William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

moat/mōt/
Noun:   A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.

At Smead Capital Management our investment committee talks and thinks about the moat of a business a great deal. Based on the definition above, we believe that a wide moat is provided by the aspects of the company and their business which prevent competition from damaging highly sustainable profitability. Wide moat is one of our eight proprietary criteria for selecting common stocks. We have seen a number of organizations begin to include logic associated with moats into their equity research formats. Unfortunately, we believe many market participants confuse the by-products of a moat with the actual moat itself. We think this spells opportunity. Looking for stocks with a wide moat that are priced as if they don’t have one adds to the advantage of the long-duration common stock investor.

I read recently that after years of trying and millions of dollars invested, Google (GOOG) is considering folding Google Wallet and Google Checkout together. When it was announced five years ago, Google Checkout was thought by some to be a potential “PayPal killer”. PayPal appears to have successfully defeated one of the largest cash-rich, wide-moat companies in the world from getting into its secure, online payment castle. PayPal’s moat includes over 100 million existing customers, consumer brand recognition and nearly a decade of statistical information on transactions. Google has the same kind of moat in search that PayPal has in payments. The economic need that PayPal meets is identification privacy and ease of transaction facilitation. It’s a huge market and will grow tremendously in the next ten years. We believe as Google admits defeat, it will mean that the moat at PayPal is so strong that it can’t be overcome by massive financial resources and tech savvy. Google had both of those merits.

PayPal is a wholly-owned subsidiary of Ebay (EBAY). Ebay has a wide moat in its core marketplace business. Ebay is one of the most recognized brands in the world and most of its advertising is free thanks to the lock it has on market share for pre-owned items. When an athletic milestone is reached, the ball or puck or jersey is expected to immediately be offered on Ebay. Sportswriter’s frequently mention this fact in their writing. When Michael Jackson dies, his memorabilia becomes an instant hit on Ebay. This moat makes the low-risk, high free-cash flow nature of Ebay’s original business nearly impregnable. After backing out the cash net of long term debt, Ebay trades for 11 to 12 times the 2012 consensus earnings estimate. It is very unusual to see a fast-growing, wide-moat business trade for anything short of a premium to the S&P 500 Index multiple.

The symptoms of a wide moat are things like high, sustainable profit margins, huge market share, pricing flexibility and long histories of these identifying characteristics. However, the symptoms are not the moat. The moat causes the symptoms. Walgreens (WAG) is one of the two largest drugstore companies in America. Their properties dominate the best locations in the US, their brand recognition is the highest in the industry, their real estate ties up very little of the company capital and they have decades of experience in customer needs and satisfaction. Their financial muscle puts them in position to buy Duane Reade and walk away from Express Scripts. A college buddy who did extensive research on the subject told me that one out of every two Americans will never get a prescription filled outside of the walls of a drugstore. Walgreens castle is being attacked by a disagreement over pricing with Express Scripts and their moat is very busy defending the company. We think it will succeed.

HR Block (HRB) has spent the last ten years fighting off the attacks of Jackson Hewitt and Liberty, two tax prep companies started by former HR Block employees. My favorite test for a moat is putting 100 people through a survey. You ask them, “What is the first thing that comes into your mind when the surveyor says tax preparation”? Almost everyone will say, “HR Block”. If the question was online payments, it’s PayPal. If it is, “where do I find pre-owned items, or sporting event tickets?” the answer is Ebay. If the question is, “who do I trust to entertain my children and spouse?” it is Disney/ESPN (DIS). If the topic is coffee the answer is Starbucks (SBUX), burgers it’s McDonalds (MCD), retail service and selection it’s Nordstrom (JWN). The moat in business is about deeply, rooted competitive advantages which business cycles can’t uproot. It is about a love affair between a company and an addicted customer base which grows as population grows.

