William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

We at Smead Capital Management (SCM) wrote a piece a few months ago called “Peak Oil Mini-Me” in which we argued that the rally in oil from $32 per barrel in March to $73 in late June had characteristics very similar to the mania which took oil up to $147 per barrel in July of 2008. In that piece, we dealt mainly with investment psychology and the idea that we had never seen a bubble burst in the investment markets get put back together in anything less than about five to seven years. Here we are at $72 per barrel today with the U.S. economy appearing to be on the mend and the same army of energy bulls still out there promoting huge upside in the commodity oil and the energy-related stocks.

My professors in college always criticized me for not providing enough evidence in my writing to back my arguments. Fortunately for me, Michael Lynch, the former director for Asian energy and security at the Center for International Studies at MIT, provided all the evidence we need in an August 25 op-ed in the New York Times. In a piece called “Peak Oil Is a Waste of Energy”, Lynch backs our argument from an energy consultant’s fundamental viewpoint.

Peak Oil is a Malthusian argument which states that geological scarcity will at some point make it impossible for global petroleum production to avoid falling. To the Malthusians this could spell economic disaster.

Like many Malthusian beliefs, peak oil theory has been promoted by a motivated group of scientists and laymen who base their conclusions on poor analyses of data and misinterpretations of technical material. But because the news media and prominent figures like James Schlesinger, a former secretary of energy, and the oilman T. Boone Pickens have taken peak oil seriously, the public is understandably alarmed.

Lynch explained that most arguments about Peak Oil are based on anecdotal information, vague references and ignorance of how the oil industry goes about finding fields and extracting petroleum. As an example, he showed how using pumped water in the Ghawar Field in Saudi Arabia scared Malthusians because the field registered 35% water. However, they failed to mention that the average field is estimated at as high as 75% water!

But those are just the latest arguments — for the most part the peak-oil crowd rests its case on three major claims: that the world is discovering only one barrel for every three or four produced; that political instability in oil-producing countries puts us at an unprecedented risk of having the spigots turned off; and that we have already used half of the two trillion barrels of oil that the earth contained.

He debunks the discovery argument quickly. He describes the fact that at the beginning of a discovery the energy industry chooses to make a conservative estimate of what is in the field. It is almost always revised upward, because of new pockets or improved technology. Those raised estimates are never counted as new discoveries. He says that you hear that all the easy oil is gone. Read Daniel Yergin’s The Prize, which is a history of the oil business from 1855 to today and you’ll realize that there never has been any easy oil.

Once you conclude that the geological claims don’t stand up, Peak Oil folks jump right into the political instability arguments. We all remember the two oil embargoes in the 1970’s and Jimmy Carter’s wool sweater. The major oil producing companies have diversified themselves around the world and have very much moved away from the Middle East dependence. In the U.S., we currently import more oil and gas from Canada than any other country.

Lynch believes that the most misleading claim of the Peak Oil advocates is that the earth is endowed with two trillion barrels of recoverable oil and we’ve used half of it already. The consensus among geologists is that there are some Ten trillion barrels out there and based on technological improvements that as much as 35% may be recoverable. Here is Lynch’s conclusion:

Oil remains abundant, and the price will likely come down closer to the historical level of $30 a barrel as new supplies come forward in the deep waters off West Africa and Latin America, in East Africa, and perhaps in the Bakken oil shale fields of Montana and North Dakota. But that may not keep the Chicken Littles from convincing policymakers in Washington and elsewhere that oil, being finite, must increase in price.

We at SCM argue that the constant enthusiasm displayed for the reflation trade and buying energy based on emerging market economic growth rates is a crowded trade. In our experiences, when investors ignore the law of supply and demand it is at their own peril. Lynch argues that supply is abundant and car buyers are reducing their demand with higher mileage cars. More supply and less demand could spell lower prices and would be very positive for the U.S. consumer, the U.S. economy, corporate profits and owners of quality companies.

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.

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The information contained in this tv appearance 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 tv appearance 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:

Paul Lim is a business writer for the New York Times and he had an interesting thesis in his article on July 19th entitled, “Picking Winners in the Next Bull Market”. He correctly acknowledged that it would be highly unusual for the leading sector of the previous Bull Market to lead the next one. For this reason, he advised hesitation on an urge to chase the emerging markets and those companies (like oil) which benefitted most from the last bull market. We can give you numerous examples from our 29 years in the investment business which back up his thesis.

From the 1974 low of 550 on the Dow Jones Industrial Average to the 1983 high around 1200, technology companies with fast earnings growth were popular. This wave crested soon after Apple and Genentech went public. Investors wanted fast growth to offset double-digit inflation rates and handed out high P/E ratios to those fast growers. When Paul Volker broke the back of inflation through tight credit and President Reagan stood down the Air-Traffic Controllers in late 1981, the game changed. Inflation began to decelerate and investor interest moved away from these popular names. Technology stocks spent seven to eight years in the dumper during a Roaring Bull Market which took the Dow to 3000 by 1990. The high P/E ratios came back to haunt investors.

