William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Last week those of us at Smead Capital Management got to listen to the wisdom of Warren Buffett and Hank Paulson. We also read some terrific economic history from Joel Kotkin in a column called “America on the Rise”. I’d like to share some of their thoughts and connect them. In this way we can help folks understand why we think this is one of the best times to own US high quality common stocks by looking for Hall of Fame Companies and use long-term holding periods.

Mr. Buffett interviewed Hank Paulson in Omaha at a big Chamber of Commerce gathering. They spent most of their time talking about the tough decisions which Paulson spearheaded in the fall of 2008 as US Treasury Secretary in the Bush administration to avert an economic catastrophe. In the second half of the talk, Hank shared some thoughts which really solidified our feelings about the “group think” which has a tendency to dominate investment decisions in the short run. He said, “Every other economy, including China, has more significant problems than we do.” You might need to read what he said again. Paulson was Treasury Secretary from June of 2006 to January of 2009 and had been the leader of Goldman Sachs in the years just prior. We have just spent the last two years hearing from a wide variety of economic pundits. Almost all of them have told us that the cleansing of 2007 through 2009 and the overhanging debt of the past 15 years is ushering in the decline of American economic glory. Whether it is “seven lean years” or the “new normal”, we’ve heard it and seen most of the people who manage money adopt it as the foundation of what drives their investments and asset allocation.

Kotkin piggybacks Paulson by demystifying China’s future and rebuts George Will’s recent writing about American “declinism”. He does this by sharing some economic history and by sharing key attributes of long-term economic growth.

“Rarely mentioned in such analyses is China’s own aging problem. The population of the People’s Republic will be considerably older than the U.S. by 2050. It also has far more boys than girls–a rather insidious problem. Among the younger generation there are already an estimated 24 million more men of marrying age than women. This is not going to end well–except perhaps for investors in prostitution and pornography.”

“In the longer term demographic trends actually place the U.S. in a relatively strong position. By the end of the first half of the 21st century, the American population aged 15 to 64–essentially your economically active cohort–are projected to grow by 42%; China’s will shrink by 10%. Comparisons with other competitors are even larger, with the E.U. shrinking by 25%, Korea by 30% and Japan by a remarkable 44%.”

Kotkin goes on to remind us how wrong the punditry has been in past cycles. Remember when Japan was eating our lunch in the 1980’s?

“The Japanese experience best illustrates how wrong punditry can be. Back in the 1970s and 1980s it was commonplace for pundits–particularly on the left–to predict Japan’s ascendance into world leadership. At the time distinguished commentators like George Lodge, Lester Thurow and Robert Reich all pointed to Europe and Japan as the nations slated to beat the U.S. on the economic battlefield. “Japan is replacing America as the world’s strongest economic power,” one prominent scholar told a Joint Economic Committee of Congress in 1986. “It is in everyone’s interest that the transition goes smoothly.”

He (Kotkin) then reminded all of us what could go wrong with China’s economic miracle and then shared his opinion of the future.

“China’s social problems will be further exacerbated by a huge, largely ill-educated restive peasant class still living in poverty. Of course America too has many problems–with stunted upward mobility, the skill levels of its workforce, its fiscal situation. But the U.S., as the Japanese scholar Fuji Kamiya once noted, possesses sokojikara, a self-renewing capacity unmatched by any country.”

“As we enter the next few decades of the new millennium, I would bet on a more youthful, still resource-rich and democratic America to maintain its preeminence even in a world where economic power continues to shift from its historic home in Europe to Asia.”

Are the pessimistic and dour pundits of today right this time? Should we be congregating our investments in the BRIC countries (Brazil, Russia, India and China) or dialing down our expectations for investment returns in the US investment markets because the inevitable “declinism” of the US economy has set in? This “group think” robs investors of the urge to concentrate on the strong balance sheet, wide moat and powerful brand companies which weather recessions and have more potential to be “Hall of Fame companies”. We believe anything that stops us from owning some of the best companies in the world this close to the aftermath of a terrible consumer-led recession is robbing us of future success.

