William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

 Dear Fellow Investors:

Early in my career I studied the investment philosophy of the most successful and admired investors like John Templeton and Peter Lynch. Both men had great long-term track records in portfolio management. John Templeton’s concept of buying common stocks at the “point of maximum pessimism” usually marks the only time you can buy a superior publicly traded business at a deeply discounted price. From Peter Lynch we got the common sense idea of observing what is going on around us to look for ideas. I’m fond of taking pictures of the lines at Starbucks or noticing three days before Christmas that Nordstrom had sold out of Gucci “Guilty”. Owning a company that meets our proprietary eight criteria and holding it for many years was also an idea Peter Lynch popularized. Doing so requires something about the company which stops it from gaining maniacal popularity, one of our sell criteria. We’d like to explain how Ebay fits Peter Lynch’s two ideas.

Internet commerce is in its early years, but any alert business person can see that there is mass adoption of PayPal. They currently have a 15% market share of internet transactions. Last year, our marketing director, Cole, commented that American Airlines has the fact that they accept PayPal on the back of their boarding pass. I used my I-phone Starbucks app yesterday to pay for my iced tea and many folks refill their Starbucks card with PayPal. The growth in PayPal probably keeps the top executives of Visa and Mastercard awake at night. Numerous other parts of Ebay’s stable of companies are seeing very fast growth and could be observed by Mr. Lynch.

To understand why Ebay won’t get a maniacal stock price, you have to understand their original business. Ebay Marketplace is the New York Stock Exchange of pre-owned goods. It also is a home for numerous “power sellers” of new and refurbished goods. It is a retailing entity which pays no rent and carries zero inventories. It is like the NYSE in that they really don’t care what the hot selling item is, as long as someone has a hot selling item on their system. This business produces massive free cash flow, but is a niche business and is probably not in a position to dominate internet retail sales growth and market share, in our opinion.

Ebay reported earnings on January 20, 2011 and pleasantly surprised the Wall Street analyst community. However, numerous analysts and news reports framed the earnings release in a very negative light even though operating earnings grew 24%. They say that since internet retail sales grew by 12% in 2010’s fourth quarter, Ebay is somewhat of a failure by only growing gross merchandise value (GMV) by 6%. I don’t remember folks criticizing Berkshire Hathaway for the slow growth in its insurance businesses, which provided Warren Buffett the float to invest in other businesses and stocks like Coca Cola, Wells Fargo, Burlington Northern and Gillette.

One of the stocks that Peter Lynch invested in to build his successful track record at the Fidelity Magellan Fund was Phillip Morris. It was the largest tobacco company in the US and was using its massive free cash flow to become a major player in the food business in the 1980’s and early 1990’s. No matter how well the earnings, cash flow and dividends grew, the stock never got an inflated price-to-earnings ratio (PE). Philip Morris was being sued by the families of smokers. Who wants to own shares in a company which is getting sued constantly? It stayed reasonable for decades and made its common stock owners wealthy in the process. From 1972 to 2001 it produced a 17.8% average annual gain for its common stock holders who stayed for the entire 30-year stretch.

Ebay has about $5 per share in cash and is expected to have operating earnings of $1.90-1.95 this year. When you back the cash out of today’s price of around $30 per share, you get $25 per share. This means that a company (PayPal), which is growing at 20% per year in sales and could be one of the most exciting businesses in the world is hiding inside a company with a 13 PE multiple. We think Peter Lynch could be smiling.

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:

As we start the year in the financial markets it appears that there are three distinct approaches being taken by those who normally invest. Since we believe the markets try to do whatever they have to do to frustrate the most people, let’s look at what would frustrate these three camps.

The smallest but most vociferous groups are those who think that this situation is most similar to 1930 through 1933. They believe that our economic difficulties will not allow a major improvement in the stock market for as long as two years. They think we will most likely retest the low in the stock market of November 20th of 2008 and very possibly go even lower. I think the strength of their argument is how cheap stocks got at the lows in 1974 and 1982 and their weakness is how much lower inflation and interest rates are today than back then and how much discounting a 50% peak to trough decline already did.

A large group today believes that sitting in cash or near-cash is the right thing to do. They kind of know in their hearts that things are cheap and attractive for purchase, but they are so traumatized by last year’s decline that they can’t bring themselves to stay in the saddle or jump back in. They also think they can’t take the psychological damage that an additional decline (predicted by the smallest group) in prices would do to their stock portfolio. The strength of their argument is that you can’t lose anything while they sit in the cash and the weakness is that nobody will ring a bell to get back in and they will likely miss the first two years of the next major U.S. bull market in stocks.

Nearly as large a group is the third one which includes us at Smead Capital Management. Folks like us want to own these common stocks for decades and enjoy what doing that normally brings. We are the traumatized optimists who wish we had received divine intervention one year ago (or listened to the divine intervention we got) and got out of the market. However, we don’t have too many regrets because we feel that long-term investors like us are going to get hit by one of these massive declines and cleansing processes every twenty years or so and it is a necessary part of admission to wealth creation. The strength of our argument is the history of investment markets and the economic history of the U.S. The weakness is we have no idea when the next great stock market will begin.

Therefore, what would frustrate the most people? A flat market or additional decline would make the first two groups happy and us sad. A huge move to the upside would make the buy-and-hold crowd like us very happy, but would frustrate everyone else. A grinding, slow and volatile recovery which takes three years and gains back everything lost last year would be similar to what happened after the 1987 crash in 1988 through 1990. It would frustrate the folks who are anxious to get their losses back quickly (like us) and leave the other two camps on the sidelines missing potentially double-digit returns. We believe this might be 2009’s most likely scenario.

In a 1995 interview in Forbes, Sir John Templeton explained his investment philosophy. He said, “People are always asking me where the outlook is good, but that’s the wrong question. The right question is: ‘Where is the outlook most miserable?” Put us with the traumatized optimists.

Best Wishes,

William Smead