William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

The Wall Street Journal reported on Nov. 2nd that non-financial publicly traded companies were holding more cash on their balance sheets than at any time in the last 40 years. The figure is 9.8% of their combined stock market capitalization. A great deal has been written lately about what officers, directors and substantial shareholders (Insiders) have been doing with holdings of their own companies. We at Smead Capital Management would like to give our take.

Since January 1st of this year there have been a number of large company buyouts. It started with Pfizer buying Wyeth and Merck buying Schering-Plough. It has accelerated last week with Stanley Works buying Black and Decker and Warren Buffett’s Berkshire Hathaway buying the rest of Burlington Northern Railroad for $100 per share in cash and stock. Why are companies so interested in buying competitors? Why is Warren Buffett spending $26 billion to buy the rest of Burlington Northern?

First, we believe they trust that the U.S. economy will make a significant comeback the next three years. Many admired experts have spent the last two years convincing us that the financial sins of the last ten years condemn us to poor economic growth for the next ten years. Here is what Warren Buffett said Tuesday morning about buying Burlington Northern Railroad:

“Our country’s future prosperity depends on its having an efficient and well-maintained rail system,” Buffett said in a press release. “Conversely, America must grow and prosper for railroads to do well.”

“It’s an all-in wager on the economic future of the United States,” he added. “I love these bets.”

Second, these companies’ financial strength allows them to gain market share while prices for common stock are depressed. Trading cash, earning almost nothing, for future corporate profits close to the bottom of the deepest recession since 1982 could look incredibly smart two or three years out. Once what Buffett sees is known to other corporate executives, you could see many buyouts as the 9.8% cash position drops to a more normal reading.

Third, James Grant called low house prices and low stock prices a “shovel-ready stimulus program” back in February. With interest rates low for conducting business and housing the most affordable in my adult lifetime, why can’t the economy do well over the next five to ten years? As we said in our missive called “Pick Your Poison”, what would we rather have, double-digit interest rates/unaffordable homes/less existing debt (1982) or low interest rates/affordable homes/large existing debts (2009)?

Warren Buffett, who we believe is the most successful insider of all time, parted with $26 billion of his company’s stock and cash to bet on future U.S. prosperity on Nov. 3rd. His company is involved in insurance, banking, railroads, food and beverages, credit cards, residential real estate, carpet, jewelry, furniture, manufactured housing, etc. At SCM, we are going to keep our view of the economic future aligned with the insider.

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

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.