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:

On November 13th, CNBC writer Jeff Cox shared the findings of a recent survey of major institutional investors put out by Bank of America/Merrill Lynch. These 111 institutional advisors have over $1 trillion in assets under management. Cox wrote, “Even as the US market continues to rally, many institutional investors are trimming their US holdings and putting more money into foreign stocks – especially those in emerging markets.” The primary motivator is a belief among these advisors that economic growth in the US will be anemic going forward. Here is a representative quote from one of the advisors surveyed: “We found a tremendous strategic desire to move away from US equities, particularly large-cap, and toward a more global mandate,” analyst John Haugh wrote in a research note. “Emerging market equities are the most desirable asset class over the next 12 months, with 42% looking to add/increase investment.”

The day before (Nov. 12th), CNBC aired an interview session conducted by Becky Quick at the Columbia Business School where students and faculty asked Bill Gates and Warren Buffett a series of questions. These questions ranged from career advice to visions of the future. In the opinion of those of us at Smead Capital Management, the most important question of the night went to Mr. Buffett as a follow up question from Becky Quick. The student had asked for Buffett’s opinion on the believability of this rally coming off the March lows given that a number of respected market participants were cautious. Buffett reminded everyone in the audience and on television that the best market year of his 67 years in the stock market was 1954. It was a recession year which saw unemployment double and yet saw a 50% gain counting dividends.

Becky followed up by asking about his recent purchases of a company in Israel and in China. She asked, “Are there more opportunities overseas or here in the US?” Buffett’s answer was short and sweet. He said, “I see more opportunity in the United States. We’re the biggest economy and we’re looking for big deals. But I am delighted to find something, you know, whether it’s in China or whether it’s in Israel, like Iscar, or whatever it may be. There are more opportunities in the United States than anyplace else.”

Buffett was not just whistling Dixie with his answer. He had spent $26 billion buying the rest of Burlington Northern the week before and was quoted as saying, “Most important of all, however, it’s an all-in wager on the economic future of the United States,” said Mr. Buffett. “I love these bets.” On November 16th we had learned that Berkshire Hathaway had doubled its position in Walmart and increased its position in Wells Fargo among net stock purchases of $2.3 billion. You probably don’t load your portfolio with the nation’s largest retailer and one of the nation’s biggest real estate lenders if you believe in an “anemic economic recovery”. We don’t know about you, but we have a choice of who we are going to take our economic prognostications from. Is it going to be Warren Buffett, who gets to see and understand as wide a swath of diverse businesses as the Chairman/CEO of one of our nation’s largest conglomerates? Or will it be far less experienced, far less successful and far less informed economic prognosticators who could be a part of a crowded trade?

All this does is make us that much more excited to own our portfolio of Large Cap Value US stocks and continue to enjoy what we believe to be a multi-year and very powerful bull market.

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 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 Wall Street Journal reported on Nov. 2nd that non-financial publicly traded companies were holding more cash on their balance sheets than at any time in the last 40 years. The figure is 9.8% of their combined stock market capitalization. A great deal has been written lately about what officers, directors and substantial shareholders (Insiders) have been doing with holdings of their own companies. We at Smead Capital Management would like to give our take.

Since January 1st of this year there have been a number of large company buyouts. It started with Pfizer buying Wyeth and Merck buying Schering-Plough. It has accelerated last week with Stanley Works buying Black and Decker and Warren Buffett’s Berkshire Hathaway buying the rest of Burlington Northern Railroad for $100 per share in cash and stock. Why are companies so interested in buying competitors? Why is Warren Buffett spending $26 billion to buy the rest of Burlington Northern?

First, we believe they trust that the U.S. economy will make a significant comeback the next three years. Many admired experts have spent the last two years convincing us that the financial sins of the last ten years condemn us to poor economic growth for the next ten years. Here is what Warren Buffett said Tuesday morning about buying Burlington Northern Railroad:

“Our country’s future prosperity depends on its having an efficient and well-maintained rail system,” Buffett said in a press release. “Conversely, America must grow and prosper for railroads to do well.”

