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.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

There are very good reasons to avoid investing in emerging markets. Below is a list of some of those reasons:

1. Political Instability (Russia, Honduras, Venezuela, etc.)
2. Small Markets (less liquid)
3. Poorly Regulated
4. Unusual Accounting
5. Currency Risk

However, I’d like to make the case for investing to make money from emerging markets. Five years ago my family and I took a trip to the Bay Islands of Honduras. While there I noticed that one of the only companies selling products to these Honduran Islanders was the Coca-Cola Company by way of the Fanta soda line. It reminded me of 1988 and Warren Buffett stepping outside of his usual proclivity to buy into the stock of a great company when the share price falls into some significant distress. Coke had gone up about five-fold since the bottom in 1982 and sported a trailing 12-month P/E ratio of 18. Buffett bought a major stake in the company and dumbfounded his fondest admirers in the process. Buffett said at that time that he “could go away for ten years” and he’d know that Coke would be doing well.

One of the main reasons that Buffett could have that kind of confidence was that the Berlin Wall was preparing to fall. Countries in Eastern Europe and Latin America were getting political freedom and adopting free-market capitalism. Any improvement in a third-world country’s circumstances was going to create a chance to sell something clean to drink. Nobody does that better than Coca Cola. With Coke he never had to take the risks listed above to make money from emerging markets. He only had to trust the brand, the balance sheet, the distribution system, the economies of scale and the management of the company.

A front page article in last week’s Wall Street Journal that discusses the distribution of drugs in emerging market countries tells you everything you need to know to make money investing in emerging markets in the next ten years. IMS Health reports that in 2003 there was $67.2 billion of prescription pharmaceuticals purchased in emerging market nations. In 2008 it had grown to $152 billion and IMS predicts it will hit $265 billion in 2013. How many companies in the world have the brands, balance sheets, patents, distribution, economies of scale and management to do this? Exporting health to the world will be an incredibly rewarding business both financially and ethically. It will help other businesses succeed by improving the quality and length of life for people in countries ranging from China and India to the smallest countries in Latin America and Africa. The difference this time is the companies that we are interested in like Merck and Pfizer are trading at distressed P/E levels as compared to the last twenty five years. Buffett did well on his investment in Coke, but the drug stocks start this cycle trading at distressed prices the way Buffett usually likes to buy shares.

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:

One of the most famous parables in the Bible can be found in the book of Luke, the Seventh Chapter. Jesus compares the Kingdom of God to farming. The farmer spreads seed around the land. Some falls on the path, gets trampled and eaten by birds. Some lands on the rocks and does not grow due to a lack of moisture. Some grows up among the thorns and gets choked in the process. Some falls on good soil and yields 100 times itself.

In the long run, the stock market is the same as farming. Most investors use an approach designed to produce short-run success. Some use momentum models designed to get on the hot path, only to get eaten up by paying too much for future success. Some invest in concept stocks and buck such low probabilities that their losers rob all the moisture from their winners. Some seek to predict the economy or use wide asset allocation and choke on errant macro-economic predictions or faith in obscure or illiquid asset classes. Some rely on wide moats and the generation of ample and long lasting free cash flow that can make many times their original investment over many decades.

At Smead Capital Management, we’d like to focus on the successful part of the farming analogy. It refers to “good soil”. What is good soil for an investor? We believe it is buying shares of an outstanding business for less than its intrinsic value and holding it for years as the company continues to succeed. We believe we are more likely to do that in companies which will survive and prosper much longer than other companies. The most important factors in longevity for a public company are balance sheet, product necessity and strength of moat.

To understand why we think this way we would like to refer you to the writing of Brett Arends of the “Wall Street Journal” in a May 11th article called, “How to Value Stocks? Ignore Economic News”. In it he chronicles the work of Ben Inker, Director of Asset Allocation at contrarian fund company Grantham Mayo Van Otterloo & Company (GMO). Inker points out that the present value or intrinsic value of a company is the discounted value of all future cash flows and dividends. And Inker can’t understand why people put so much emphasis on what is going on in the stock market right now or in the economy next year when they seek to analyze common stocks. He thinks they are mistaken for two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. “Since stocks do not have an expiration date and dividends grow over time,” Mr. Inker argues, “the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future.”

How distant? Using Mr. Inker’s hypothesis, it turns out that about 75% of the value of shares is actually based on dividends that will be paid more than eleven years from now. Half the value is based on dividends to be paid after 25 years, and a quarter on those to be paid after about 50 years.

In other words, when you look at the market today, three quarters of its true value is based on what companies will earn and pay out after 2020 and half is based on what they will do after 2034. So really, how much attention should you pay to next quarter’s earnings?

