William Smead
Chief Executive Officer
Chief Investment Officer
Dear Clients and Prospective Clients:
In the midst of this historically poor start to the year 2009 in the stock market (S&P 500 year-to-date return), we thought it would be helpful to give you some reading in between the lines of the Berkshire Hathaway Annual Letter.
1) “Book Value fell 9.6% and the stock price fell 32%”
Translation: This was the worst year out of 44 on an absolute basis for Berkshire Hathaway. Book value has grown at 20.3% on average over 44 years!
2) “By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”
Translation: What we at SCM describe as an “economic coma” has been as swift and violent as any Warren Buffett has seen in his adult business life.
3) “Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”
Translation: It has been a long time since we had a major and painful economic contraction. We have grown soft because of it and the steep decline in stocks has every intention of robbing all of us of our optimism. It won’t rob Warren’s and it won’t rob ours at SCM.
4) “Take a look again at the 44-year table on page 2. In 75% of those years, the S&P stocks recorded again. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’ t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”
Translation: Don’t extrapolate forward the recent down trend. Picture where you are as an owner of common stocks and where you want to be in five years and stick with your discipline.
5) “I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”
Translation: Warren got caught in the “Peak Oil” Bubble last year and believes that oil will rise in price in the future. Too many investment people agree with Warren and we believe that he will need a great deal of time to get even on Conoco.
6) “I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 m illion for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”
Translation: Warren’s existing holdings in Wells Fargo, American Express axp and US Bank usb punished him in the last year and he got burned badly by dabbling in a few new financial institutions. There is grace for us at SCM in his difficulties!
7) “The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.
Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.
Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
Translation: Good quality stocks and bonds are underpriced and U.S. Treasuries, money market funds, CD’s and savings accounts are overpriced! However, to gain the benefit from this investment discrepancy you must deal with the possibility that the markets continue to deepen the underpricing and raise the overpricing!
We know we have given you a great deal to consider, but in these trying times in investing we hope we are serving you well by modeling the behavior of the greatest investor of all time.
Warm Regards,
William Smead
The securities identified and described in this missive 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.
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