overall and to the sector compared to the last 30 to 40 years. In other words, to find good long-term sectors to roost in, you try to buy the most future success for the least amount of money. What a novel concept!

Which group or sector fits these characteristics today? We believe the drug stocks are an obvious candidate. They have some of the lowest P/E ratios they’ve had in 20 years and they pay way above average dividends to the market. Their stocks have been poor performers since 2001 and they have the threat of socialized medicine breathing down their neck. Ironically, we also believe they are a great way to play the economic growth in emerging markets (see our missive “Playing Emerging Markets”).

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.