We at SCM love his logical and mathematical conclusion. Since most of the current value of a company comes from discounting cash flows and dividends coming years and decades from now, our analysis should be spent trying to ferret out the companies which can survive at high levels of profitability the longest. It reminds us of why Warren Buffett paid an astounding 18 times trailing earnings to buy a large stake in Coca Cola back in 1988. When asked why Buffett answered, “‘Let’s say you were going away for ten years,’ he explained. and you wanted to make one investment and you know everything that you know now, and you couldn’t change it while you’re gone. What would you think about?’” He knew that he could discount cash flows and dividends thirty, forty and even fifty years out and Inker proves that those future flows make up most of the current or intrinsic value of a stock.

His second reason is that economic performance follows a fairly consistent long-term path and gravitates towards the mean. If the economy has been terrible, it is likely to revert back to acting better. If it has been terrific for quite awhile, it is headed for difficulty. At SCM we are asking whether the current economic trouble is making our companies more or less likely to survive and prosper for many decades? We think the overwhelming answer is that the current circumstances are making the kinds of companies we like to own more likely to survive! Six Flags declares bankruptcy and Disney gets stronger. Washington Mutual disappears and Wells Fargo gets stronger. Nobody wants to finance young biotechs, so Merck and Pfizer will buy most of the great future science. The list goes on and on. The economic cleansing of the last two years has done more to strengthen and widen the moats of strong balance sheet companies with powerful brands and distribution chains than any phase in history in our opinion. However, since these facts are long term in nature, the marketplace actually discounts these virtues rather than giving them their usual premium. We believe that the next few years could very well rectify the under valuation of the most valuable franchises in business and our companies could turn out to be “good soil”. We will leave investments on the path, on a rock or in the thorns to someone else.

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:

I believe that an individual’s income is close to the average of their ten best friends. This could be why an estimated 35,000 people sought to make friends with Warren Buffett and Charlie Munger in Omaha on Saturday at the Berkshire Hathaway Annual Meeting. Buffett is the Chairman and Chief Investment Officer of Berkshire and is the world’s third wealthiest man, while Charlie is Vice-Chairman and has a $1.5 Billion net worth (which is not chump change). Even at the ages of 78 and 85, respectively, these two billionaire investors can hand out the wisdom.

What I find the most interesting about what these men say about investing is the clarity and simplicity of their investment decisions. Unfortunately for most investors, the part that holds most people back from imitating these great investors is the patience, contrarianism and humility associated with executing a non-widely diversified buy and hold common stock investing style. At Smead Capital Management we seek to practice these virtues.

Here are examples from last weekend of these separating virtues:

On the subject of patience, Charlie Munger said Friday, “I think the reality is that if you hold a stock for a long long term even though it’s screamingly successful as an investment, you will have huge declines in the value of that stock two or three times in half a century. And I don’t think that should bother long term holders all that much.”

While everyone is scared to death of banks, the ultra contrary Buffett said, “I would love to buy all of US Bancorp or I would love to buy all of Wells Fargo, if we were allowed to do it.” Buffett spoke again about Wells Fargo and the $9 price it had earlier this year. “If I had put all my net worth in one stock, that would be the stock.” This is a stock he started buying in the last major financial crisis in 1991.

On the search for a Chief Investment Officer to replace him in the future, Buffett shared that he has found four good potential replacements. Instead of chasing recent out-performance (like most investors do), he shared that none of them had beaten the S&P 500 Index last year (which means they lost more than 37% of their beginning year value). He and Munger also added that sitting on large amounts of cash to avoid last year’s decline did not impress them or influence their decision.

On another note of humility, Warren had to eat some humble pie. “Buffett said Saturday that he was ‘disappointed’ when Moody’s cut its Berkshire ratings, though he said the decision was lamentable mostly because it led to a 1oss of ‘bragging rights’ – not because it will materially raise Berkshire’s borrowing costs.” Maybe it is God’s way of getting him back for undercutting the municipal bond insurance companies and then using information they had shared with him to compete in the bond insurance business in the middle of the panic and the credit crisis last year. Warren needs to relearn the Mike Milken lesson of the junk bond era of the 1980′s. Leave some business for everyone else and not just crumbs.

On simplicity, both men reiterated that if you need a calculator for making an investment decision or if your investment relies on computing some sophisticated mathematical formula, in their minds it is a bad idea. I always told my kids that all the math you need to learn to make a great deal of money in investing or in business is learned by the end of 7th grade.

Reading and listening to these two great investors over the weekend makes those of us at SCM that much more excited about the great companies we own, the investors who are along with us for the ride and how much money we could make in the aftermath of the recent fire sale in the stock market. You supply the patience and we’ll supply what we think are the great companies because the stock market has already handed out the humility!

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.