Warren Buffett was asked by the Financial Crisis Commission what one single characteristic he looks for in a business. He referred to the stickiness of the customer and the company’s ability to raise prices without affecting unit sales. We feel the moat of the business is what protects the ongoing success of a business even when legitimate competition comes along. It is what is behind wonderful long-term profitability and high levels of free cash flow. Moat analysis is not about number crunching, it is about mind-space control and forces which block or kill competition.

Lastly, we at SCM are value investors. Something very difficult has usually had to happen to open the door for us to get a good entry price on common shares of a wide-moat company. Ironically, in many cases, the temporary reason for the disfavor actually increases the size of the wide moat. Big pharmaceutical companies have had the most hostile political, regulatory and legal environment in the industry’s history the last four years. Major drug stocks have seen blockbuster products lose their patent and the combination of the aforementioned forces have brought many drug stocks down to the lowest PE quintile (bottom 20%) in the S&P 500 index. Instead of doing permanent damage to companies like Merck (MRK), Pfizer (PFE) and Bristol Myers (BMY), these circumstances have increased the depth and width of their moat. It is estimated that a new drug costs over one billion dollars to create and bring to market. Nobody besides these large pharma giants can afford to fight the battle. This high original investment threshold has turned the biotech industry into mostly farm teams feeding the major leagues. Smaller drug and biotech firms do research for creating wonderful new health science and are forced to hand it off to someone with deep pockets and an international manufacturing and sales force. Now that companies like Merck and Amgen (AMGN) are having great success with new products, the naysayers can begin to recognize how incredibly well defended these companies are from competition going forward. We believe they have wide moats.

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

Printable Version

Dear Fellow Investors:

We have now seen the S&P 500 Index drop below 1150 five times since the first of August. The overriding reasons, listed in no particular order, are fears of another contraction in the US economy, European sovereign debt and bank problems, a lack of political leadership in Washington D.C. and persistent unemployment data. These problems have caused an 18% decline in the index from peak to trough and have given those of us who stay fully invested in high quality stocks another opportunity to examine our thesis.

Our thesis is that by owning the companies which fit our proprietary eight criteria and making changes very sparingly, we can garner the historically superior returns which come from equity ownership and exceed the return of the index over long-term time periods. This comes from a combination of dividends, dividend increases and capital appreciation.

Even though we are not traders or short-term oriented, we at Smead Capital Management would like to throw out a few opinions which cause us to be very positive about the stock market over the next one to two years.

1) While market participants look to the US government and the Federal Reserve Board for answers, US Households are doing remarkable and historical work of getting their finances in order. The Household Debt Service Ratio dropped to 11.09% at the end of June after being as high as 14% in late 2007. This is the ratio of how much of the average family’s gross income is dedicated to debt service. The statistics are reported on a 90-day lag, which means that the ratio is probably below 11% by now. At the pace that households are improving their income statements, we could see a ratio of 10.6% in the next year. Numbers below 11% existed in 1982 and 1992 at the beginning of extended periods of prosperity. What this means is that households could take on monthly payments comfortably and that bodes well for the employment rich automobile and housing industries.

2) Usually bearish firm, Grantham, Mayo, Van Otterloo (GMO), recently put out an extensive research piece indicating that US housing participants are making the “Error of Pessimism”. They are arguing that US housing is in position to become a bright spot in the US economy.

3) Commodity prices are plunging. In the same piece, GMO argued that China is making the “Error of Optimism” in residential real estate. If real estate activity falls off in China, commodities will continue to decline. No politician could duplicate the incredibly simulative effect of lower gasoline prices, not to mention the enormous psychological benefits in a mobile society like ours.

4) Pretty much all stock market participants are bearish. Mutual funds specializing in US Large-Cap equities have suffered huge net liquidations for months. Sentiment polls look similar to the spring of 2009, right before a huge gain in the following two years. Stock correlations are running at highs only seen in the 1987 crash period. This means that the professional traders are selling baskets of stocks simultaneously without regard to their quality. When low correlations come back in the future there is a lot of wheat to separate from the chaff.