“It’s an all-in wager on the economic future of the United States,” he added. “I love these bets.”

Second, these companies’ financial strength allows them to gain market share while prices for common stock are depressed. Trading cash, earning almost nothing, for future corporate profits close to the bottom of the deepest recession since 1982 could look incredibly smart two or three years out. Once what Buffett sees is known to other corporate executives, you could see many buyouts as the 9.8% cash position drops to a more normal reading.

Third, James Grant called low house prices and low stock prices a “shovel-ready stimulus program” back in February. With interest rates low for conducting business and housing the most affordable in my adult lifetime, why can’t the economy do well over the next five to ten years? As we said in our missive called “Pick Your Poison”, what would we rather have, double-digit interest rates/unaffordable homes/less existing debt (1982) or low interest rates/affordable homes/large existing debts (2009)?

Warren Buffett, who we believe is the most successful insider of all time, parted with $26 billion of his company’s stock and cash to bet on future U.S. prosperity on Nov. 3rd. His company is involved in insurance, banking, railroads, food and beverages, credit cards, residential real estate, carpet, jewelry, furniture, manufactured housing, etc. At SCM, we are going to keep our view of the economic future aligned with the insider.

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 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:

We are witnessing one of the greatest battles to control the hearts and minds of investors that we at Smead Capital Management have just about ever seen. In one corner you have PIMCO and their fearless leader Bill Gross, buying longer-term Treasury bonds. They see the world as a giant game of deleveraging as the large U.S. government and household debt is worked off in a muted economic recovery. They see a “new normal” set of spending patterns and higher savings rates leading to slow growth rates and low levels of inflation or possibly deflation. It is our opinion that PIMCO and Gross have been super successful, outperforming other bond market participants for years in one of the best bond investing eras in U.S. history. The amount of money they manage has reached legendary proportions and they have huge influence in the debt markets in which they maneuver.

In the other corner are such heavyweights as Warren Buffett, James Grant and Julian Robertson. Buffett is actively buying stocks in the U.S. He fears that inflation is a natural by-product of all the efforts of the Federal Reserve Board and U.S. Government to stimulate the economy. James Grant, one of the best writers and contrary thinkers in the money world, recently shared his opinions in an op-ed piece in the New York Times. Looking back at history, Grant surmises that the deeper the recession the more explosive and powerful the two to three-year economic rebound has been. He sees the large camp of economists assuming a poor/jobless recovery as a good psychological signal. Julian Robertson, one of the deans of Hedge Fund investing, is short U.S. Treasuries across the board and sees very high interest and inflation rates coming as a consequence of quantitative easing and Federal stimulus efforts. Who should you/we believe?

First, I’d like to give you our SCM caveats. We believe that the merits of the companies we invest in based on our Eight Criteria are the most important factor in how we will do over the next ten years. Second, we don’t believe we can predict the stock market or the economy. We like the fact that our criteria has the tendency to find strong balance sheets, powerful brands, high free cash flow generators and wide moats, because they are more likely to withstand whatever environment plays out.

With caveats in hand, here is SCM’s feeling about the arguments from these titans. Bond mutual funds have been receiving $20 of inflows for every $1 received by equity funds since the beginning of March. In our 29 years, we have virtually never seen that kind of overwhelming popularity get rewarded over the next three years. Therefore, Bill Gross and PIMCO look due to have the markets they dominate become more difficult. Since 1984 we have had a huge bull market in Treasury bonds as they peaked at 14% interest rate. At 3.4% today, PIMCO has mathematics working against them. Near the end of the 1982 to 1999 era, Warren Buffett and common stocks were enormously popular. Buffett spoke in Sun Valley to a group of business owners and executives who had been made mega-wealthy by the bull market in stocks. He told them that stocks would do poorly from then to 2016, if history was any guide. He was spot on, as the next ten years proved to be one of the worst decades in U.S. history for stocks. I don’t hear PIMCO saying anything vaguely similar about bonds today.

