William Smead
Chief Executive Officer
Chief Investment Officer

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 Dear Fellow Investors:

Early in my career I studied the investment philosophy of the most successful and admired investors like John Templeton and Peter Lynch. Both men had great long-term track records in portfolio management. John Templeton’s concept of buying common stocks at the “point of maximum pessimism” usually marks the only time you can buy a superior publicly traded business at a deeply discounted price. From Peter Lynch we got the common sense idea of observing what is going on around us to look for ideas. I’m fond of taking pictures of the lines at Starbucks or noticing three days before Christmas that Nordstrom had sold out of Gucci “Guilty”. Owning a company that meets our proprietary eight criteria and holding it for many years was also an idea Peter Lynch popularized. Doing so requires something about the company which stops it from gaining maniacal popularity, one of our sell criteria. We’d like to explain how Ebay fits Peter Lynch’s two ideas.

Internet commerce is in its early years, but any alert business person can see that there is mass adoption of PayPal. They currently have a 15% market share of internet transactions. Last year, our marketing director, Cole, commented that American Airlines has the fact that they accept PayPal on the back of their boarding pass. I used my I-phone Starbucks app yesterday to pay for my iced tea and many folks refill their Starbucks card with PayPal. The growth in PayPal probably keeps the top executives of Visa and Mastercard awake at night. Numerous other parts of Ebay’s stable of companies are seeing very fast growth and could be observed by Mr. Lynch.

To understand why Ebay won’t get a maniacal stock price, you have to understand their original business. Ebay Marketplace is the New York Stock Exchange of pre-owned goods. It also is a home for numerous “power sellers” of new and refurbished goods. It is a retailing entity which pays no rent and carries zero inventories. It is like the NYSE in that they really don’t care what the hot selling item is, as long as someone has a hot selling item on their system. This business produces massive free cash flow, but is a niche business and is probably not in a position to dominate internet retail sales growth and market share, in our opinion.

Ebay reported earnings on January 20, 2011 and pleasantly surprised the Wall Street analyst community. However, numerous analysts and news reports framed the earnings release in a very negative light even though operating earnings grew 24%. They say that since internet retail sales grew by 12% in 2010’s fourth quarter, Ebay is somewhat of a failure by only growing gross merchandise value (GMV) by 6%. I don’t remember folks criticizing Berkshire Hathaway for the slow growth in its insurance businesses, which provided Warren Buffett the float to invest in other businesses and stocks like Coca Cola, Wells Fargo, Burlington Northern and Gillette.

One of the stocks that Peter Lynch invested in to build his successful track record at the Fidelity Magellan Fund was Phillip Morris. It was the largest tobacco company in the US and was using its massive free cash flow to become a major player in the food business in the 1980’s and early 1990’s. No matter how well the earnings, cash flow and dividends grew, the stock never got an inflated price-to-earnings ratio (PE). Philip Morris was being sued by the families of smokers. Who wants to own shares in a company which is getting sued constantly? It stayed reasonable for decades and made its common stock owners wealthy in the process. From 1972 to 2001 it produced a 17.8% average annual gain for its common stock holders who stayed for the entire 30-year stretch.

Ebay has about $5 per share in cash and is expected to have operating earnings of $1.90-1.95 this year. When you back the cash out of today’s price of around $30 per share, you get $25 per share. This means that a company (PayPal), which is growing at 20% per year in sales and could be one of the most exciting businesses in the world is hiding inside a company with a 13 PE multiple. We think Peter Lynch could be smiling.

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

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Dear Fellow Investors:

The largest bond mutual fund company on the planet has built its entire thesis around what they call the “New Normal”. It is the idea that the large overhang of debt in the US and the deleveraging which governments and households need to execute will cause an extended period of meager economic growth. At a conference in Sydney, Australia last week, another well-known money manager called that view “idiotic” and boldly predicted a very bright next ten years for our economy and the US stock market. Who should you believe?

Most of the respected money managers who fall into the “new normal” camp make their assumptions by looking at the twenty years of agony which Japan has gone through since 1990. In the aftermath of their stock and real estate bubbles breaking in 1990 (those of you excited about China should take note) fiscal and monetary policies all seemed to fail in a liquidity trap. Since their stock market and economy haven’t grown in 20 years of deflation, the thesis goes, we must have a very long penance period to go through ourselves. The theory is that the financial sins of the last fifteen years were so egregious that the punishment must match the crime. Another way of looking at it is that the economic system got very dirty and it will take a lot longer to clean it.

We have found a wonderful statistic to follow provided by the Federal Reserve Board that speaks directly to this subject. It is called the Household Debt Service Ratio (HDSR). It computes how much of US household income is required to service household debts. The statistics go back to 1980 and paint a picture of an economy that has to heal itself every ten years or so. Here is the link to the chart: http://www.federalreserve.gov/releases/housedebt/.