5) We believe our companies have performed well in a less than stellar environment. The dividend growth the next five to ten years could set records as these lean powerhouses gush free cash flow. Howard Schultz pointed out, as an example, that Starbucks has $2 billion in cash on their balance sheet and might be interested in strategic acquisitions.

6) Insiders (officers and directors of public companies) have been as aggressive in their purchases of their own company’s stock as they were in early in 2009.

We believe many of our stocks have held up quite well in this environment, but some of them look especially attractive at this point. Financial stocks seem to be in a capitulation phase and Wells Fargo (WFC) and Aflac (AFL) look particularly attractive. The household debt ratio inspires us about Disney (DIS), Cabela’s (CAB) and H&R Block (HRB) in what we call our “staple” consumer discretionary category. In healthcare, Mylan Labs (MYL) is retesting its August low and saw significant insider buying at these price levels last month. We would be remiss to not mention that PayPal/ Ebay (EBAY) is preparing to become a major payment force in stores for the first time. It is nice to start a business with 100 million existing customers.

In conclusion, we have reasons for being the optimistic contrarians, even over the next one to two 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. 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

Printable Version

Dear Fellow Investors:

While China’s economy is hitting the wall and investors are beginning to deal with what we believe is a major bear market in commodities, it is time to stop and examine some of the bargains created by the recent correction.

We have said many times that valuation matters. We believe one of the biggest bargains currently is Aflac (AFL). They are the largest seller of supplemental health insurance in Japan and the US. Japan and the US are probably the two countries which would benefit more from a decline in commodity prices than any others in the world. Aflac sells at 7.5 times 2011 First Call consensus earnings estimates and has dropped from a high of $58 per share earlier in the year. It appears to us that Aflac’s stock price takes a dive every time that Greece and other PIG countries dominate the economic news cycle. Aflac has a huge international bond portfolio. A tiny percentage of that is in the weaker European countries. While investors mope about these concerns they are ignoring a powerful positive force in the US. As health insurance costs rise for businesses, deductibles will go up. As deductibles rise and the expense gets too great, companies will offer Aflac’s supplemental health policies in their benefits package. If Aflac has the same kind of success in the US they’ve had from rising deductibles in Japan, it could be huge.

We have argued for two years that Ebay continues to be the most underrated success story in the US. Marked improvements in their marketplace business are causing an acceleration in earnings. This is happening at the same time as PayPal is growing revenues at the rate of 20-25% year to year. We believe that the in-store payment system in the US is going to get revolutionized in the next five years. PayPal’s growth is yet to include being a major payment player at physical stores. With the experiences and technology advantages they have from the online world, we believe they will get their fair share. Ebay trades at 14.5 times operating earnings for calendar 2011 First Call consensus. This doesn’t include the $5 per share in cash on the balance sheet. They have wisely harvested Skype and gained further entry into the intersection of the virtual and real economy by purchasing GSI Commerce.

Our sum of the parts analysis of the company looks like this:

Disney’s First Call consensus estimates for fiscal 2011 and fiscal 2012 are around $2.56 and $2.99. Do you have any idea how many kids have had trips to Disneyworld and Disneyland postponed by the economic cleansing of the last three years? We believe oil prices will decline in the next year and lower gasoline prices could unleash pent-up demand for Disney vacations similar to what happened in the mid 1980’s. The stock has been under pressure as worries about a settlement between the NFL owners and players has been slow to happen. In our opinion, there is probably more certainty of where Disney is going in the next twenty years than any company in the US. This certainty should mean a premium multiple of 18 times the $2.99 per share earnings estimate or around $54 per share. We look for a big ramp up in dividends in Disney as well as many of our other companies.

After the original economic disappointment, we feel China’s slowdown will be the best non-government stimulus package ever invented. We believe the upcoming commodity bear market will usher in a great era for non-cyclical US companies and a sustained period of non-inflationary prosperity.

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

Printable Version
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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.