William Smead
Chief Executive Officer
Chief Investment Officer

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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.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

Found in the old testament book of Genesis in chapter 6 is the story of Noah and the flood. God is described as “very angry” with the behavior of the people he created and instead of eliminating everyone and everything he chose to extend grace to a man named Noah, his wife, sons and their spouses. Once God chose Noah he gave him marching orders to build an Ark. This huge boat was to be 450 feet long, 75 feet high and 45 feet tall. Noah and his three sons obediently spent over 100 years building the Ark and explained to people that they needed to turn from their wicked ways and join his family in the boat.

This might have been the most difficult task ever set in front of a mortal man in history. There is no evidence in the first five chapters of the bible that it had ever rained before. Life spans were very long in Noah’s time (600-770 years), but it took about 20% of his life to build the Ark. Noah had no formal religion or community support mechanism surrounding him and his family. He had to be the ultimate contrarian and perform the whole time as if he were going to be right all along. When the flood finally receded and Noah was vindicated, God provided a rainbow as a sign that he would never drown everyone again and as a reminder to his people.

At Smead Capital Management we formed a company two years ago based on a series of things we believe about investing. We are building a mutual fund and separate account management business at SCM which is our Ark. Here are ways that we believe our work is similar to Noah’s task:

1) It hasn’t been easy to make money in stocks since early 1998 and that is equivalent to not raining for a long time.

2) Many retired investors wonder if they have the time to invest in the project.

3) The percentage of market participants who are actually long-term buyers and holders of good quality securities has become a small minority of overall participants.

4) Some financial institutions and some households are drowning in the lending and borrowing sins they’ve committed over the last ten years.

5) Aspects of our stock picking discipline which have generated big advantages over long periods of time have temporarily been postponed by the worst bear market since the 1930’s.

6) The economy that follows the aftermath of this economic and stock market flood could be more pleasing because market participants will be more humble and less debt ridden. This reduces economic swings going forward and makes us all more vigilant of the behaviors which caused the problems in the first place.

Unlike us, Noah didn’t have 24 hour news coverage of his project and massive amounts of information on the outcome of current human behaviors multiplying on the internet. His critics probably started out numerable, but lost interest quickly and had very little power to sway public opinion. Besides, he looked nuts right from the beginning. Our critics grow more numerous as time goes on even though all recorded economic history shows that time is a great healer and investment results revert to the mean. We at SCM are looking forward to our rainbows in the stock market over the next five to ten years when we believe the doors will open to the “Next Great U.S. Stock Market”.

Warm Regards,

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

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Dear Clients and Prospective Clients:

Reverse psychology is a terrific tool for those of us who fear success. I was a college golfer at little Whitman College in what is now the NCAA Division III level. Our handicaps ranged from about 2 to 10 and for most of us it was a good day if you broke 80 on the links. We had won the conference championship in May, but thanks to a wonderful summer job ($8/hour and lots of overtime) wrapping rolls on the paper machines at Crown Zellerbach, I played very little golf that summer. My wife was my girlfriend back then and she also worked the summer in the paper mill. We worked opposite shifts most of the time and had a very poor social life that summer. As a reward to ourselves, we decided to quit a week early and go up to Vancouver, B.C. and Victoria on a week vacation before I headed back to Walla Walla for my junior year of college. The day after I terminated work and two days before we were to leave for our trip was the Orchid Hills Golf Club Championship in my hometown of Washougal, Washington. It was a 72-hole two weekend tournament which I’d had no success in before. I told Becky that I would play the first weekend and then drop out and not play the following weekend. By now you can guess what happened. I was so relaxed that I shot 74 and 73. I was tied for the lead and would have to cut our one week trip to five days to be back for the final 36 holes. Becky was steamed.

The U.S. stock market had its third best week since World War II last week and our phones have either gone bad or investors have been stopped in their tracks. A large number of investors have sought shelter the last year from our “Abusive Parent” (search “An Abusive Parent” at www.smeadblog.com) and sit in money-market funds, t-bills, CDs and savings accounts. The amount in cash relative to stock market capitalization is twice the level of any bear market low of the last 40 years. The silence is deafening because the stock market could have a run like I had the first weekend of the Club Championship and most of the people on the sidelines will not re-enter the market until huge gains have occurred. Financial and Drug stocks led the way last week and it wouldn’t surprise us if the Drug stocks lead the next great bull market. If you are under-invested, our phone lines are open.

P.S. Just for the record, I shot 77 & 78 the second weekend and ended up in 3rd place in the golf tournament.

Best Wishes,

William Smead

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:

At Smead Capital Management we are strong believers in owning high-quality recession-resistant common stocks and holding them for many years to create wealth and meet economic needs. Normally, the finest of the U.S. banks are a great way to make dividends and ultimately see capital appreciation. However, the current efforts on the part of the U.S. Treasury to stabilize our financial system seem to be having a detrimental affect on the common stocks of exactly those banks which the Treasury wants to build our financial system around. We are adjusting to this new reality and let me explain.

One of our eight criteria for selecting companies is shareholder friendliness. Is the company allocating capital, paying and/or raising dividends, buying back stock and making effective acquisitions in a way that is friendly to shareholders? In the case of a JP Morgan or a Wells Fargo, the answer to that question in the past has been absolutely. But in the new environment of Treasury intervention their past record appears to be breaking down. When the Treasury is giving you money to invest and wants you to loan it out, can you buy back stock when a lousy market environment drives your stock price lower? When a current negative feedback loop exists in the economy where one company’s layoffs lead to layoffs of others companies, doesn’t that put further loan write downs at the bank in position to make it hard to pay the dividends? When this all played out at Washington Federal Savings and Loan here in Seattle recently, it was a warning shot across the bow. Nobody has been more conservative about lending, credit quality and expense control than Washington Fed, but they were asked to take TARP money and cut their dividend soon after by 76%.

The problem is we are using for-profit institutions to produce goals for a non-profit institution and the companies are being run for the social good rather than for the shareholders. Investments in these great companies are being diluted and the rewards for their survival and future prosperity are being pushed out further into the future. This is because they aren’t being controlled by outstanding management people like CEO Jamie Dimon or John Stumpf, but rather have had control put in the hands of the U.S. Government. We are re-researching all of our financial companies to see if these dynamics are in force and could be detrimental to our capital over the next 12 months. With a plethora of great companies which meet our eight criteria available out there and unaffected by Treasury intervention, we think the opportunities could work in our favor until the time comes when we can understand the affect on shareholders and management friendliness of this new business model.

Best Wishes,

William Smead