William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Back in March of 2009 we did a presentation titled “Bull Market Stew”. The idea was that you could look back at the circumstances surrounding major US stock market bottoms just prior to huge bull market moves and compare the current circumstance. The neat thing was that much like a chef on the Food Network, you are simply gathering ingredients, preparing them as the recipe dictates and expecting to cook up the finished product. You’d expect the “new” stew to turn out very similar to prior stews. Today’s circumstance is so similar to March of 2009 that we thought we should run through the ingredients we listed back then and give our viewpoint on where they are today:

1. One or more major Bear Market declines in the prior ten years, preferably with a decline of more than 40% and overall poor multi-year stock market performance—True, 2000-2002 Bear Market and 2007-2009 Bear Market are totally fresh in the minds of investors.

2. Historically depressed stock prices, especially among the traditionally most admired companies—True, PE ratios on the S&P 500 Index are the most depressed they’ve been in 26 years.

3. Massive negative psychology among individual and professional investors—True, American Association of Individual Investor’s and Investor Intelligence Polls show that US investors are as negative as in early 2009.

4. Normally successful and admired money managers are called out on the carpet and in some ways humiliated—True, Bruce Berkowitz, Kenneth Heebner, Bill Miller and John Paulson have all come under recent media criticism.

5. Buy and hold investing viewed as an idea that is no longer useful—True, an example is Jonathon Burton’s quote from a recent Marketwatch.com article:

“Stock investing therefore will need to become more nimble and proactive, a far cry from the ‘set-it-and-forget-it,’ buy-and-hold mantra that most individual investors who came of age in the past 30 years have been taught.
“The next decade will likely be one where buy and hold will generally be a fairly poor option in developed markets,” Deutsche Bank analysts told clients in a report last month. “There will be large cyclical rallies punctuated by recessions and funding crises.”

6. Seemingly unsolvable economic problems as part of a deep recession—True, Grease (Greece) is the Word.

7. Accommodative Federal Reserve Monetary Policy and fiscally stimulative measures from the U.S. Government—True, Operation Twist and deficit spending.

8. The Public doing 80% of New York Stock Exchange Short Sales—Can’t Track, but public fear measures like VIX, GLD and others are off the charts.

9. Cash in Money Market Funds at record levels in relation to stock market capitalization and paying low interest rates—True (Federal Reserve Z-1 Report)

10. Very intelligent and credible economists and analysts explaining clearly and logically how terrible things are going to be for many years—True, Bill Gross’s October letter.

The last time we were in this situation, the S&P 500 Index went from 676 on March 9, 2009 to a closing high at 1363 on the 29th of April of this year. My math tells me that was a gain of over 100%. We believe it will be different this time. The next Bull Market, in our opinion, will be huge and won’t include the risk on, risk off format. As the US recovery continues and China’s troubles multiply, commodities could plummet and US companies in the Energy, Basic Materials and Heavy Industrial sectors could be dead money at best or huge performance drags at worst. This could be a “bifurcated” market like the one that occurred when Tech stocks plummeted in 2000 and “old economy” stocks rose.

We like our “staple” consumer discretionary stocks like SBUX, DIS, JWN, HRB and CAB. We like Pharmaceutical stocks like MRK, BMY, ABT, PFE and MYL. We like quality financials like WFC, BEN, BRK and AFL. Warren Buffett said last week that the US economy is “very, very unlikely to go back into a recession”. If he is right and we think he is, this could be one of the best set ups for a bull market in my 31 years of working in the US stock market.

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:

We at Smead Capital Management (SCM) have argued for nearly two years that long duration common stocks are undervalued in relation to shorter duration stocks. Moats have a great deal to do with long durations because to last a long time with high levels of profitability requires that competition gets fought off for decades. Your moat is what defends you from competition. Most long duration investors gravitate to consumer staple stocks and they have been particularly good performers over the last three-year period, which includes the meltdown of 2008. We would argue that despite good performance from the markets low in March of 2009 that there are consumer discretionary companies with moats strong enough to be considered staples. Since the moats exist, these companies should be valued alongside long-duration staple stocks like Coke or Pepsi or Costco or Hershey at a Price-to-Earnings Ratio (PE) premium of 20%. With the current multiple on the S&P 500 Index at around 14x trailing and 12x 2011 consensus earnings, this would give us some opportunities to look for undervalued franchises with PE multiple discounts.

To understand how moats affect duration and why we believe many “staple” stocks are hiding in the consumer discretionary category I will take you back to a conversation I had with a media person recently. She had interviewed an analyst commenting on Disney’s (DIS) earnings report and was comparing Disney’s Toy Story III with a movie released by another studio. What she didn’t take the time to consider and what the vast majority of both professional and amateur investors don’t consider is the duration of a Disney movie compared to almost any other studio. We at SCM believe that five-year old kids around the world will be watching those shows for one hundred years. Your kids, grandkids, great-grand kids and all future generations are going to be entertained by images created in the past, which can be reproduced inexpensively with very high profit margins. Disney gets to re-release movies in the theater every seven to ten years because of the sentimental attachment and goodwill associated with wholesome family entertainment. This is a powerful moat.

