William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

When a market has been strong, there is no limit to the number of people who will tell you how good it is going to be for the foreseeable future. When a market has gone down for a long time, a multitude will tell you how far down it is going and how long the downtrend will last.

At Smead Capital Management we have developed a term for this that we call a “Well-Known Fact”. By definition (Smead Unabridged Dictionary), a “Well-Known Fact” is a body of economic information which is known by all market participants and has been acted upon by nearly everyone who could care or has the financial wherewithal to care to act. It is best understood through the comments of former Intel CEO, Andy Grove, who said that the best advice he ever got in business came from a professor at the City College of New York. The professor said, “When everyone knows that something is so, nobody knows nothin’.” By nothin’ the professor infers nothing that could do you any good. When everyone believes a fact and has acted on it to an extreme, nothing good can come to you from believing it from an investment standpoint.

Here is a series of “Well-Known Facts” from recent history. Also noted are the assets that were purchased to act on the fact and the end result of the extreme:

Fact 1: The Internet will change our lives. — Asset Purchased: Tech Stocks — Result: From the peak of early 2000, tech stocks fell 80% in 2.5 years.

Fact 2: Residential Real Estate only goes up. — Asset Purchased: Homes in sunshine states of Arizona, Florida, Nevada and California. — Result: 40-50% price drops and a majority of the nation’s foreclosures.

Fact 3: Brazil, Russia, India and China (BRIC) will grow faster than the industrialized world. — Assets Purchased: Commodities and Emerging Market Mutual Funds. — Result: Commodities drop 60-80% and Emerging Markets fall 50-70%.

At the extreme, whatever value that is connected to the assets involved with the “well-known fact” doesn’t matter in either direction and there is no shortage of both expert and non-expert opinion on how high or low the asset prices will go. Henry Blodgett saw the moon for Qualcomm and internet stocks in 1999. No shortage of cable shows taught you to “Flip this House” in 2005. And in 2008, Goldman Sachs’ Oil analyst put a $200-250 price possibility on a barrel of oil. Not to mention T. Boone Pickens, who has been attempting to talk oil prices up since it peaked at $147 per barrel last year.

In the opinion of SCM, here is the new “Well-Known Fact”.

Fact 4: The massive amount of borrowing attached to homes and personal finances in the U.S. over the last ten years dooms us to a three to four-year recession/depression which is not treatable by policy makers and could ultimately cause a total collapse of our financial system. — Assets Purchased: U.S. Treasury Bills, Notes and Bonds; Gold and “virtuous non-U.S. currencies”. — Assets Sold: Common Stocks including the finest companies in America. – Experts: Nouriel Roubini, Jimmy Rogers, Marc Faber, etc., etc. etc.

The T-bills and gold are easy for us to see through. There is a bubble of fear and uncertainty. Therefore, any asset which seems to give protection against fear should get way over-priced at the height of the fear. We wonder how people are going to feel about earning little or no interest for years. I drove by a guy on Pima Road in North Scottsdale today selling Safes on the side of the road. Gun sales are through the roof. These actually make more sense to me than the money-market funds, savings accounts, CD’s and T-bills. If the premier U.S. companies don’t survive and prosper, there will be no tax revenue to insure deposits, back money-market funds and redeem government debt. If our Disney, Abbott Labs and WalMart don’t make it, you need a one-acre garden, a nearby water supply and a set of big guns and lots of ammo.

As bad as this decline has beaten our stocks in the short-run, you’d think that we wouldn’t love it just as much as the other “well-known facts”. You’d be wrong. This one is possibly setting up faithful and persevering blue-chip stock investors for the positive ride of their lifetime. First, today’s Wall Street Journal is talking about an additional decline of more than 20% off a stock market which has been pummeled more than any market other than the 1929-32 “Great Depression” decline. Second, sentiment polls from the American Association of Individual Investors and Bespoke Research show that a MAJORITY of market participants believe that the stock market will fall more than 20% from here. Third, our wonderful and well-trained clients have called me more times in the last two weeks to tell me that the market is going down more and is going down for another one to two years. All these prognostications coming from folks we’ve worked for for years and have n ever had an personal opinion about the short-term stock market direction prior to this year.Fourth, there is more cash on the sidelines in money-market funds relative to total U.S. stock market capitalization than any time in the last 60 years.

We could go on all day with additional evidence, but we think you get the picture. We believe there has probably never been a better day to buy quality U.S. stocks (for a two to three-year holding period) in our lifetime than today. The reason is that everyone knows that the opposite is so and, therefore, “nobody knows nothin’.”

BUY-BUY-BUY

Warm Regards,

William Smead

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

Dear Clients and Prospective Clients:

In the midst of this historically poor start to the year 2009 in the stock market (S&P 500 year-to-date return), we thought it would be helpful to give you some reading in between the lines of the Berkshire Hathaway Annual Letter.

