William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

We are witnessing one of the greatest battles to control the hearts and minds of investors that we at Smead Capital Management have just about ever seen. In one corner you have PIMCO and their fearless leader Bill Gross, buying longer-term Treasury bonds. They see the world as a giant game of deleveraging as the large U.S. government and household debt is worked off in a muted economic recovery. They see a “new normal” set of spending patterns and higher savings rates leading to slow growth rates and low levels of inflation or possibly deflation. It is our opinion that PIMCO and Gross have been super successful, outperforming other bond market participants for years in one of the best bond investing eras in U.S. history. The amount of money they manage has reached legendary proportions and they have huge influence in the debt markets in which they maneuver.

In the other corner are such heavyweights as Warren Buffett, James Grant and Julian Robertson. Buffett is actively buying stocks in the U.S. He fears that inflation is a natural by-product of all the efforts of the Federal Reserve Board and U.S. Government to stimulate the economy. James Grant, one of the best writers and contrary thinkers in the money world, recently shared his opinions in an op-ed piece in the New York Times. Looking back at history, Grant surmises that the deeper the recession the more explosive and powerful the two to three-year economic rebound has been. He sees the large camp of economists assuming a poor/jobless recovery as a good psychological signal. Julian Robertson, one of the deans of Hedge Fund investing, is short U.S. Treasuries across the board and sees very high interest and inflation rates coming as a consequence of quantitative easing and Federal stimulus efforts. Who should you/we believe?

First, I’d like to give you our SCM caveats. We believe that the merits of the companies we invest in based on our Eight Criteria are the most important factor in how we will do over the next ten years. Second, we don’t believe we can predict the stock market or the economy. We like the fact that our criteria has the tendency to find strong balance sheets, powerful brands, high free cash flow generators and wide moats, because they are more likely to withstand whatever environment plays out.

With caveats in hand, here is SCM’s feeling about the arguments from these titans. Bond mutual funds have been receiving $20 of inflows for every $1 received by equity funds since the beginning of March. In our 29 years, we have virtually never seen that kind of overwhelming popularity get rewarded over the next three years. Therefore, Bill Gross and PIMCO look due to have the markets they dominate become more difficult. Since 1984 we have had a huge bull market in Treasury bonds as they peaked at 14% interest rate. At 3.4% today, PIMCO has mathematics working against them. Near the end of the 1982 to 1999 era, Warren Buffett and common stocks were enormously popular. Buffett spoke in Sun Valley to a group of business owners and executives who had been made mega-wealthy by the bull market in stocks. He told them that stocks would do poorly from then to 2016, if history was any guide. He was spot on, as the next ten years proved to be one of the worst decades in U.S. history for stocks. I don’t hear PIMCO saying anything vaguely similar about bonds today.

We don’t agree with Julian Robertson, primarily because of the speed and magnitude of interest rate increases he is advertising. He looked on T.V. the other day like someone who had a big position going and wants to by-pass the normal holding period to see it succeed. There is little evidence that the over-capitalization of the banks in the U.S. is resulting in any meaningful lending and debt monetization (read “Monopoly Money”). We believe the inflation he fears appears to be years away, not months.

Last, but not least, is James Grant. We believe that he has a few powerful forces working in his favor. The economic coma we entered last year in September lasted until the end of March of 2009. Any discretionary economic activity which occurs in the next six months could cause fairly sizable economic growth numbers and possibly boost consumer confidence and hiring. Maybe as important is how unequivocally negative most market participants are about the long-term future of the U.S. economy. I was around in 1982. There was as much disbelief in the possibility of a rousing long-term comeback in the U.S. economy then as there is now. As fellow contrarians, we believe he must be taken seriously. We should harken our thoughts to some of the widespread belief on the part of investors who may be adding more smoke to the “Mythical Argument.”

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:

If there is any agreement out there among investors, it surrounds the measures being taken by the Federal Reserve to stabilize the financial system and prevent a 1930’s style contraction. These same investors agree that these actions to revive our economy will lead to high levels of inflation. We’ve rarely seen a future expectation get baked into the stock market as quickly as this topic. People from the political right (who bash Obama) and those from the left (who like Warren Buffett love him) are in agreement. Money could be made by playing the devil’s advocate. At Smead Capital Management, we’d like to make the case that this crowd could be wrong. To understand why, we have to take you back to childhood games of Monopoly.