Disney shares trade for around $34 and they are consensus estimated to earn around $2.39/share by the Thomson Reuters news service in 2011. This means that the owner of ESPN, the world’s most successful theme parks, ABC and cable networks and the most awesome film library that ever babysat a child, trades for 14x next year’s earnings. We believe the greatest brands deserve a healthy premium to that average. At a PE of 18 sometime during the next year, Disney could trade up 30% from where it trades today.

Nordstrom (JWN) started out selling shoes and supplies to folks headed to Alaska by boat from Seattle. They have given customers a level of service for decades that is commensurate with how they would like to be treated themselves. The ability to improve the self image of customers is a competitive advantage which precedes the company. They now operate in a three-tiered business model. They have their flagship stores, Nordstrom Rack stores and one of the fastest growing and most successful online stores in the world. When Nordstrom opens a store in the area it is an event. They opened a Rack store in lower Manhattan a few months ago and it appears to be ripping the cover off of the ball. Imagine well-chosen inventory and very personal, courteous service. The goodwill in the brand and the ongoing, reinforcing experiences has caused Nordstrom to sail through the worst consumer recession in 70 years as their moat defended them from competition.

Nordstrom is projected to earn around $2.50 per share in the fiscal year ended January of 2011 and $3.00 in year ending January of 2012. At a market multiple of 15 PE on next year’s earnings it would trade at $45 per share as compared to current prices around $33 per share. At the premium of a wide-moat consumer staple, JWN would trade above $50 per share in the next one to two years.

Can you name the number two worldwide gourmet coffee company? Starbuck’s (SBUX) has so many intriguing aspects to its wide moat that we hardly know where to begin. Their product is legal and addictive. They cause customers to feel better about themselves. They now are seeking to dominate three huge market niches. First, they are growing their flagship stores and offerings around the world. Second, they are rolling out Seattle’s Best Coffee as a gourmet coffee to the masses at Subway, Burger King and outlets everywhere. Third, they are going to use their strong brand to tackle the instant coffee market through VIA. With the product respect and goodwill this company has, who would bet against them.

Starbucks trades currently around $24 per share. We have compared them to the Wrigley Corporation. Wrigley made the generic product chewing gum synonymous with their name. We rarely saw the stock trade at less than a 20 PE multiple in the last 30 years before going private. Starbuck’s owns the gourmet coffee category the way Wrigley owns chewing gum and trades at 16x the earnings estimate for the fiscal year that starts in October. A 20 PE multiple would create a 25% gain in the next 12 months.

These are three examples of powerful moats causing what we believe are “staple” businesses in the consumer discretionary category. Time will tell if the marketplace gives them the PE multiples we think those moats and their stability deserves.

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:

Why do most people make money owning their home? Why do folks make money on company stock and ten-year options? The answer is they hold these investments for a long time. If you hold a sound investment for ten to twenty years you typically get rewarded quite well. However, most human beings never participate in an investment for twenty years in anything other than their home or a piece of investment property. Why do investors hold most investments for short time periods when all the evidence is that you get the greatest rewards for long holding periods?

Historically, homes have appreciated at around 5% in the U.S. and common stocks have gained around 10% from a combination of appreciation and dividends. Why do US households have most of their capital tied up in real estate? We believe the biggest factor is liquidity. The only investments folks hold for twenty years are relatively illiquid. The cost and hassle of buying and selling property causes people to hang on. The hassle of moving your residence and the added monthly payments of buying a new one preclude activity. The fact that the price is not printed in the newspaper every day and there isn’t a willing buyer every day causes longer holding periods. We at Smead Capital Management think people are better off for having invested in real estate for long holding periods.

This brings us to our theme for this year-Hall of Fame Companies. Hall of Fame Companies have unusual success, great consistency and long duration. Why haven’t more investors participated on an uninterrupted basis in the common stock of McDonald’s (MCD) or Disney (DIS) or Merck (MRK) the last twenty years? Why do investors put their investable assets with money managers, financial advisors or financial institutions which make no attempt to own the same good quality common stocks for a long time? We believe one of the main reasons is that these terrific companies and their common shares are liquid every business day of the year. Someone offers to buy your shares every day. The temptation to time the cycles or shorten the reward period is overwhelming.

The New York Stock Exchange reported in 2009 that the average holding period for common stocks dropped below a year for the first time since the late 1920′s. Since investors invest in their rear-view mirror and good quality common stocks have had one of their worst ten-year stretches in history, investors don’t believe that they can get a long-term reward from the very thing that they are the most likely to get it from. One of our main jobs as portfolio managers is to help these very liquid investments become illiquid. Most investors and money managers take their cue from stock market trends, economic growth expectations or views of the current political leadership. We want to shepherd folks through long holding periods with companies that fit our Eight Criteria. In the process, we believe we will be able to look back in twenty years and realize that our client’s wealth has been determined by the companies we own which end up making the Hall of Fame.

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.