Paul used the example of the Tech stocks leading the Bull Market which peaked in early 2000. The next Bull Market started in late 2002 and just like today, some of the best early gains came from the last Bull Market’s leaders—Technology. It was a head fake. Energy and emerging markets turned out to be the big winners. Microsoft, Cisco and Intel skipped the last Bull Market for the most part.

More important to us is who could lead the next Bull Market in U.S. stocks. To understand which groups might be the best place to be you have to ask what were the characteristics at the bottom of prior market lows of the leading sector. First, they were out of favor. This is primarily from poor stock price performance, but also usually because of bad news incorporated in their stock prices which they have no control over. The sector to buy at the 1982 low was consumer staples. The stocks were depressed and they were about to gain the economic benefit of commodity prices dropping dramatically. Lower input prices expanded profit margins and earnings. Coke, Pepsi, Kraft, General Mills, General Foods and Beatrice Foods were some of the names that lead that 1980’s Bull Market.

Second, to be the leading sector of the next Bull Market it helps to be the center of attention of the worst things that happened in the prior Bear Market. Banks and Savings and Loan institutions couldn’t have been any more out of favor coming out of our national financial crisis between 1988 and 1992. They were despised for being the heart of the problem which caused the first President Bush to not get re-elected because it was “the economy, stupid”. With Enron and the collapse of energy trading in 2001 and 2002 leading the Bear Market down, it was only natural that energy-related stocks bottomed at such depressed prices that they were a powerhouse for stock buyers from 2002 to 2007.

Third, and most importantly, the Bull Market’s leading sector offered its future success at a huge discount to the future success of other sectors and the market itself. We measure this by comparing P/E ratios and dividend payout ratios to the market overall and to the sector compared to the last 30 to 40 years. In other words, to find good long-term sectors to roost in, you try to buy the most future success for the least amount of money. What a novel concept!

Which group or sector fits these characteristics today? We believe the drug stocks are an obvious candidate. They have some of the lowest P/E ratios they’ve had in 20 years and they pay way above average dividends to the market. Their stocks have been poor performers since 2001 and they have the threat of socialized medicine breathing down their neck. Ironically, we also believe they are a great way to play the economic growth in emerging markets (see our missive “Playing Emerging Markets”).

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:

In prior missives, we at Smead Capital Management have shared with you that there is a large group of money managers and investors who are counted as bullish, but are actually bearish. These investors own the reflation trade or what we like to refer to as “Peak Oil Mini-Me”. Their thesis says that the Federal Reserve and U.S. Treasury are flooding the world with dollars and “printing” money and the only way to take advantage of those facts is to be long oil, gold and other commodities. The current market correction is all about them and the truth behind their thesis.

We believe the truth is that if all that the government is doing causes a rapid improvement in the economy and quickly leads to very high levels of inflation, we’ve got even bigger problems later on to deal with. We sincerely believe these “Long Bears” are wrong. Their frustration is causing a significant and temporary pullback in the S&P 500 Index. We believe that the U.S. Economy will begin a long slow growth phase beginning in the fourth quarter of this year (Oct. 1-Dec. 31). A year ago the economy went into a coma in September. We have since reset our spending 10% lower than the prior year. This spending cut is much deeper than 10% appears because it is about half of the discretionary spending we do each month. The recovery doesn’t occur because of what the government does. Growth occurs because the economic benchmark has been lowered and economic activity is compared to how you were doing in the same quarter of the prior year.

The Federal Reserve’s actions and the government stimulus doesn’t scare us because of the banks need to replenish their capital. They will return to a good business of lending money to credit worthy people with sizeable down payments. A recent study by Stan Liebowitz in the Wall Street Journal has shown that the number one correlation to foreclosure was the lack of any down payment.

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

This return to normal banking will take three to five years. At the same time, individual households and businesses are going to be very hesitant for years and maybe decades to borrow money. Add it all up and you quickly decide that we will not recover by returning to the foolish lending and borrowing of the last ten years. In our minds this means that we won’t reflate the economy. If you don’t reflate the economy, the case for oil, gold and commodities go right out the window and will look foolish; especially after last year’s oil and commodity bubble burst. History shows that bubble markets are dead money for a long time after breaking, just look at the Nasdaq today compared to the peak of the tech bubble in early 2000.

So who wins in this scenario? The winners will be the “Long Bulls”. The “Long Bulls” believe that all the fear of the last 18 months has left the prices of many of the world’s best companies far below their intrinsic value. A long and slow economic recovery with an accommodative Federal Reserve could lay the groundwork for businesses with strong balance sheets and wide moats to gain market share. This would allow them to grow nicely from the “reset” of consumer spending levels. It could be a long period without excesses, which are usually created by too much leverage. As the debts of individuals and the government are paid back, an automatic restraint is put on the economy keeping it from overheating. Single-digit earnings growth in a slow economic era could produce price-to-earnings expansion. We believe large quality company shares will be the place to be for the next five to seven years.

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.