William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In his new book “Great by Choice”, Jim Collins talks about the discipline that the companies which performed the best over the last thirty years had exhibited. He used comparisons between companies in various industries. In property casualty insurance, he compared Progressive to Safeco. The watershed moment when the success of the two companies parted was in the late 1980′s and early 1990′s. Prior to that time both companies ran underwriting profits each year. This meant that they paid out less than 100% of the premiums collected. Unfortunately, for the shareholders of Safeco, the high interest rates of the 1980′s and the favorably stock price increases of the 1980′s and 1990′s lured them into allowing investment returns to override underwriting discipline. When interest rates became historically low and stock market returns gravitated to the mean, Progressive’s underwriting profit left Safeco in the dust.

What triggered our thoughts here was a blog I read at Barron’s online last week. It said that a Credit Suisse analyst was recommending that investors swap out of Walgreens (WAG) into Rite Aid (RAD). The reason for the negative view of Walgreens on the part of the analyst was his expectation of only a 25% likelihood that Walgreens will settle their dispute over pricing with Express Scripts. Walgreens would have lower revenue and profits in the near future if they lose the Express Scripts revenue. Walgreens has already told analysts that it could cost them as much as $.21 of their 2012 earnings per share (EPS). We at Smead Capital Management believe that the weakness in Walgreens stock created by the uncertainty associated with the Express Scripts negotiation and separation has created a wonderful buying opportunity.

Collins focused on the companies which overcame unforeseen economic and business problems and returned a 10-fold increase in stock price. He calls them 10x companies. His work is done looking backward, while our work is done looking forward. Progressive didn’t earn as much in the years when investment markets provided high returns, but they prospered in the 2000′s when investment returns were problematic at best. They gave up some income in the short run to be a 10x company in the long run.

Why would Walgreens walk away from billions in revenue from Express Scripts? For the same reason that Progressive did. At the pricing levels dictated by Express Scripts, Walgreens would produce meager margins on that part of its business (3-5 percent of revenue) and drag down return on equity. Their stock has already fallen from the mid 40′s to the low 30′s. According to our calculations of intrinsic value based on multiple current earnings possibilities, Walgreens trades at a 33-50% discount to its intrinsic value. Walgreens stock has risen from around $4.17 twenty years ago and pays an $.80 dividend to those fortunate enough to have held on. It meets all eight of our proprietary criteria and is a stellar corporate citizen.

Which brings me to the lunacy of recommending a sale of Walgreens in exchange for Rite Aid. Rite Aid is a small-cap company with a deeply checkered past and porous balance sheet. Trading Walgreens at these prices for Rite Aid would be like swapping a new Lexus for an over-sized ten-year old gas guzzler, box seats for the nose bleed section or Kate Middleton for a troubled Hollywood Starlet! Rite Aid has accounting problems and a consistent history of shareholder unfriendliness. It might go up, but it should not be included in the same conversation. We believe that Walgreens is going to be “Great by Choice”.

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:

Jim Collins is the author of a book that I have mentioned from time to time called “Good to Great”. He has attempted to help us understand the difference between merely good companies and the few great ones which have been demonstrating “greatness” over the years. What these “great” companies do in the most difficult business circumstances could give us some clues on what to do in this current economic and investment environment. The current environment is already establishing itself as the most difficult set of circumstances we have faced since the 1930′s.

To help us understand the approach of “great” companies in difficult circumstances, Collins retells the story of James Stockdale, a POW camp survivor from the Vietnam War. Stockdale withstood the kind of long imprisonment which Senator John McCain withstood and is still fresh in our memories. This survivor explained that it wasn’t the pessimists or the optimists which survived, but rather the realists. Pessimists died early on trying to escape, knowing that they didn’t have it in them to hold on for years. Optimists expected the very best and would say things like, “We will be out of here by Thanksgiving.” Thanksgiving would come and go and the optimist would turn to Easter as the point where it would all be better. Eventually, a number of optimistic deadlines would pass and the optimist would lose hope and turn into a pessimist. The realist said, “I will do whatever it takes to get through this regardless of how long it takes to get through it.” There is an inherent optimism in the position taken by the realist. The grim reality must be balanced against the great blessing for you on the other side of the valley.We are in the midst of a business coma and stock market liquidation that has to do with financial sins committed over the last ten years. It is holding all participants (workers, investors and companies) prisoner regardless of whether or not we or our companies were part of creating the problem. We do not know how long the “business coma” will last, how long stocks will be liquidated to find a bottom and how soon the inevitable rebound will come! However, we must survive.

At Smead Capital Management we have staked the survival of our portfolios on the balance sheet strength of our companies, the necessary nature of their products and the enduring quality and “mind control” of their brands. In other words, we have sought to own the realist companies which can get through this regardless of how long it takes. And we do this to not only survive, but also because the reward on the other side of the valley is huge from a historical point of view. If you made it all the way through the Great Depression to 1937 with your blue chip stocks, you saw a huge rebound in stock prices from the 1932 lows.

What can you do to be a realistic owner and steward of your assets? Make sure you are investing money in the stock market which can stay invested for at least three to five years. Put the money you need in the next two years in a safe financial instrument like a Certificate of Deposit or money-market fund. Reduce portfolio withdrawals until things improve. Where possible, liquidate non-liquid assets like boats, cars and non-income producing real estate or use them as a charitable donations in a substitution for cash outlays. If needed, review your portfolio with us regardless of whether or not we oversee all the assets.

What should we look for to get a sense that this storm is passing? First, look for low enough new home sales figures to put some of the weaker publicly traded homebuilders into Chapter 11 bankruptcy. Second, look for Arizona, California, Florida and Nevada unsold home inventories to decline. Thirdly, look for some highly respected, nationally recognized stock portfolio managers to give up or get fired (it happened right before the Tech bubble broke in early 2000). Lastly, look for the interest rate differential to narrow between high-grade corporate bonds and Treasury bonds.

We intend to survive these circumstances with you and are here to serve you in any realistic way we can.

Warmest regards,