In the winter when we were trapped inside or in the summer when baseball was over, my friends and I played hours of Monopoly. The game is played on a board representing four streets or neighborhoods. Each player starts with $2000 in cash and collects $200 for every time they pass Go. The bank exists for collecting payments for the purchase of properties and buildings. Its second function is paying rewards that can be reaped by landing on certain favorable squares. While one travels around the board, they can use their money to buy properties. If you accumulate two to three properties in the same neighborhood, you can buy houses and ultimately hotels to place on your properties. When an opposing player lands on your property, they pay you rent. The more real estate you own as well as the amount of additions (houses and hotels) to the property, the greater the rent that is paid. The object of the game is to create monopolies and eventually bankrupt your opponents.

To this point the actions of Fed Chairman Ben Bernanke and the Federal Reserve Board have been both systematic (backing money-market funds) and stimulative (dramatically growing the money supply). They sought to and succeeded in driving down interest rates and reestablished normal inter-bank borrowing in the process. Both conservatives and liberals are convinced that the huge increase in the money supply (printing of money) will result in an economic recovery which is followed soon after by very high levels of inflation.

Bernanke’s actions are the equivalent of doubling the amount of money held by the bank in the game of Monopoly. If the bank has twice as much money and you pass Go, they give you $200 just like when the bank had less. None of the bank paid rewards change because of the bank having more money. The only way to inflate the game or inflate the economy is to directly put money into the hands of the players. Ironically, to speed up the game as kids, we did just that and gave each player an extra $2,000 or stuffed the center area with thousands of dollars. The more money players had, the faster they bought property and buildings. The faster the Monopolies developed, the faster that everyone but the winner went bankrupt.

The Federal Reserve has increased the money supply immensely, but the institutions and systems for putting the money into the hands of the players are not functioning. Banks are building capital to meet stress tests and working hard to work through existing loans on the books. Non-bank lenders have practically disappeared from lending and securitization is nearly non-existent. Savers sit in CD’s and money-market funds at dismally low interest rates and borrowers cut spending to pay off prior debts and build meaningful savings. They are passing Go and getting the same $200 even though the bank has twice as much money as they did before. Investors have twice as much cash in money market funds as any historical low point in the stock market for forty years. The lower rates are great for getting through the existing debts, but are a big drag on the incomes of conservative fixed-income investors.

Unless the Federal Reserve starts paying $400 for passing Go or people who have learned all the negatives about borrowed money suddenly start borrowing again, the inflation fears are over-blown at best and possibly dead wrong at worst. We will see you at Boardwalk or Park Place if these fears prove incorrect.

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
Subscribe to the Missives Podcast
Click here to listen to this Missive

Dear Clients and Prospective Clients:

Economists, policy makers, regulators and investors spend most of their adult life worrying about the worst Economic calamity of their early adulthood. From 1946 to 1973, every time we had a recession it brought intense fear of the next “Great Depression” happening. Despite hyper-vigilance on the part of economists and policy makers, it took 30 years for investor’s to trust stocks thereafter. They should have been more confident as the Dow Jones Industrial Average rose from 92.92 on April 28th, 1942 to 995.15 by February 9th, 1966. This appreciation does not take into account dividends. The great run in the stock market in the 1950’s happened while we worked off the debts incurred fighting the Depression and World War II.

Inflation reared its ugly head in the 1960’s and 1970’s. Economists like Alan Greenspan and Paul Volcker have caused us to be hyper-vigilant since then to not allow inflation to find its footing. Despite the fact that inflation fell all through the 1980’s and 1990’s, investor’s did not trust stocks until the late 1990’s and by then most of the good money had been made.

Today the biggest economic calamity in the minds of economists, policy makers, regulators and investors has been the over-capitalization of real estate and high levels of debt attached to our economy. Economists like Nouriel Roubini and policy makers like Barnie Frank are leading the charge to remind us to not let the animals out of the barn, now that they are already out.

We at Smead Capital Management believe that the real estate markets will be tame for years. Working down our current debt levels the next ten years will indelibly etch better and healthier attitudes into borrowers of all kinds. We believe that rather than waiting 20 years to trust good quality stocks, we should trust them right 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. 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.

Why do I share this? In 1979-1981 we were told by respectable experts that our economy would never again be the powerhouse of the world. In 1992, experts told us that banking would never be as profitable in the future because of the S. and L. debacle and the closing of 1000 of the 8000 banks that existed in 1988. A young governor from Arkansas argued in the 1992 election that “it was the economy, stupid.” This cleansing we are going through currently is powerful and difficult, but not new. While Merrill Lynch is no longer independent as of this morning, we are still “Bullish on America”

Call us today for reinforcement or join us tomorrow at our Roadshow Event in Seattle to review our discipline and consider which Northwest stocks deserve our affection.

William Smead