William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

In a column online for the Wall Street Journal on Sunday, March 20th, Mark Gongloff wrote that the recent unrest in the Middle East and the earthquake/tsunami disaster in Japan has returned us to a risk on/risk off environment. At the same site under Opinions, Andy Kessler talked about the effect that normalized short-term interest rates would have in an editorial called: “Raise Rates to Boost the Economy”. Markets are again dominated by very high correlations and short duration trading patterns during a correction which has knocked about 6 percent off of the S&P 500 Index. As owners of fundamentally sound companies with strong balance sheets, we agree with their observations and would like to expound.

Federal Reserve Board Chairman, Ben Bernanke has maintained very low short-term interest rates to prevent a Depression. He sought to provide wide spreads to our banking system so that their profits would effectively recapitalize our banking system. Simultaneously, he bought US consumers time to repair their balance sheets and income statements. Major banks proved him correct on March 18th by raising dividends and announcing massive stock buybacks. Consumers have shown to be quick studies as they have lowered their Household Debt Service Ratio (HDSR) from around 14 percent in late 2007 to 11.75 percent at the end of 2010. Our research at Smead Capital Management (SCM) indicates that households could be below 11 percent as soon as a year from now. This is a level which spawned five-year economic growth periods in both the 1980’s and the 1990’s.

The real question is two-fold. First, can the US economic recovery withstand higher short-term interest rates? Second, what investments will investors be happy with when the government is not offering monetary stimulus as a wind behind the back of American businesses and households?

Artificially low interest rates are a friend to capital intensive businesses. When capital is inexpensive, those who need it most, benefit the most. Low rates are beneficial to smaller companies which can borrow at rates normally reserved for only the financially strongest companies. These low rates are the friend of leveraged companies and private equity companies which buy and own companies and use leverage in the process. Lastly, these low rates are the friend of commodity investors and foreign emerging markets who have pegged their currency to the US dollar. Unfortunately, these facts all appear in the rear-view mirror and might be the most crowded multiple-asset class trade this portfolio manager has seen in 31 years in the investment business!

One of the strengths of the US economy is its resilience. This resilience is a by-product of our willingness to trust Adam Smith’s “Invisible Hand”, which lets the marketplace decide who wins and who loses. The Japanese brought interest rates down and kept them down for 20 years. Their economy and stock market has been terrible. They did this to stay away from washing out the losers and dealing with recapitalizing their banking system. They killed their economy to maintain employment, postpone admitting mistakes and did not allow significant immigration to offset population decline and aging. We are hopeful that the current tragedy might cause them to wipe their slate clean and begin to grow again.

We need to think very soon of taking the training wheels off of the US economy and allow interest rates to gravitate to where the market will take them. We at SCM think it will have the affect of sending the tide out. As Warren Buffett is fond of saying, “It’s only when the tide goes out that you learn who’s been swimming naked.” More normal rates would benefit cash rich companies, savings rich households and present meaningful risk-less opportunity cost to speculative investments. Investments in commodities, emerging market stocks, capital intensive basic material manufacturers and heavy industrial companies have fed off of emerging market prosperity which is appealing in a negative real interest rate environment. Here is how Kessler describes the possibilities:

“But along with a likely lower stock market and failing banks will be several positive effects that will finally kick-start the economy. Oil and wheat and commodities will see a 20%-30% drop in price as speculators run for the hills. This will be a de facto tax cut for consumers. Hiring should restart when businesses see normal short-term rates, most likely 2%.

Similarly, the dollar, suddenly backed by rising interest rates, will start to rise. Unlike those foolish enough to believe that a lower dollar is the path to growth, a higher dollar will lower prices across the board, especially at Wal-Mart—shoes, shirts and sugar. Even better, the companies that are leading the economy, such as Apple and EMC, will benefit from lower costs for memory and storage, as will Google and Facebook stocking their data centers. This price cut on productivity tools will be a good thing for the economy and the real wealth effect.

And even better, despite rising costs from higher short-term rates, surviving banks will lose their fear of rising long-term rates and will start lowering banking spreads, signaling their willingness to lend and fund a real recovery.”

As India and China tighten credit and the US lets QE2 die a slow death, we could be on the cusp of the tide change. As interest rates rise, correlations should decline and investment durations will lengthen, in SCM’s opinion. When this happens, large, well-capitalized non-cyclical US companies will be gushing free cash flow and won’t see demand for their products diminish. When it is obvious that the tide has changed, those who are naked will be exposed and our economy will prosper as we sort out the winners and losers.

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:

On Wall Street there are a number of old adages and one of the all-time favorites is the trend is your friend. In this week’s missive, we at Smead Capital Management would like to talk about trends that exist in today’s market. In the process, we will try to determine if they truly are the investor’s friend.