As you can see by looking at the chart, household debt service has ranged from close to 14% in late 2007 and early 2008 to as low as 10.6% in 1980 and 1983. It peaked at around 12.4% in 1987 and bottomed in 1993 at 10.8%. After peaking at nearly 14% two years ago, it has fallen to 12.13% as of June 30, 2010. Our conclusions from this chart are as follows. First, you could conclude that to have an extended period of robust economic growth that you need to start with HDSR below 11%. Growth was strong from 1982 to 1987 and again in 1993 through 2000 because US households had plenty of ability to add debt and service the additional payments.

Second, economic growth is muted as debt service ratios improve. The Bank and Savings & Loan debacle of the late 1980’s and early 1990’s included a six-year stretch of slow economic growth which brought the HDSR down from 12.38% to 10.8%. President George Bush I failed to get re-elected in 1992 because “It’s the Economy, Stupid”. Economic growth was slow as Americans were more inclined to improve debt service than to spend.
Third, “new normal” advocates are correct that we had a great deal more work to do to get the HDSR down to attractive levels. To drop from 14% HDSR to below 11% is a huge task and is likely to take one to two more years to accomplish. Therefore, economic growth in the US should remain slow during the remainder of this HDSR reduction stretch.

Lastly, the Japan comparisons are wrong and outlandish. It took six years from 1987 to 1993 to get our HDSR down to attractive levels the last time we had a major cleansing episode, a drop of 1.58%. We just knocked it down by 2% in two years! At the pace we are on, we could get below 11% in five quarters of results which is one year from now, September 30th, 2011. Japan didn’t confess their financial sins in the 1990’s and didn’t clean out their financial system of its bad loans. If you don’t confess, you don’t heal. Their population shrank due to low birthrates and slim immigration practices. Their economy is limited by a lack of natural resources and limited useful land.

As we maintain ownership of companies which fit our eight criteria, we choose to assume that the dreariest scenarios are wrong because of their expected length. The ability of Americans to adapt by necessity is legendary. The only question to answer is how long the healing will take. There is an arrogance surrounding the “new normal” camp because they believe they know what the economy is going to do. The great money manager, Peter Lynch, of Fidelity Magellan fame said, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes”. It appears that the vast majority of market participants have forgotten his rule. CNBC’s broadcasts used to be about stocks and stock picking. The drama in the financial markets today is centered on economic statistics.

History shows that once the healing is complete US economic growth at the 4 to 6% level can ensue. We happen to agree that investors are setting themselves up for disappointment if their view of the next ten years is too negative. There is more work to do, but the US stock market is an anticipatory vehicle. Our positive view of the US stock market is contrary and it makes us feel more comfortable.

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

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Click here to listen to this Missive

Dear Clients and Prospective Clients:

We at Smead Capital Management are not afraid to admire people who disagree with us. If someone sincerely believes that the stock market is going to do poorly over the next two years, puts their money where their mouth is and sticks to their guns, we have nothing against them. We don’t agree with them, but we can accept their position. They are Bears on the market and they most likely believe that price earnings ratios didn’t get low enough in March to justify a bottom or they believe that the debt accumulated in the last ten years will stifle economic growth and retard the financial system. They go by names like Roubini, Faber, Tice and Rogers. We have no problem with them and we think that the way they have scared everyone is going to make long-term buy and hold investors like us a ton of money.

However, there is a second kind of Bear in the marketplace and we consider them to be dishonest Bears. They are the hedge fund managers, mutual fund managers and individual investors who temporarily own some stocks, but own them with one foot out the door the entire time. This is the “Fast Money” crowd and they are looking for something to own for six weeks to three months. Jim Cramer is there poster child and the discount brokers and stock exchanges are their sponsors. They are the worst kind of momentum investors. We consider them bears because the way they are organized and postured makes for very little likelihood that they or their clients would gain the benefits from holding common stocks for many years. After all, over long stretches of time a significant part of what you make from owning common stocks comes from dividends. In affect they rent stocks rather than own them. They whip around ETFs, are attracted to momentum markets like Gold and Oil and love high levels of volatility. Included in this category are the hyper-inflation folks who are invested in commodity oriented common stocks and think they are going to make a great deal of money from an economic comeback that ruins everything with high levels of inflation like in the late 1970’s and early 1980’s.

We normally wouldn’t really care about these “Closet Bears”. Unfortunately, in this market cycle, they have ended up with way more of the existing capital than normal. It makes sense because after the decline from October of 2007 to March of 2009 most humans who have the courage to participate want to get out of the way quickly if things turn sour again. So you have the “Real Bears” who are in cash and short stocks, mortified from what happened this year. Then you have the “Closet Bears” long stocks for two months at a time with one foot out the door all along.

To be a “Real Bull” you have to be fully invested in quality stocks which are selected based on how well they might do over the long term. Peter Lynch is our poster child. He was asked in early March about the stock market and he said, “I’m the wrong guy to ask because I’m always bullish.” Watch on T.V. and in what you read. If you see a hedge fund or mutual fund manager say that they are bullish on the market and then explain that they are long Oil, Gold and Basic Materials, you are staring a bear in the face!

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.