William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

I’ve always felt very fortunate to have received a solid education at Whitman College in Walla Walla, WA. In Micro- and Macroeconomics, we studied marginal supply and marginal demand. In calculus, we learned the mathematics surrounding the rate of change occurring at the margin. We learned that producers and their competitors produce until marginal profit moves to zero. What was so important about the things which happened at the margin?

We at Smead Capital Management have been pondering the interview Jim Chanos did with Charlie Rose on April 12, 2010. He explained to a very frustrated Mr. Rose that the seeds of a credit driven bubble in the commercial and residential real estate markets in China are about to burst. This will happen, he explains, despite the best efforts of the communist government to combat the bubble and ultimately deal with the effects. In this “treadmill to hell”, Chanos shows that the bubble in real estate there is as egregious as the subprime bubble we had in 2005-07 in the US.

However, to make money from these phenomena unwinding, Chanos is not placing most of his bets against Chinese companies. When asked by Mr. Rose what he is selling short, Chanos said, “But probably more importantly from an investment point of view this has implications for the people selling stuff to China, commodity, people – anything that are selling things to people who put up high-rise buildings, cement, glass, copper. That’s where you’re going to see probably a step function down in demand – steel, because right now it’s all going to China.” To understand why he is shorting commodities and commodity producers to benefit from a dramatic slowdown in GDP growth in China, you have to understand how important demand at the margin is to the market price of copper or steel or oil. Un-interrupted GDP growth in China and India has been at the forefront of investor confidence in commodities and emerging stock markets. Therefore, at the margin, massive quantities of worldwide capital are committed to these investments. This commitment is tied to un-interrupted growth and could disappear very fast. Chanos says, “And then there’s this precarious tipping point where suddenly you can’t sell a project. And then it’s just as if everyone from the port side of the cruise ship goes to the starboard side of the cruise ship all at once.”If institutional investors felt that marginal demand for commodities was going to be impacted by an economic slowdown in China, you could get an outsized move down in commodity prices. Like when the tech stock bubble died, you’d suddenly had no bid.

We at SCM can give you two recent examples of similar phenomena. From 2001-2005 in Phoenix, you could see how the residential and commercial real estate booms were affecting the overall economy at the margin. We estimated that as much as 30% of the economy of Phoenix was tied to the building, financing, selling and maintenance of commercial and residential real estate. Prior to demand disappearing at the margin in 2006, there were an amazing number of vehicles driving around Arizona highways with contractor logos on the side. Today, you have to look vigilantly to find logo-laced trucks associated with the building and maintenance of homes. The Phoenix economy cratered when home prices cratered and commercial properties followed right behind.

In the fall of 2008, toxic loans on the books of the major US financial institutions created a panic and total stock market meltdown. At the margin, retail sales fell 10% on a year over year basis by the end of 2008. In turn, purchases not being made at the margin triggered lower sales and profits at companies all over the country. Massive nationwide layoffs ensued as producers, distributors and retailers adjusted to the change in demand. The unemployment rate in the US rose from around 5% in 2006 to over 10% in 2009. Most folks didn’t lose their job, but at the margin everyone’s behavior was impacted by the folks that did. Remember, the vast majority of everything that went on in the US economy in 2008 did go on in 2009, but at the margin everyone moved to the other side of the boat.

Chanos claims that 50-60% of the GDP of China is tied directly to residential and commercial real estate. When investment capital sees a slowdown in construction, it will cause the same kind of loss of confidence in the commodity and emerging market thesis, at the margin, which we saw in Phoenix in 2006-07 and we saw in the US economy in 2008-09. As in everything in economics, some will benefit and some will lose. We like US large capitalization recession-resistant “quality” stocks as defined by our eight criteria and would avoid commodities, commodity producers, commodity exporting nations and construction-related heavy industrial companies. Remember, most of what went on before will still go on, but at the margin is where the confidence is set or lost.

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 Clients and Prospective Clients:

At the start of the year, we at Smead Capital Management predicted that 2009 would be like 1988. In the aftermath of the 1987 Stock Market Crash the market thrashed around violently in both directions before settling at the end of the year with about a 10% gain counting dividends. People had to put up with a great deal of volatility to earn that gain in 1988 and we felt that 2009 would look similar. We are halfway through the year and 2009 appears to be 1988 on steroids. The down swings and upswings have already been huge, but the stock market is about where it started the year.

We also have felt that the economy would begin to grow again once we got past the massive “reset” in consumer spending which started in September and October of 2008. Spending figures are typically measured against the prior year. We have continued to believe the year over year retail sales comparisons will be positive in the fourth quarter of this year as compared to the economic coma figures of late 2008. The stock market is an anticipatory vehicle and we expected that the market’s rally would begin six to nine months before the economy improved. It did in fact bottom around March 9th or six to seven months before the consumer spending reset turned one year old.