We are contrarians and look for extremes of psychology primarily to attempt to spot trend changes early. The biggest trend which exists today is the secular decline of US Treasury interest rates over the last 29 years and the bull market that has occurred in the bond market as a result of those lower rates. In 1981, the ten-year Treasury Bond peaked at an interest rate of over 15%. Today it is just below 4% and bottomed out below 3% in the panic and stock market meltdown of the fall of 2008 and the winter of 2009. Many highly respected experts are predicting that interest rates could rise to 6% on ten-year Treasury Bonds in the next couple of years. The avalanche of money which flooded into the bond market from the middle of 2008 right up to today is an indication that this secular trend could be changing. The only caveat we have is that overall borrowing in the US should drop to lower levels in the next ten years as we work off the leverage of the prior ten-year borrowing binge. Our vote is that the long-term secular trend of declining Treasury interest rates is not your friend.

Since the year 2000, bull markets in emerging market stocks and commodities which benefit from the above-average GDP growth, has been a major trend. We believe that the maintenance of this trend is dependent on un-interrupted growth in China. We are biased toward the contrary thinking of Jim Chanos on this subject. Since commodities and emerging markets have been the best place to be for ten years and China is due for a stumble, we don’t think this trend is your friend.

Starbucks is a coffee/restaurant company which has prided itself on being hip, cool and on the cutting edge. Starbucks has had a tendency to be a corporate game changer. They recently declared their first dividend of $.10 per quarter. Non-financial public companies are sitting on record setting amounts of cash on their balance sheets and are generating very high levels of free cash flow due to cost cutting. As sales and earnings rebound, look for other companies, which either pay no dividend or a low percentage of after-tax profits, to pay or raise their dividend. Not only does this make good sense for shareholders, but it makes great sense for top executives who would like to get paid more for their efforts. If the board raises your salary or pays you a bonus, the media and populist politicians are going to be all over you like a blanket. If you pay a dividend or raise the dividend and you own a big slug of your common stock, you get a sizable pay increase without criticism. Howard Schultz got a huge annual income increase from the Starbucks dividend and I haven’t seen one media article of condemnation or a populist politician offer a comment. We own a number of companies in this situation like Ebay, Amgen and Microsoft. We think this is a new trend and for the long-term investor, it could definitely be your friend.

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

Dear Clients and Prospective Clients:

There is an amazing fact in investment analysis. The longer you are right, the greater the amount of intelligence people attribute to you. Along those same lines the more money you make in business, the more intelligent people think you are. It’s like the investment world is perpetually playing the board game LIFE. In the game, if you are lucky enough to get the right roll at the beginning, you become a Doctor. The medical profession had the highest income in the game and made you more likely to win. The game was invented in the 1960′s, when Doctors were the highest paid professionals in town and were also the most educated. Since they had the highest incomes and most years in school, people asked for their opinion on a broad array of subjects under the assumption that their personal success and academic education made their opinion more valuable.
 
At extremes in markets there has usually been someone of stature who felt early on that what has happened would happen. The longer that the trend continued and the longer that the person of stature continued to predict its continuation, the more intelligence investors attached to them. A few historical examples are in order. In the very high interest days of the early 1980′s two economists, Dr. Henry Kaufman and Dr. Albert Wojinalower, correctly predicted that the Federal Reserve and its leader Paul Volcker would tighten credit and raise interest rates high enough to break the back of inflation. They were called Dr. Doom and Dr. Death because of their bearish views on the bond market and the economy. Unfortunately for them (at the time that they were considered the most intelligent form their correct predictions) they were predicting 22 to 25% Prime interest rates at the peak in 1981 and told everyone to stay out of bonds at the single best time to buy them in U.S. history !
 
Mary Meeker and Henry Blodget were technology stock analysts in the late 1990′s and rode the dot-com bubble for everything it was worth. Once again they were idolized and ascribed great intelligence until the bubble burst and they stayed bullish a long way into the crash. They crushed their fan club in the process. More recently, the oil analysts at Goldman Sach’s were riding high from predicting in 2005 that oil would climb immensely in the coming years. They predicted $90 per barrel oil and ratcheted that prediction up as oil exceeded that target in 2007 and 2008. When oil reached $145 per barrel, they were considered total geniuses and flatly predicted a run as high as $200. I haven’t heard a word about them lately as oil is below $50.
 
Today, a banking analyst at Oppenheimer by the name of Meredith Whitney and a New York University Professor by the name of Nouriel Roubini, who correctly predicted much of the difficulty experienced in the banking and financial companies the last two years, move the markets every time they appear on CNBC or Bloomberg. Their intelligence meter is through the roof and the respect the markets pay them matches it. We at SCM assume that they will be singing the same tune all the way through the bottoming process and could be scaring investors away from financial companies at the bottom the same way that Henry Kaufman and Albert Wojinalower did with bonds in 1981! Remember, the longer a trend is in place the more risky it is to bet that it will continue and all of us are human, even the experts you see and hear on television.

Best Wishes in this Holiday Season,

William Smead