William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

At Smead Capital Management (SCM) our contrarianism and urge to purchase stocks with low PE ratios has led us to own what we think are the finest and most recession resistant companies in the world. To understand our portfolio and where we are in history you must read Randall Forsyth’s column in Barron’s dated June 21, 2010, an article written by Jason Zweig in the Wall Street Journal over the weekend called “So that’s why investors can’t think for themselves” and Brian Belski’s research note at OPCO yesterday (June 21st, 2010). Randall quotes work by Jason Trennert on “The New Lords of Finance: Policy’s Long Shadow Over the Markets”. In it Trennert argues that a small group of policy makers in places like Washington D.C., Brussels and Beijing (whether elected or not) are “exerting enormous influence over the economic cycle”. He says and Forsyth reiterates, “All of this has led to a certain sclerosis when it comes to the behavior of certain large companies. Among the symptoms is that these companies sit on record levels of cash.” Forsyth points out that it wouldn’t be so bad if the cash was being used to raise dividends and do stock buybacks instead of hoarding it in t-bills earning virtually zilch. He also goes on to show how investor behavior has been led around by reaction to the policy makers and the inaction on the part of the leaders of large US corporations:

“Leaving aside the philosophical implications, the practical investment effect is that investors appear willing to hold cash earning 0% or 10-year Treasuries yielding 3.25% “and yet remain unwilling to buy large-cap growth stocks with fortress balance sheets and decent dividend yields trading at low double-digit earnings multiples,” Trennert says.

Jason Zweig’s article cuts to the core of the current opportunity in Large Cap Non-Cyclical US stocks. Here is his thesis:

“Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear. In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn’t just give investors a sense of “safety in numbers.” It also gives them pleasure. That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the “consensus view” on Wall Street.”

Therefore, at the “basic human level” it is unnatural to be a lonely contrarian and what could be more lonely than owning large quality companies which have not been the place to be since they peaked in popularity back in 1999. Throw in the worldwide policy elites publicly dressing down your industry and demonizing large profitable companies in general and you have what we believe is a prescription for historically extreme undervaluation and absolute low PE’s. This makes us at SCM just drool and lays the groundwork for what we believe will be 7 to 10 years of above average performance.

People say things like, “small to mid-cap stocks are still doing way better”, even though they are dramatically more expensive on a trailing and estimated PE ratio basis. The smaller your company is the less chance that the policy makers are going to use you as a populist punching bag. We believe the biology study proves what John Templeton clearly understood in creating an incredibly good track record in the Templeton Growth Fund from 1950-1990. He said, “The time of maximum pessimism is the best time to buy”. The price you get without any reinforcement from the crowd is the price that will generate the most future success with the least amount of risk.

In a report out yesterday called “Dividends and Buybacks Increasing”, Brian Belski and his folks at OPCO show that despite the coma that the circumstances of the last three years have put companies and investors in, that the dividend increases and stock buybacks are coming anyway. Templeton might have called that the first light at the end of the tunnel. Belski also shows that it bodes well for overall stock market returns. Rejuvenation phases in dividend and stock buyback activity in the past has coincided with very solid and positive results in the S&P 500 Index. Our portfolios are loaded with recent dividend increases and massive added stock buyback activity because our companies have strong balance sheets for the most part and generate way above average free cash flow. From all of this we believe there can be only one conclusion for the patient investor.

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:

As a reward for executing a hectic east coast business trip, we went to a play called “God of Carnage”. Jeff Daniels and Lucy Liu starred in this four-actor, one-act play about two couples seeking to deal with a fight between their two 11-year old sons. The 90 minutes of conversation originally centered around how to deal with Lucy’s son punching the other boy and breaking two teeth. It was amicable at first, but then ultimately descended into arguments. The conversation exposed most of the individual flaws of all four parents and definitely exposed all the cracks in each marriage. It was very humorous.

Lucy’s husband played the part of an attorney who represented a drug company. He was on the cell phone constantly dealing with a crisis related to the side effects of one pharmaceutical product. His dishonest attitude and lack of ethics were on display as he interrupted the discussion on how to deal with the consequences of the fight between the two boys. Since art is a reflection of the culture of the day, the inherent evil of this man and the company which he represented were one of the main centerpieces of the play.

At Smead Capital Management (SCM), we are especially interested in what John Templeton called “the point of maximum pessimism”. To understand pessimism you have to look to the media, to the arts and to what we call “the well-known fact”. This is a body of economic information which is known to all participants and has been pretty much acted on by anyone who would care to act. As the City College of New York professor told former Intel CEO Andy Grove, “When everybody knows that something is so, it means nobody knows nothing.” Our politicians, media and artists know that “Drug” companies are evil. Investors know to stay away from them. The major pharmaceutical companies all trade in the lowest Price/Earning (PE) ratio quintile in the S&P 500 Index, and are the cheapest compared to the other sectors of the US stock market as we have seen in 20 years. Drug stocks haven’t been this small a part of the S&P 500 Index since 1984.

This reminds us of the documentary in 2003 about McDonald’s called “Supersize Me”. A young man ate three meals a day at McDonald’s for six weeks and agreed that he would supersize his meal every time an employee asked him if he would like to. He gained a great deal of weight, saw his cholesterol shoot through the sky and was well on his way to killing himself through food over the longer haul. The “well-known fact” in 2003 was that McDonald’s sells unhealthy, high fat foods and doesn’t care whether they are going to kill you in the process. Investors were sure that there would be a big backlash and McDonald’s business would be damaged for years. The stock bottomed out around $15 per share, way down from prices above $30 per share just a few years before.

Pharmaceutical companies make vaccines, treatments and cures by manufacturing medicine. They seek to profit from improving the health of human beings and extending the quality and duration of life. The barriers to entry in their industry are very high because it costs about $1 billion to produce a blockbuster drug. They receive patent protection because many of the medicines they attempt to create never make it to the market and only end up creating expenses. These companies maintain fortress-like balance sheets and earn very high returns on unleveraged capital. In the process, they generate massive levels of free cash flow and pay generous dividends.

The point of maximum pessimism associated with the makers of medicine is tied to four main beliefs. First, they are an easy punching bag for politicians (including the President of the US). Most studies put pharmaceutical sales at around 10% of what we spend on healthcare in the US. Second, they’ve been feasted on by litigators. The Vioxx settlement shows that whatever downside risk there is associated with a medicine will get exploited to the maximum until we get tort reform. Third, the FDA is scared to approve new medicines at the expense of thousands of people who lives might be hugely impacted by use of a drug not yet approved for sale. Lastly, a number of major existing blockbusters are losing their patent in the next four years and investors can’t visualize where these once admired companies will get future revenue growth.

Today, McDonald’s is around $70 per share and has been one of the best large cap performers in the S&P 500 Index since the documentary was released nationwide in theatres. They have added healthier choices to their menu, but they still make most of their money selling clean, inexpensive, high-fat content food all over the world.

At SCM, we believe the makers of medicine have very little downside risk as the result of the attitudes exhibited by the play “God of Carnage”. As we drive up to the New York Stock Exchange window to order our common stocks, we ask for pharmaceutical manufacturers and say, “Supersize Me”.

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.