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

The King is Dead, Long Live the King 

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William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

We know that we have been in an “economic coma” for the last three to four months and almost every business and individual household is retrenching. Since we are raising our savings rate and reducing our consumption, most businesses are reducing employment. Simultaneously, investors are hoarding low interest rate vehicles like T-bills, CDs and money market funds. They are also not being enticed by depressed stock prices and high corporate bond rates to make the investments they would normally make. Warren Buffett describes it as a “negative feedback loop”.

At Smead Capital Management, we have done a great deal of analysis on past major market declines coinciding with deep economic contractions. We believe that corporate survival and brand perpetuation are the most important issues. For that reason, we are focusing on owning three kinds of large capitalization companies:

1. We own companies with no debt and billions in cash sitting on their balance sheet. Their earnings might be disappointingly lower than the previous year (Microsoft, Ebay, Starbucks), but since they are still very profitable, gush massive free-cash flow and have billions in cash on their balance sheets, the survival of the company is not a part of the discussion. For us this also includes companies like Accenture and Amgen.
2. We own companies which have debt, but have massive amounts of cash on their balance sheet. They also have the ability through free-cash flow to retire their debt over a short number of years. This group includes Merck, Pfizer and Abbott Laboratories. Some of them will have impressive earnings, but most will be disappointing compared to last year at the same time.
3. We own companies which have less cash than debt, but have such reliable businesses and customer bases that we feel their survival is not in any way threatened by the current circumstances. Disney, WalMart, AT&T and Verizon would be good examples. Let’s consider Disney for just a moment. They will definitely be hurt by attendance at theme parks in 2009. What could be easily neglected is that we are going to be staying home more and watching High School Musical or ESPN. Disney (which owns ABC and 80% of ESPN) rakes in a greater and greater share of advertising dollars as it dominates wholesome family entertainment through cable, movies and network television. For companies like AT&T and Verizon, cell phone service is probably the last expense cut in an unemployed person’s home.

We do not know when the bottom will ultimately be established in the stock market during this very difficult phase. We believe that those who focus on quarterly earnings reports and stock price declines will not enjoy the wealth creation that comes as the stock market leads us out of this “economic coma” . We believe this cleansing of epic proportion in both consumer and investor attitudes plants the seeds for a long and healthy bull market.

Best Wishes,

William Smead

Disclosure: 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.

2. We believe we are in the third and hopefully final phase of liquidation in the worst financial panic, credit crisis and business coma that we have seen since the 1930’s. The first phase of liquidation was tied to sub-prime mortgages and the financial institutions that got caught up in them. The second phase of liquidation was the de-leveraging of hedge funds, private equity funds and businesses and investors who were counter parties to failed institutions like Lehman Holdings, AIG and WAMU. The third phase, which we are in right now, is the liquidation by stock market participants (primarily mutual funds and other institutional investors) of company shares due to concerns that the temporary business coma could become a two-year coma.

3. We believe that the strength of our company’s balance sheets and the elimination of their existing and potential competitors by the business coma will cause them to not only be survivors, but to prosper. Sprint is crippled in comparison to AT&T and Verizon. Disney’s theme parks, Movie division and Cable Network gain market share from less well financed industry foes. New drug companies aren’t getting funded while Merck, Pfizer, Abbott Labs and Amgen sit on billions of cash, are gushing free cash flow and fund incredible research. WalMart and Nordstrom’s are seeing major competitors declare Chapter 11 bankruptcy. JP Morgan, Wells Fargo and the Bank of New York/Mellon appear to be the cream of the remaining banks.

4. We believe that we under-estimated the severity and length of this liquidation and over-estimated the attractiveness of our necessity businesses and how well their balance sheet strength and dividend payments would defend our capital.

5. We believe that the bull market that follows this bear market will be ten to fifteen years long and will repay those of us that make it through this current financial misery many times over. However, we don’t know how soon the “Next Great U.S. Stock Market” will begin or what the magnitude of any additional liquidation will be.

We sincerely appreciate you considering our thoughts,

William Smead