William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

Found in the old testament book of Genesis in chapter 6 is the story of Noah and the flood. God is described as “very angry” with the behavior of the people he created and instead of eliminating everyone and everything he chose to extend grace to a man named Noah, his wife, sons and their spouses. Once God chose Noah he gave him marching orders to build an Ark. This huge boat was to be 450 feet long, 75 feet high and 45 feet tall. Noah and his three sons obediently spent over 100 years building the Ark and explained to people that they needed to turn from their wicked ways and join his family in the boat.

This might have been the most difficult task ever set in front of a mortal man in history. There is no evidence in the first five chapters of the bible that it had ever rained before. Life spans were very long in Noah’s time (600-770 years), but it took about 20% of his life to build the Ark. Noah had no formal religion or community support mechanism surrounding him and his family. He had to be the ultimate contrarian and perform the whole time as if he were going to be right all along. When the flood finally receded and Noah was vindicated, God provided a rainbow as a sign that he would never drown everyone again and as a reminder to his people.

At Smead Capital Management we formed a company two years ago based on a series of things we believe about investing. We are building a mutual fund and separate account management business at SCM which is our Ark. Here are ways that we believe our work is similar to Noah’s task:

1) It hasn’t been easy to make money in stocks since early 1998 and that is equivalent to not raining for a long time.

2) Many retired investors wonder if they have the time to invest in the project.

3) The percentage of market participants who are actually long-term buyers and holders of good quality securities has become a small minority of overall participants.

4) Some financial institutions and some households are drowning in the lending and borrowing sins they’ve committed over the last ten years.

5) Aspects of our stock picking discipline which have generated big advantages over long periods of time have temporarily been postponed by the worst bear market since the 1930’s.

6) The economy that follows the aftermath of this economic and stock market flood could be more pleasing because market participants will be more humble and less debt ridden. This reduces economic swings going forward and makes us all more vigilant of the behaviors which caused the problems in the first place.

Unlike us, Noah didn’t have 24 hour news coverage of his project and massive amounts of information on the outcome of current human behaviors multiplying on the internet. His critics probably started out numerable, but lost interest quickly and had very little power to sway public opinion. Besides, he looked nuts right from the beginning. Our critics grow more numerous as time goes on even though all recorded economic history shows that time is a great healer and investment results revert to the mean. We at SCM are looking forward to our rainbows in the stock market over the next five to ten years when we believe the doors will open to the “Next Great U.S. Stock Market”.

Warm Regards,

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 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 Clients and Prospective Clients:

Three years ago Americans were spending all of their after-tax paycheck and were borrowing above and beyond take-home pay to attain a certain standard of living. Most of the money came from loans against home equity or credit cards which were paid off by borrowing through home equity loans or mortgage refinancing. At Smead Capital Management, we think in terms of the U.S. going from a 104% spending society in 2006 to a 95% spending society today. Government statistics show that above and beyond our 401(k) or 403(b) contributions we are saving close to 5% of our after-tax paycheck. In less than a year we have reduced consumption at the household level by 9%. Since Household Consumption has made up 70% of Gross Domestic Product in recent years, this puts a 6.3% drag on the GDP comparisons beginning in early fall of 2008. Notice that the fourth quarter 2008 GDP figure was revised to -6.3%. This is very similar to our estimate of reset spending patterns.

All companies will need to deal with this reset of spending patterns. The U.S. automobile industry is having a very hard time with this reset because auto purchases are a big-ticket item. A $200 to $1000 per month payment doesn’t fit very well into the budgets of the newly reset households. People are holding on to cars for longer than nine years on average and auto repair businesses are flourishing. Auto industry experts talk about a sales level of 9 to 10 million vehicles sold in the U.S. in 2009 which is down from 15 to 16 million vehicles in 2006. It will take time for them to work through this reset as folks naturally err on the side of being overly conservative for awhile.

We like to think about who is being the least affected by the reset in spending patterns or who has put their companies the farthest ahead in adapting to the new patterns. We expect them to be the leaders of the “Next Great U.S. Stock Market” because we believe they will be maximizing their brand and balance sheet strength during the reset and will hit the ground running when we begin to grow from the reset spending levels. The loss of blockbuster drug revenue due to patents running out has forced Merck and Pfizer to flex their balance sheet muscle to buy Schering-Plough and Wyeth, respectively. People have reduced their doctor visits and cut back in healthcare, but it is much less than a 9% cutback. These companies get a huge part of their income from outside the country and the two most populated countries of China and India are becoming wealthy enough to demand the best in pharmaceutical products for the first time in their history.