There have been some big surprises for us this year and those surprises are a big part of the market’s recent pullback. We believe that the economic “reset” is going to become the kickoff of an era of slower growth and unwillingness on the part of the average consumer to take on debt. In this slow and consistent era we expect a substantial premium to be placed on the companies which perform well despite the new environment and borrowing reluctance. In the prior era, investors basked in the belief that the growth in emerging market countries like Brazil, Russia, India and China would drive worldwide growth, thus placing a premium on the production and distribution of natural resources like oil, basic materials and fertilizer. These cyclical industries out-performed the market from 2004-2008, got clobbered from the second half of 2008 into the new year and came roaring back in the rally off of the March bottom.

If we are right and investors resign themselves at some point to the new environment, the normal premium for strong balance sheets, brand recognition and consistency of customer base should be reestablished. This means lower P/E ratios for cyclical businesses and higher P/E ratios for companies that meet our strict 8 criteria. What normally is highly valued by investors will take its usual place in the hierarchy of common stocks. We believe this current correction in the market is the beginning of a flow of money away from investor attempts to revive the BRIC trade. We expect to move toward a premium for large quality blue chip companies with relatively non-cyclical businesses. We wait patiently.

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:

As the first four weeks of a powerful upswing in the stock market unfolds, we thought we would use a few moments of your time to ask a few questions.

1) What if the crowds of professional and individual investors are as wrong at extremes this time as they have been in the past?

2) What if the money in money market funds, CDs, savings accounts and T-bills all tries to come back into stocks at the same time?

3) What if Warren Buffett’s Oct 18, 2008 editorial about “Buy American, I Am” proves to be excellent advice?

4) What if the people who were smart enough to avoid some of the bear market on the way down never get back in on the way back up?

5) What if the fact that stocks dramatically outperform Treasury Bonds over long periods of time reasserts itself quickly?

6) What if buying and holding blue chips stocks works significantly better than trading in and out?

7) What if President Obama is the lucky man who leads our country as it successfully comes back from the worst economic contraction since the 1930’s?

8 ) What if gold, which has been trading exclusively on fear, goes down or nowhere for years?

9) What if everybody stops postponing the work they need to do on their home?

10) What if everyone who needs a new car buys one?

11) What if Starbuck’s coffee continues to be legal, addictive and tastes great?

12) What if the major Pharmaceutical companies sell more drugs in the future in China and India than they sell in the U.S.?

13) What if the people who sat through the worst stock market decline in 70 years are fully invested at the bottom and enjoy years of success because of it?

If you are underinvested in common stocks and/or are not investing with us, it is not too late to buy by any means!

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.

We believe we will succeed over the next ten years because the quality and financial strength of our companies leads them to survival and survival leads to prosperity. The number one damager of long-term profitability is competition. How many new drug companies are being funded by the IPO’s of Common Stock? How many phone and cable companies? How many brand-name retailers are appearing on the seen? How many new asset custodians and money managers? How many software or technology consulting firms are debuting? The answer is nearly zero and in fact the opposite is happening! Our companies are seeing their competitors decline or disappear in direct industry competition and investment alternatives are dropping like flies. How about those hot commodities and commodity-related stocks? How about those emerging international stock markets? How about those glamour tech stocks?

Is the population of the world shrinking? In the U.S. we are delivering the most babies (4.3 million last year) since the height of the baby boom in 1957. China and India should create massive new markets for pharmaceuticals, entertainment, software, consulting and money management/custodianship. More customers and fewer competitors, sounds like a dream come true.

History is on our side! U.S. investors were doomed to succeed in 1932, 1942, 1974, 1982 and 1990. They were blessed to fail in 1929, 1966 and 1999.

We have no idea when this panic hits bottom. However, if you can survive this, we believe you are doomed to succeed!

Warmest regards,

William Smead

You’ll notice that we “cried” mostly negative opinions since 1998. However, beginning in a missive we sent on January 18th, we began to alert you to the “Next Great U.S. Stock Market”. The next bull market in U.S. stocks could be the most explosive to the upside that we have ever seen. More cash is on the sidelines than anytime since 1982 and it is being paid the lowest interest rate on Treasuries for 50 years. Stocks are the cheapest they’ve been in over twenty years. Warren Buffett is spending $3 to $5 billion each week on companies like Goldman Sachs and General Electric in an effort to overtake Bill Gates as the world’s richest man. Even my well-trained clients are calling me daily asking if they should bail out instead of doing what Buffett is doing and buy, buy, buy. Lastly, everyone was looking for capitulation in the market and we got it this week. We believe the “Next Great U.S. Stock Market” is on the way and our prediction is that the first leg of the next bull market will be the best first leg of my lifetime. And that is no fairy tale!

Warmest regards,

William Smead