William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

As many of our clients and investors know, we at Smead Capital Management are focused on owning outstanding companies for a long time. In this process, we include attention to the psychological parts of investing because we want to “be fearful when others are greedy and greedy when others are fearful.” A strange contradiction has popped up in the psychological world among sentiment polls this last week. We thought we could shed a little light on the subject and trigger some healthy discussion.

Last week’s Investor’s Intelligence poll showed that bulls were 51% and bears were 19.8% of the newsletter writers. It was the most optimistic that these investment newsletter writers have been since late 2007. The bear number below 20% is a sign for caution and the positive spread of 31% is also a reason to expect a correction in the market in our opinion.

In the same week, the American Association of Individual Investors released their poll which showed that 34% of their members who responded were bullish and 49% were bearish. These kinds of negative attitudes were seen during the bear market decline during 2008. In other words, individuals are as negative after a 50+% rebound in the market as they were after 20% declines during 2008. This has been a bullish signal and a buy indicator in the past. Quite a contradiction in these two sentiment polls.

Why do we believe the newsletter writers are bullish? First, we’ve had a big run up and they don’t want to look foolish. Second, many of them stay invested in the market even when they are negative and adjust the level of investment to represent negative or positive attitudes. The most critical factor among investment professionals, in our opinion, is that most of them kept significant money in the market through the March 2009 lows. Third, they know the history of the markets better than individuals. They know that depressed stock prices, a friendly Federal Reserve Board, extremely negative psychology and massive cash on the sidelines spells what we like to call “Bull Market Stew”.

In our opinion, the number one reason that individuals are negative is that they did not have to stay in the market through the bottom in March. Many individuals pulled out of their stocks and stock funds in the last four months of the decline and have not yet come back in. Just as pride stops newsletter writers from staying bearish in an up move, pride stops individuals who got out too late from getting back into the stock market. Second, a great deal of the individual investor money which fled the market in late 2008 and early 2009 went into certificates of deposit (CD’s) and can’t be accessed until maturity without penalty. The cash in money market funds, savings accounts and CD’s still equals a larger percentage of the Wilshire 5000 index today than it did at the bottom of the market in 2003, 1982 and 1974 (despite the 52% move off of the bottom). Who wants to pay a 1% penalty to prove that they made a big mistake by getting out of the stock market somewhere near the bottom? Lastly, individuals buy high and sell low, historically, and have been trained to hold stocks for less than a year by the poor ten-year performance of the S&P 500 Index. Holding periods on the New York Stock Exchange are the lowest since the late 1920’s. Scarcity creates value. What is scarce right now are the investors who are willing to participate in quality companies and execute long holding periods.

How do we believe this contradiction in the sentiment polls will get cured? We believe a market breather could do the trick. Time will also move us farther into trusting an economic recovery and away from the point at which those who got out too late, got out. However, none of these short-term oddities should move us away from executing the discipline of maintaining ownership in quality common stocks for long periods of time.

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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Dear Clients and Prospective Clients:

As portfolio managers, we feel like the children of an abusive parent. The parent spent the last 29 years teaching us the difference between right and wrong. We in turn have been executing the behaviors that are preferred by the abusive parent. Unfortunately, the abusive parent chooses to abuse us financially and psychologically. Many have rightly fled the household of the abusive parent and gone to investment shelters until the abusive parent is arrested or in some other way is stopped from inflicting pain on its family.

Here is a list of some of those right behaviors:

1) Buy and hold Blue Chip stocks for the long haul
2) Buy companies with strong balance sheets and strong brands
3) Buy at points of “maximum pessimism”
4) Use insider buying as an indicator of future business success by those who know the company best

The only times that long-term investing hasn’t worked has been if you bought in at a major high point. The bad news is that the end of 1999 and beginning of 2000 was just one of those historical high points. In the American Association of Individual Investor’s sentiment poll in early 2000, their members peaked with 72% bullish one week and two weeks later saw only 6% bearish on the stock market. This total belief and participation caused ridiculously high prices and effectively ruined the normally virtuous behavior. Our look back over the last ten years makes us recognize how abusive this greater than 50% decline has been as a snapshot in time, but the ground work was laid in the enthusiasm of the market bubble ten years ago. Ten years of the stock indexes losing money has successfully convinced a majority of the remaining participants to seek shelter.

To understand how balance sheet strength has been turned on its head, just watch Jeff Immelt, the CEO of GE, try to defend its AAA rating as the stock falls to the recent $6 to $7 level per share. There has been about $300 billion lost in the last 17 months by owners of this former blue chip. Is that any way to treat people you are supposed to reward?

We are probability people here at Smead Capital Management. We feel our job is to stack favorable probabilities into the financial life of our investors. Just look at point number 3. There have been at least four cataclysmic selling waves since October of 2007. Each would have qualified as the “point of maximum pessimism” in 80% of our experiences over the last 29 years. Each effort to be optimistic on our part has just been another good excuse to get bashed around by our abusive parent, the U.S. stock market.

If anything, the insider buying (which has been at record levels for months) has been a contrary indicator. Almost every time a sizable buy or series of buys are made, it seems that a curse has been attached to it. When you buy a financial stock with a strong history and an outstanding management team after an insider buying spree, it is like you pulled your pants down, bent over and said, “Hit me.” Our abusive parent has been glad to do so.

When will we stop getting abused in the stock market for right behaviors? The good news is it could be soon. In the same A.A.I.I. sentiment poll taken this last week, the members were 70% bearish and only 18% bullish. It is a record level of bearishness in 21 years of polling each week. The highest prior reading to now was 67% bearish at the bottom in October 1990 in the middle of the bank and S&L Crisis. More importantly from a psychological stand point, the magnitude of today’s negativity could be as good an indicator as 2000’s ridiculous enthusiasm was. It topped out one of the greatest bull markets of all time. Beware though, those extreme sentiment readings of 2000 came two weeks apart and we could need verification of this one.

Why do we care? We care because the best ten-year stretches in the stock market have followed the worst abuse in the past and the crowd of those already in the shelter far exceeds those of us trying to execute historically right behaviors.

Warm Regards,

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.