1) “Book Value fell 9.6% and the stock price fell 32%”

Translation: This was the worst year out of 44 on an absolute basis for Berkshire Hathaway. Book value has grown at 20.3% on average over 44 years!

2) “By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Translation: What we at SCM describe as an “economic coma” has been as swift and violent as any Warren Buffett has seen in his adult business life.

3) “Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

Translation: It has been a long time since we had a major and painful economic contraction. We have grown soft because of it and the steep decline in stocks has every intention of robbing all of us of our optimism. It won’t rob Warren’s and it won’t rob ours at SCM.

4) “Take a look again at the 44-year table on page 2. In 75% of those years, the S&P stocks recorded again. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’ t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”

Translation: Don’t extrapolate forward the recent down trend. Picture where you are as an owner of common stocks and where you want to be in five years and stick with your discipline.

5) “I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

Translation: Warren got caught in the “Peak Oil” Bubble last year and believes that oil will rise in price in the future. Too many investment people agree with Warren and we believe that he will need a great deal of time to get even on Conoco.

6) “I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 m illion for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

Translation: Warren’s existing holdings in Wells Fargo, American Express axp and US Bank usb punished him in the last year and he got burned badly by dabbling in a few new financial institutions. There is grace for us at SCM in his difficulties!

7) “The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

Translation: Good quality stocks and bonds are underpriced and U.S. Treasuries, money market funds, CD’s and savings accounts are overpriced! However, to gain the benefit from this investment discrepancy you must deal with the possibility that the markets continue to deepen the underpricing and raise the overpricing!

We know we have given you a great deal to consider, but in these trying times in investing we hope we are serving you well by modeling the behavior of the greatest investor of all time.

Warm Regards,

William Smead

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

Dear Clients and Prospective Clients:

In his wonderful book A Short History of Financial Euphoria, John Kenneth Galbraith wrote that human beings ascribe higher and higher levels of intelligence to people based on how much money they make and business success they have. The opposite would be that a lower and lower level of intelligence are ascribe to investors and business people as difficult economic and stock market circumstances dominate the news. Charlie Munger, who is the vice-chairman of Berkshire Hathaway, told Stanford Business School MBA candidates a few years ago that psychology is the most undervalued discipline in business. I’d like to combine the wisdom of the timeless academic Galbraith and the respect for psychology from the super-successful investor Munger to ponder our current market conditions.

The stock market in the U.S. has already fallen 50% from peak to trough since October of 2007 to today. Among many admirable money managers and stock pickers, we at Smead Capital Management appear to have very little intelligence and our IQ seems to get lower by the week. This decline ranks as the worst bear market by magnitude since the 1929-32 market, which lost over 80% of its value from peak to trough.

Perma-bear, Jeremy Grantham, who because of his negative stance on the stock market over the last 10 years is ascribed a great deal of intelligence. He has written extensively recently that he believes “high quality” U.S. stocks provide good long-term value at these levels, but strongly cautions investors that these kind of psychological business crises can overshoot to the downside. He therefore urges consistent buying, but warns that the S&P 500 Index could drop as low as 600 (around 770 today) before it makes a bottom. His main reason for the concern about the downside is that negative psychology and a negative feedback loop can dictate a great deal of panic through human behavior.

It is our view that additional major downside movement in the U.S. stock market could only be justified by a much greater economic contraction than the one we have seen so far (5% contraction year to year) or a substantial increase in U.S. Treasury bond interest rates. Many of the most negative stock market prognosticators look at the market bottoms in 1932, 1974 and 1982. Those market bottoms averaged price-to-earnings ratios of 6-8 and dividends yields of 6%. The 1932 bottom included 25% unemployment and was part of four years averaging 12% year to year contraction in the economy. The economy was chopped in half in four years. The other two bottoms at those historically low average P/E ratios (1974 and 1982) saw Treasury interest rate peaks of 9 to 10% and 13 to 15%, respectively. Therefore, without a near complete collapse in the economy or dramatically higher Treasury interest rates, we don’t see those worst-case scenarios being realized.

None of this makes the bullets we are all sweating fit through our pores any better. However, Grantham points out that his quantitative models show above average returns the next seven years on the S&P 500 Index. Bargain prices on outstanding companies with bright futures outweigh the negative psychology around us and the low level of intelligence ascribed to us for saying so.

Best Wishes,

William Smead

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

Dear Clients and Prospective Clients:

Before the next ten years of successful stock market investing gets away from us, we at Smead Capital Management would like to remind everyone that the purpose for investing is to build wealth to enhance future purchasing power. If you watch investment shows on T.V. or read investment magazines, newspapers or websites, you’d think that the object of the game is to be smart. However, let’s look at some of today’s key topics to see what is currently considered dumb and smart in the investment world. Then, let’s ask if they build wealth over long periods of time.