Starbuck’s has adapted with a discount membership card, instant coffee and breakfast value meals. They’ve closed poor performing locations and cut corporate expenses. Walmart is grabbing market share as it reminds everyone to “Save Money, Live Better.” The folks who go to Walmart now, who used to think that they were above the fray, will add numerous spur of the moment purchases once the economy rebounds or stops contracting sometime later this year or early next year. Disney will control more and more eyeballs through ESPN, ABC and Disney Channel because people are staying home and watching more T.V. When advertising revenue rebounds, Disney will have gained market share. They will ultimately pick up customers from less well financed theme parks who fail or downsize as well as movie production companies that no longer get funded. Movie ticket sales are up 16% year over year as we escape to the theatres.

There are many more stories among our companies to tell associated with the new household consumption levels, but we believe our portfolios could take advantage of what the future brings despite this difficult transition from households hitting the spending reset button.

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 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 Clients and Prospective Clients:

Everyone who goes to college wants to earn a bachelors degree. Many young people show up at college as freshmen and get off to a very difficult start. I was one of those freshmen. My first set of mid-semester tests showed that I had learned the subject matter in an underwhelming way. I was unable to separate the significant from the insignificant. I also tried to get by with an unusually good memory and a below average amount of time spent on studies. Fortunately, my professors had seen many a cocky 18-year old roll through the halls of Whitman College and took mercy on me. They said that they would grade me for the semester on improvement and that I needed to buckle down.

The first year of college you have four main problems. First, you are forced to establish a life pattern without the walls to bounce between which had been set up for you by your parents and your community. Second, the complexity of the classes and the mental disciplines to be learned were geometrically tougher than high school classes were. Third, you weren’t yet trained to cull and analyze information for what is important, which caused you to dwell on the interesting but seldom important parts of the material. Fourth, the people I was competing with for grades were folks who came into the process with much better study skills and way fewer sports and social interests than yours truly.

Why do I bring this up in an investment blog? This huge decline in the stock market the last 18 months has thrown us outside the walls we used to bounce off of. Many of us want to transfer to an easier school (CDs, Money-Market funds, T-bills, etc.). We are overwhelmed by 24-hour news and the internet burying us in information about what might happen in the short run and some of the most believable opinions are very complex. We are more attuned to the information about the next couple of months than we are about the next 5 to 10 years. Lastly, fear is driving us to extrapolate the negative and envy those who have temporarily sidestepped some of the decline. It seems like they have better investment study skills.

Since I turned things around and graduated with a solid GPA from an academically tough school, please consider the opinions of Smead Capital Management on what doesn’t matter in the long run and what does.

What doesn’t matter!
1) Stocks could go down more in the short run.
2) The economic contraction could last longer than the non-pessimists think.
3) Inflation could run wild if we have a strong recovery.
4) Oil could have a big price increase in a strong recovery.

What does matter!
1) When U.S. stocks have produced a negative return looking back over the prior ten years, they have produced a positive 14.5% return on average the following ten years (Four prior instances–1875, 1895, 1919, 1974). The average of these four events has quadrupled stock portfolios in 10 years if dividends where reinvested. Stay in school and don’t transfer. Buy if you have cash.
2) Stocks are cheap in relation to normalized profits and U.S. economic output (GDP).
3) There is 50% more cash on the sidelines at this low point relative to stock market capitalization than there was at the bottom in 1974.
4) Companies are starting to buy each other (IBM is buying Sun Microsystems, Pfizer buying Wyeth and Merck buying Schering Plough).
5) Oil was a bubble as recently as last year and bubble markets which break take years to put back together. Just ask investors in the Tech-heavy NASDAQ, which peaked at 5000 early in the year 2000, who learned the hard way with no significant success in nine years. I’m glad that commodities are not collapsing in price, but it will be years before they are the place to be again in our opinion.

Hang in there because we will all be sophomores soon.

