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

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Dear Fellow Investors:

The floating bridge between Seattle and Bellevue in Washington State is being rebuilt and will be paid for by tolls. The Narrows Bridge between Tacoma and Gig Harbor crossing Puget Sound has been rebuilt and folks are paying a toll to cross back and forth. I paid for toll privileges in the rental car when I was in New York in May visiting clients. You can’t pass back and forth without using these roads and, therefore, the lock you have on the customer and your pricing power are immense. Warren Buffett used to talk a great deal about toll bridges among companies and why it makes for a great business.

A toll bridge company is one which everyone or a great number of people must cross or do business with and the best ones require very little labor and additional capital investment to maintain. It can be a utility in nature like electricity, phone, prescription drugs or cable service. Or in today’s world it can be ESPN or internet search or an internet payment system. At Smead Capital Management we believe that toll bridge companies are being underestimated in the current market. The primary reason for this underestimation is the time frame which most investors operate, the worldwide scope of today’s toll bridges and their connection to technologies/futuristic nature.

Toll bridge companies typically involve receiving a small amount of money from millions or billions of people for a long time. They are most rewarding to investors with long holding periods. Since the New York Stock Exchange reported recently that the average holding period for stocks traded on its exchange had fallen below one year and since that is the lowest figure since the late 1920’s, we can safely assume there are very few real long-term buy and hold investors out there today. Since there are few long-term investors and very little money demanding these types of investments, we can also assume there are very few people analyzing toll bridge aspects of a business which would lead to long duration success. Under those assumptions, it is safe to assume that there is drastically less than normal demand for the common stock of these companies. Toll bridge companies have a tendency to produce very high levels of free cash flow, have wide moats (barriers to competition) and are shareholder friendly (stock buybacks and dividend increases). It means the supply of common stock shares have a strong possibility of declining. If anything happens to cause a normal or higher level of demand for longer-term investment in common stock, higher prices could follow.

Toll Bridge companies are underestimated because of their worldwide scope. PayPal serves the world as the most popular payment system on the internet. Billions of transactions will pay them a small toll. Most humans have only had 5 to 10 years experience buying and selling online. It is safe to assume that as the population ages and today’s tech savvy twenty something’s become the Mom’s and Dad’s of the future that online transactions could grow exponentially around the world. It is hard for even me to wrap my mind around that fact. It is even harder for investors with 6 to 12 month time frames in mind to even care about considering this. ESPN (80% owned by Disney) controls almost every fan of US sports in one way or another. They have Monday Night Football, the World Series of Poker and mountains and mountains of College sports programming. And they don’t have to pay most of the actors and actresses. In the World Series of Poker the actors and actresses pay $10,000 each to act for free! ESPN then rebroadcasts the main event over and over and over much like Disney resells cartoon movies made by artists from decades gone by without any additional production expense. Like Jack Nicholson’s character said in As Good as It Gets, “the fact that I understand this makes me feel good about myself.”

The best toll bridges might be passing people my age (51) by because they have emerged in the last ten years and have new technologies connected to them. Most of the respected value investors in this country are over the age of 50 and more than likely are not regular users of the future’s best toll bridges. I have never personally bought or sold anything on Ebay. Cloud computing sounds to me like something that requires use of psychedelic mushrooms. Ordering whatever you want to watch on TV at exactly the time you want to watch it probably makes a great deal of sense to Brian Roberts, CEO of Comcast, but matters very little to multibillion dollar money managers who read annual reports for a living and live and die by how they do each quarter. Roberts is buying what we believe are deeply undervalued entertainment assets to add to his toll bridge in cable service and high-speed internet access. Short-term oriented money managers and investors think he is a fool for doing it.

In conclusion, we are excited about the long-term potential of investing in toll bridge companies and believe that underestimation equates to undervaluation.

Holiday 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 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.