William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Music played on gigantic church organs has structural and variable components. The church the organ is housed in, the organ, the pipes and the bench you sit on to play the organ are all critical fixed components. The organist and the sheet music are variable. Each church has multiple organists, but some songs are written and used by almost every church which has an organ. Think of “How Great Thou Art” or “Amazing Grace” and imagine how many copies of the sheet music to these old hymns are sold. The fixed or structural components are critical, but not a great business, because once you have an organ, pipes and a bench you won’t need a new one for a long time. This is what some people call infrastructure. The organ and organ pipe business is only as good as large church growth. Every church needs sheet music even if it only has a keyboard. The writer of songs and their sheet music publishing house don’t have to invest in churches, organs, pipes, benches or pianists to sell their product. Someone else is bearing most of the cost associated with creating the need for your product. And your product wears out faster than the other components of great music.

I’ll give you a few historical examples. SLM Holdings (SLM) or Sallie Mae facilitates the student lending process. They don’t have to create colleges or students or the favorable economics that a college education provides. Coca Cola (KO) sells syrup for soda drinks. They don’t have to create McDonald’s (MCD) restaurants or movie theaters or sporting events or homes. Microsoft (MSFT) didn’t make computers or semiconductors. They only made the operating systems and the software for utilizing the computer. Computer and semiconductor manufacturers bore a large part of the cost of the industry. Not only did these companies (SLM, KO, MFST) have repeat business, but someone else covered a large part of the expense associated with the impressive profitability, high returns on equity and long duration of the business. If you are wondering, this is exactly why we don’t like Microsoft trying to invent new product lines by bearing the brunt of the structural expenses.

Which brings us to an announcement made by Proctor and Gamble (PG) recently. They are going to begin selling their top brands directly through the Internet. They say it is because they can learn large amounts of information about their customers. We know that WalMart (WMT) has every intention of being the dominant online merchandising company in the world and Amazon has the lead at the moment. Nordstrom (JWN) is growing faster in their online division than in any other aspect of their business. What does this tell us? It tells us that these great companies are going to bear a large part of the structural costs of a company called PayPal, the largest online payment system and a wholly-owned subsidiary of eBay (EBAY). The next time you look at a company to invest, consider how much of the structural costs of the industry they bear and it might help you figure out if they can make terrific money from making great music.

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
Subscribe to the Missives Podcast
Click here to listen to this Missive

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.