Ultra-Smart—Sitting in Cash, preferably U.S. Treasuries.
Those who were smart in 2008 held inordinate parts of their assets in cash or treasuries and missed some part of the stock market’s horrendous decline. They earned anywhere from 3% interest to as low as 0% toward the end of the year. It can be a very smart strategy in the short run, but has always been blown away as soon as everything returns to something more normal. We believe when normality returns those who sat in cash will have to stare longingly at the portfolios of their “dumb” friends who sat through abusive declines in the value of their blue chip stocks to get long-term returns averaging 10%.

Smart—Trading in and out of stocks.
Wade Cook hasn’t been out of business that long, but it is hard for you all to remember his advertisements which told people to “cash flow” their stocks. He said, “Buy a stock at $1 and sell it at $2, wait for it to go back down to $1 and do it again.” Wade spent time in jail for his misrepresentations, but the “Fast Money” people or Jim Cramer’s followers won’t. You’d have to be pretty “dumb” to sit through last year’s volatility when you could have been trading the enormous market swings (mostly down swings, they fail to mention). I think that if you add up the gains and losses, commissions taxes and you find that trading almost never builds wealth (unless your Charles Schwab).

Smart—Participating in highly sophisticated and esoteric asset classes.
Commodities, hedge funds, private equity, emerging international markets, short selling and the like always look and sound smart because of the exclusivity and complexity. The exclusivity and complexity contributes to dramatically higher participation costs (a leading cause of wealth destruction) and who knows if anyone ends up building wealth (see Bernard Madoff).

Smart—Gold.
Gold was $1000 an ounce when I was in college 30 years ago. It is $870 today. Am I missing something?

Dumb—Buy and Hold Blue Chip Stocks.
How could anyone be so dumb as to buy and hold the finest companies in the world like Disney or Microsoft or Nordstrom? Don’t they know that we have the worst recession since the 1930’s? Don’t they know what Professor Roubini says? Haven’t they been in China with Jimmy Rogers? Didn’t they see how bad it was last year?

Dumb—Buy American Stocks
Everyone knows that the smart people are investing in China and emerging markets! They must know that Warren Buffett will be wrong this time (NY Times Op-Ed Oct. 16, 2008—Buy American, I did). Didn’t he get wealthy?

Dumb—Leaving your stocks to your alma-mater.
I love reading the stories of the elderly man or woman who leaves their stock certificates to their favorite charity. A schoolmarm who left the school millions or the guy who left the Union Gospel Mission thousands and thousands of dollars of utility stocks buried under his mobile home. It was never gold or trading techniques or complex investments they left, it was common stocks.

At any given time the best investments can look smart or dumb depending on when you look and where we are in the market. However when traditionally solid wealth creation disciplines are challenged, it could be time to get excited. We love what we do at SCM and we hope you all join us in this worthy and hopefully wealth building endeavor.

Happy New Year!

William Smead

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

The darkest days in World War Two were during the bombing of London. Air raid signals would blare and folks would go underground and wait for the bombing to get over. Since the United States had not yet entered the fight and mainland Europe had been overrun by the Germans, the British were left to stand alone. The relentlessness of the pounding and the loneliness could have broken the spirits of the British. With the strong leadership of Winston Churchill and their own grit and courage, they held on. The Pearl Harbor attack of Dec. 7 of 1941 brought the U.S. into the War and also initiated the process which led to an Allied victory.

For investors in U.S. common stocks, the year 2008 will go down as a year of unrelenting declines. We investors feel bombed out and many of us have sought shelter in Treasury securities, CD’s and money market funds. Today’s early trading fits the pattern we’ve seen all year. Stocks are down across the board without any discrimination between companies or sectors which might fare the best going forward. It is indiscriminate bombing and very disheartening and lonely.

Much like the British did, we must display courage and grit as long-term investors. The deep, long-lasting recession, which the experts have predicted since November of 2007, is trying to convince us to give up hope, just like the prospect of a long war tried to convince the Brits. We have to withstand overnight bombings as Hedge Funds redemptions, Mutual Fund liquidations and Margin calls force across the board selling without regard for future prospects.

In World War Two, the reward for not giving up was the defeat of an evil Dictator and an out of control regime called Nazi Germany. Financial matters are not nearly as important, but from these depressed prices on common stocks, significantly lower commodity prices, low interest rates and high levels of human ingenuity, we at Smead Capital Management believe a great deal of wealth could be created by owning U.S. common stocks over the next five to ten years. We intend to pursue victory with a portfolio that can withstand whatever bombings that remain and can prosper in the good years to follow.

Best Wishes in this Holiday Season,

William Smead