William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Kairos (καιρός) is an ancient Greek word meaning the right or opportune moment (the supreme moment).

The world of value investing and portfolio management includes mean reversion and patience. Speculative episodes typically go on for much longer than expected. This fact forces us at Smead Capital Management to take a stand by avoiding overvalued common stocks and owning undervalued shares for a period of time before the marketplace chooses to recognize capital misallocation. Everyone would love to make their adjustments at the “Kairos” or supreme moment when that which is over-priced begins to tumble and that which is undervalued starts catching a bid.

We believe that the greatest existing misallocation of capital in the world today is based on over-confidence in the uninterrupted growth of emerging markets. The BRIC trade, as it is affectionately known, has impacted a speculative episode in emerging markets (debt and equity), currencies, precious metals, oil and other commodities, exchange-traded-funds (ETFs), cyclical companies in the heavy industrial and basic material sectors and small/mid cap outperformance. China is 9.4% of world GDP and 19% of the world’s population, but as China Business Professor Michael Pettis shared recently, here is China’s share of global demand for various commodities:

• Cement demand represents 53.2% of global demand
• Iron ore = 47.7%
• Coal = 46.9%
• Pigs = 46.4%
• Steel = 45.4%
• Lead = 44.6%
• Zinc = 41.3%
• Aluminum = 40.6%
• Copper = 38.9%
• Eggs = 37.2%
• Nickel = 36.3%

Since most equity portfolio managers are all too familiar with career risk, they hesitate to walk away from owning the popular parts of the marketplace. Think of how difficult it has been for us in the last year to be heavily under-weighted energy stocks as they rose 40% in the six months ended Feb. 23, 2011. This was only the sixth time in 70 years that the energy stocks had done that well. How do you indentify the “Kairos” or supreme moment for pursuing the mean reversion that the statistics tell you are inevitably coming?

We use watershed events and the writing/public pronouncements of smart people. In this way we pay attention to the kinds of things which have happened or have been communicated at other major change points. Below is a partial list of recent watershed events:

• Caterpillar bought Bucyrus International
• Glencore (the world’s largest commodity trader) is attempting to go public in May
• The Texas State University System announced massive physical gold holdings
• Silver prices went parabolic with the silver ETF trading exceeding the trading on the SPY (S&P 500 Index)
• Cargill is spinning off Mosaic (maker of fertilizer)
• Massive inflows into emerging market mutual funds in 2009-10
• ETF trading dominates exchange volume
• Open interest on US commodity exchanges is higher than at the 2008 commodity peak
• CNBC and Bloomberg devote their TV time to commodities and macro-economic news and thought

We could go on, but you get the idea. On the smart people side of the ledger has been famous short-seller, Jim Chanos, who calls China’s use of infrastructure investments as the “Treadmill to Hell”. Maintaining economic growth by over-investing in unneeded buildings and infrastructure ultimately leads to the recognition of bad loans and a poisoned banking system. Chanos is no longer alone in his opinions.

The Financial Times has brought forth the ideas of UBS Economist Robert Magnus and Deutsche Bank Strategist John-Paul Smith. Magnus refers to China’s investment-intensive growth model and exogenous circumstances as pushing it toward what Magnus calls a “Minsky moment”. Minsky warned that the process of leverage always culminates in instability. Magnus asks, “Could China be flirting with a similar outcome?” Here is how he (Magnus) describes what has been going on there:

“What China calls ‘total social financing’ – conventional bank loans and most other external sources of finance – was still 38 per cent of GDP in the first quarter of 2011, almost as high as in 2009 when China implemented a credit-centric stimulus programme. The credit intensity of growth, or the amount of new credit generated for each unit of CGDP growth, has risen from 1-1.3 before 2009 to 4.3 in 2011.”

 In other words, it is taking nearly four times as much borrowed money to fuel GDP growth in China in 2011 as it did in 2009. The “Treadmill” has sped up, to use Chanos’ metaphor.

John-Paul Smith is more focused on emerging markets in general. He argues that inflation and how it is dealt with in emerging market countries like China will lead to grief. He explains that they are very slow to deal with the inflation problem and are more prone to use government interference in industry. In Smith’s view, this will cause US companies to be much more nimble going forward. Magnus backs up Smith by examining where China is in the credit cycle. He argues on an inflation-adjusted basis that China’s “real” interest rates are the lowest in 13 years. They are way behind the curve and their catching up process could coincide with the ramp-down of their capital intensive real property binge.

Here is the irony of where we are today. We can’t say that this is the Kairos moment or the Minsky moment. We believe that we are seeing the kind of watershed events and comments from smart people which have been seen at other pivotal times in capital markets. Magnus says, “A Chinese Minsky moment would hit global growth and resource markets and shock the consensus.” In our opinion, the risk-reward relationship has worked its way to favoring those of us who are betting that the “Kairos” or “Supreme Moment” is not far off.

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:

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

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

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.