Warmest 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.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

Reverse psychology is a terrific tool for those of us who fear success. I was a college golfer at little Whitman College in what is now the NCAA Division III level. Our handicaps ranged from about 2 to 10 and for most of us it was a good day if you broke 80 on the links. We had won the conference championship in May, but thanks to a wonderful summer job ($8/hour and lots of overtime) wrapping rolls on the paper machines at Crown Zellerbach, I played very little golf that summer. My wife was my girlfriend back then and she also worked the summer in the paper mill. We worked opposite shifts most of the time and had a very poor social life that summer. As a reward to ourselves, we decided to quit a week early and go up to Vancouver, B.C. and Victoria on a week vacation before I headed back to Walla Walla for my junior year of college. The day after I terminated work and two days before we were to leave for our trip was the Orchid Hills Golf Club Championship in my hometown of Washougal, Washington. It was a 72-hole two weekend tournament which I’d had no success in before. I told Becky that I would play the first weekend and then drop out and not play the following weekend. By now you can guess what happened. I was so relaxed that I shot 74 and 73. I was tied for the lead and would have to cut our one week trip to five days to be back for the final 36 holes. Becky was steamed.

The U.S. stock market had its third best week since World War II last week and our phones have either gone bad or investors have been stopped in their tracks. A large number of investors have sought shelter the last year from our “Abusive Parent” (search “An Abusive Parent” at www.smeadblog.com) and sit in money-market funds, t-bills, CDs and savings accounts. The amount in cash relative to stock market capitalization is twice the level of any bear market low of the last 40 years. The silence is deafening because the stock market could have a run like I had the first weekend of the Club Championship and most of the people on the sidelines will not re-enter the market until huge gains have occurred. Financial and Drug stocks led the way last week and it wouldn’t surprise us if the Drug stocks lead the next great bull market. If you are under-invested, our phone lines are open.

P.S. Just for the record, I shot 77 & 78 the second weekend and ended up in 3rd place in the golf tournament.

Best Wishes,

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.

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

In the movie, “Sixth Sense”, the little boy could see dead people. Unbeknownst to the movie viewers, the dead people included the character played by Bruce Willis who was counseling him. On one hand, Willis’s Character helped calm this child’s fears surrounding the haunting episodes he had with dead people. At the moment we see dead investors/consumers and the U.S. Government is playing the role Bruce Willis played. Much like receiving counseling from a dead person, the U.S. Government’s Rescue and Stimulus plans can serve to make the patient (investors and consumers) more nervous.

SCM Portfolio Manager Tony Scherrer has come up with a great analogy to explain the current circumstances which we have described as an “Economic or Business Coma”. He reminded us that some people who have come out of comas tell loved ones that visited them that they heard them speaking while they were comatose! At Smead Capital Management we are speaking and writing to many folks out there who are in an investment coma. They are listening and hearing us, but they are immobilized by what they see around them. We know the news has been horrible on the job front and in the stock market (worst January in history) and here in Seattle we are just now getting hit by the layoffs and business closures that most of the country has been going through for over a year.

Many of those who are listening to us will call us when they and everyone else come out of this business coma. Unfortunately, they are likely to pay dramatically more to buy shares of the best U.S. companies at that time. The primary reason for not buying into our portfolios now is the worry that the coma will last longer than expected and we will look foolish in six to twelve months. There is $8 Trillion dollars sitting in T-bills, money-market funds, short-term CD’s, checking and savings accounts and those amounts represent incredibly high levels versus Total U.S. Stock Market Capitalization. The offset to the fear of looking foolish is the fear of avoiding a possible rampage of buyers. Imagine what it will look like if most of these people come out of the business coma at the same time and all try to reestablish their investments simultaneously.

On top of individual investors being in a coma, institutional investors like pension plans and endowment funds have spent the last three years chasing performance under the guise of wide asset-class diversification. Their emerging market, hedge fund, private equity, energy and commodity investments not only didn’t protect them, but also turned out to be illiquid in many cases. We see massive capital employed in dead investment strategies which will haunt them for years in the “Next Great U.S. Stock Market.” To get back on track for retirees and organizations, these institutional investors could ultimately come back to U.S. Large Cap Stocks and take advantage of their long-term historical success and constant liquidity. These institutional investors could be part of the rampage as well as they give up on the popular strategies of the last three years.

We have no idea when this business/economic coma ends, but we unequivocally believe it will end as all the previous ones did! We believe that those of us who act while we are surrounded by dead investors and consumers could be proven to have a “Sixth Sense”.

Best Wishes,

William Smead