We don’t agree with Julian Robertson, primarily because of the speed and magnitude of interest rate increases he is advertising. He looked on T.V. the other day like someone who had a big position going and wants to by-pass the normal holding period to see it succeed. There is little evidence that the over-capitalization of the banks in the U.S. is resulting in any meaningful lending and debt monetization (read “Monopoly Money”). We believe the inflation he fears appears to be years away, not months.

Last, but not least, is James Grant. We believe that he has a few powerful forces working in his favor. The economic coma we entered last year in September lasted until the end of March of 2009. Any discretionary economic activity which occurs in the next six months could cause fairly sizable economic growth numbers and possibly boost consumer confidence and hiring. Maybe as important is how unequivocally negative most market participants are about the long-term future of the U.S. economy. I was around in 1982. There was as much disbelief in the possibility of a rousing long-term comeback in the U.S. economy then as there is now. As fellow contrarians, we believe he must be taken seriously. We should harken our thoughts to some of the widespread belief on the part of investors who may be adding more smoke to the “Mythical Argument.”

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 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 Clients and Prospective Clients:

Oppenheimer’s Chief Market Strategist, Brian Belski, put out a great piece of research last week (”US Strategy Weekly: Shifting Focus to Value Over Growth”) on the composition of the companies which make up the Value half of the market capitalization of the S&P 500 Index. The index is divided into growth and value partitions by the factors listed in the table below. High ratios in the growth factors show investor’s expect a bright or growing future. High yields in the value factors infer low future expectations on the part of investors.

The two accompanying charts appear to “paint a thousand words” in the opinion of Smead Capital Management. The first chart shows the number of companies in the value side of the index has grown immensely in the last 15 years. We believe it is not unusual for this to happen in the aftermath of a major market decline.

The second chart shows which sectors of the S&P 500 Value Index are the most over and under-represented in the S&P 500 Value Index today as compared to the average of the Value Index over the last 15 years.

We have only begun to decipher the “thousand words”, but here are a few. First, what would have caused the growth half of the index to require far fewer companies than before to equal 50 percent of the S&P 500 Index’s market capitalization? When the growth factors improved in the energy industry, investors moved massive amounts of capital into the sector. Energy is the most under-represented in the value side of the index (4.7%) compared to normal (12.6%). These energy companies tie up a massive amount of capital due to their capital intensive nature, taking money away from other sectors. Many other cyclical stocks hold above-average growth factors as the lemmings have overcrowded the BRIC trade, giving market premiums to capital and labor intensive companies. We have admired the stock picking of folks like FPA’s Robert Rodriguez and the sector analysis of Jimmy Rogers for 20 years, but they both need to consider that owning energy and living in Singapore is not lonely contrarianism today. If this was the course of action to take, we should move Smead Capital Management to the New York/New Jersey metropolitan area to be closer to the drug companies to show our bold contrarian spirit.

Second, what is over-represented in the Value half of the Index compared to normal? Consumer staples and healthcare, by a whopping margin! Consumer Staples represent 14.9% today versus the normal 4.4% in the value index while healthcare is 13.6% today versus its normal 4.5% weighting in the value half of the S&P 500 Index. Many of these companies have beautiful balance sheets, strong international brands, generate massive free cash flow and earn high returns on capital. We haven’t done the research yet, but we believe we will find that consumer staples and healthcare are normally as under-represented in the S&P 500 Value Index at this point in the cycle as energy is this time.

I heard Warren Buffett tell a story about raising money for his early partnership. We believe it does a great job of illustrating why we at SCM don’t want to own BRIC trade cyclical companies. He went to see the owner of the largest farm equipment dealer in Omaha when he was raising money for his partnership in the 1950’s. He asked the owner how he had done this year. The owner told him he had done great. Warren asked what he did with the profits. The owner went over to the office window and pulled open the drape. He told him that it was all sitting on the lot as he showed Warren the inventory for the coming year. In many cases, a great year in a capital intensive business leads to more capital expenditures and little free cash flow for investors. Consumer staple and healthcare companies have a history of producing consistent free cash flow which the owners/management of the company can use any way they see fit to enhance shareholder value.

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 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.