William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

You have to love the GEICO commercials that run on television. Whether it is the little piggy going “wee, wee all the way home” or Randy Johnson throwing snowballs, they seem to strike our funny bone. A recent one is a spoof of the popular antique show from PBS where folks bring collectibles and have them valued. A lady brings a ceramic hand with a bird in it. The gentleman looks at her in all seriousness and announces that it is worth “two in the bush”. The lady that owns it is very happy to get that premium valuation.

The US stock market has been handing out some very tough lessons to investors over the last ten years and, in our opinion, most participants are missing one of the more important of these lessons. Are you ready? A bird in the hand is worth two in the bush. For the owners of a business or partial ownership through publicly traded common stock, it is better to receive cash each year from the company over and above the cash flow that is reinvested into future company growth. In an article titled, “A Reality Check”, Marketwatch columnist Mark Hulbert draws on research which proves this point very accurately. His article refuted a popular theory which states that low dividend payout ratios should contribute to higher corporate growth rates.

“In fact, as I mentioned in my column earlier this week when discussing Cisco’s decision to initiate a dividend, there is some evidence that companies with higher payout ratios also have higher earnings growth rates. One of the first studies in this regard appeared in the January/February 2003 issue of Financial Analysts Journal: “Surprise! Higher Dividends = Higher Earnings Growth,” by Cliff Asness of AQR Capital Management, and Robert Arnott of Research Affiliates.

This finding ran directly counter to the long-standing theory, and has subsequently been subjected to additional scrutiny. Yet the result has been replicated. Another study, for example, which appeared in the January/February 2006 issue of Financial Analysts Journal, looked at 11 foreign countries’ stock markets and found that, just as had been found to be the case in the U.S., “higher payout ratios do indeed lead to higher real earnings growth.”

At Smead Capital Management (SCM), we have many reasons for believing that stacking up cash on the balance sheet of companies is not a contributor to faster growth or intelligent acquisitions. The first reason is obvious to us. How many executives of major corporations would be hired for their skills at common stock analysis or as economists? We would like to think that they are great leaders and quite possibly most have the gifts of administration. However, it is unlikely that they have asset allocation skills like Warren Buffett or Jack Welch. Secondly, consider basic human motivation. When a company is fat and happy are they more or less likely to make good capital allocation decisions. Lastly, when resources are scarce, folks have a tendency to be way more motivated. I trained young stockbrokers in the 1980’s at Drexel Burnham Lambert and we were glad when the young brokers took out a mortgage. Remember, necessity is the mother of invention.

In his prior column on the Cisco Systems dividend announcement, Hulbert wrote the following:

“I base this counter-intuitive claim on a famous 1986 article by Michael Jensen, who now is an emeritus professor of business administration at Harvard Business School. Writing in the May 1986 issue of the prestigious American Economic Review, Jensen predicted that companies would be less efficient to the degree they hoarded cash above and beyond what was needed for current operations.

The reason? That cash too often burns a hole in managers’ pockets, and they end up doing a poor job of investing that cash — engaging instead in foolish pursuits like empire building. These perverse incentives exist, according to Jensen, because “growth increases managers’ power by increasing the resources under their control.”

With the thought in mind that dividends have made up as much as 46% of very long-term returns in US common stock investing, let’s put our view of current circumstances together.

1. The balance sheets of US public corporations are loaded with cash
2. As the economy slowly recovers over the next five years, free cash flow will grow
3. Dividend payout ratios have room to rise
4. As demonstrated in the bond market, investors are hungry for income
5. Aging developed country populations need income

We believe companies which grow their dividends the most could very well attract a great deal of capital. To grow your dividends you need growing levels of free cash flow and plenty of room to raise your payout ratio. You also need the humility at the top and in the corporate boardroom to realize that the other shareholders of your business are better at figuring out what to do with their “bird in the hand” than you are. It is likely significantly better than the “two in the bush” expected from earning paltry interest or paying ridiculous premiums for acquisitions. At SCM, free-cash flow is one of our main criteria and we think you will rarely see our portfolio with a lower current payout ratio than now.

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:

Morningstar did some neat fund flow analysis recently which was picked up by a column written by Mark Hulbert on MarketWatch called, “Active vs. Passive”. In it he described how fund flows had moved toward passive or index investing among US equity funds and away from active managers in the last ten years. The amount of US equity assets which are indexed grew from 12% to 22% of the total pie. Theoretically the more that investors or their advisors index, the more likely active managers would be to gain the upper hand over passive investments in the S&P 500 Index (scarcity creates value). Unfortunately for the active managers, this was not the case as only 20% of active managers beat the market over the ten years. In the article, Hulbert concluded that all the added advantage that active managers might have received from greater passive participation was dissipated or offset by the increased portfolio activity (turnover) of stock mutual fund managers. At Smead Capital Management, we think these results and information are important to contemplate because it sheds light on what it means to be a wise contrarian investor in early 2010 and in the future.

The S&P 500 Index has obvious built in advantages over active funds. As a benchmark it has no management fee. Therefore, throughout the year the index will gain the advantage of not paying a management fee of .50%-1.00%. The active managers automatically have to overcome this difference through better performance. Second, there are no operational costs associated with the index. In the actively managed US equity fund universe this adds up to an average of 1.31% per year including the management fee. Third, the index has very low turnover historically. This means that trading costs and bid and asked spreads do little to reduce the returns of the index. Lastly, the S&P 500 Index is a market-capitalization weighted index. It means that the S&P 500 Index holds its winners to a fault while allowing the duds (like General Motors) to run their stock price into the ground. At SCM, we believe this is one of the index’s biggest built in advantages over active managers. The math is that you can make 10 times your money on a big winner, but you can never lose more than 100% of your money on a stock going bankrupt.

Academic research has shown repeatedly that long time periods allow value to get recognized in the marketplace. Eugene Fama’s work on efficient markets at the University of Chicago focused on low price to book value. Others like Bauman, Conover and Miller as well as David Dreman have shown clearly that buying the lowest P/E ratio stocks has soundly beaten the market averages if measured over a ten year or longer time frame. This shows that long durations produce better results for both passive and active investors.

Ben Inker, research director at Grantham, Mayo and Van Otterloo (GMO), exposed what is wrong with the high level of activity and portfolio turnover at the average actively managed fund. His work shows that 75 per cent of the current intrinsic value of a stock comes from cash flows earned more than 11 years from now. Why are short term business prospects receiving most of the professional investor attention when company durational success should be their focus? Ironically, in 2009 the average holding period for a stock on the New York Stock Exchange dropped below a year for the first time in 70 plus years. Not only have fund managers been more impatient, but individual and institutional investors have been as well! On top of all this is the fact that dividends and dividend increases make up a substantial part of long-term returns produced by participating in US equity investments. The average investor doesn’t stay around long enough to collect an entire year of dividend payments.

Let’s put this wonderful band of players together and see what we come up with. When stocks do poorly for a decade, investors are motivated to try to compact duration or holdings periods on stocks to gain an advantage. In the process they cede success to the S&P 500 Index. And by being impatient and too active they fail to take advantage of the kinds of under valuations provided by cheap stocks. We believe these advantages include dividends, dividend growth and companies with long duration business characteristics (wide moats and strong balance sheets).

It appears that good stock selection, with an eye on low PE’s and long duration business characteristics could be very successful for the patient US equity fund manager. It also appears to be quite contrary to the popular view and methodology of active managers in 2010.

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.