William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Two watershed events were announced in the last two weeks. First, Warren Buffett disclosed a massive amount of open market purchases of US large-cap stocks. Second, Legg Mason announced that Bill Miller is “stepping down” as Chief Investment Officer of his firm and as manager of the Value Trust. These are two of the greatest stock pickers of all time and the change in direction for both men is driven by who they answer to and how favorable investing could be in the US large-cap space going forward.

In 1999, at the Allen and Co. event in Sun Valley, Buffett warned how poorly technology stock investments would do going forward and how muted US large-cap returns would be from 1999 to 2016. He explained how the Fortune 500 companies were trading at 30 times profits and that profit margins were at the high end of historical ranges. Therefore, he laid out an incredibly difficult road for those who pick large-cap US equities.

Buffett runs a holding company in which he is the largest shareholder. In effect, he answers to no one. When publicly traded US large-cap stocks got way over-priced in the late 1990′s, Buffett shifted to private equity purchases of entire companies. He bought all the outstanding shares of General Reinsurance and Geico. He made numerous smaller acquisitions like Mid-American Energy. Buffett got his investments away from having the prices quoted every day and allowed his publicly traded portfolio to become a minority of Berkshire’s assets. He continued that approach in 2009 by buying all of Burlington Northern and recently bought Lubrizol.

Bill Miller beat the S&P 500 index for 15 straight years making his shareholders, his parent company and himself very wealthy. The last five of those years included much less spectacular returns between 2000 and 2005. He ran relatively concentrated portfolios and was adored by the media. The index has gone nowhere for 12 years and Miller answers to shareholders. They have expressed their disappointment by driving Value Trust’s assets down to $2.8 billion from a peak of $20 billion. Bill stepped down voluntarily or was asked to. Either way, it is exactly what happens at the end of a stretch where investors have been massive net liquidators of US Large-Cap stocks.

Buffett has no career risk and no one to answer to. He told Becky Quick on TV that he feels US large-cap stocks are undervalued relative to other asset classes. He bought $10.7 billion of IBM (IBM) and added to Wells Fargo (WFC). His underling, Todd Combs, bought shares of numerous US large-caps for Berkshire as well. Buffett is happy at these prices to get back into public shares priced every day.

In 1999, Buffett felt that two things beside market levels could affect overall stock prices. He said that a drop in government interest rates from 6 percent to 3 percent would double the value of stocks. He also said that high sustained profit margins would positively impact stock prices. Both of those have happened. Lastly, stocks have done worse than Buffett expected despite these facts.

We believe putting this all together for us as contrarians means one thing. The time to net liquidate US large- cap equity is over because Bill Miller is being given up on and Warren Buffett believes the risk reward in these stocks is very favorable. In our opinion, it is time to buy a concentrated portfolio of US large-cap stocks. We suggest you do this while avoiding the BRIC trade, in case you have someone to answer to.

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:

We have now seen the S&P 500 Index drop below 1150 five times since the first of August. The overriding reasons, listed in no particular order, are fears of another contraction in the US economy, European sovereign debt and bank problems, a lack of political leadership in Washington D.C. and persistent unemployment data. These problems have caused an 18% decline in the index from peak to trough and have given those of us who stay fully invested in high quality stocks another opportunity to examine our thesis.

Our thesis is that by owning the companies which fit our proprietary eight criteria and making changes very sparingly, we can garner the historically superior returns which come from equity ownership and exceed the return of the index over long-term time periods. This comes from a combination of dividends, dividend increases and capital appreciation.

Even though we are not traders or short-term oriented, we at Smead Capital Management would like to throw out a few opinions which cause us to be very positive about the stock market over the next one to two years.

1) While market participants look to the US government and the Federal Reserve Board for answers, US Households are doing remarkable and historical work of getting their finances in order. The Household Debt Service Ratio dropped to 11.09% at the end of June after being as high as 14% in late 2007. This is the ratio of how much of the average family’s gross income is dedicated to debt service. The statistics are reported on a 90-day lag, which means that the ratio is probably below 11% by now. At the pace that households are improving their income statements, we could see a ratio of 10.6% in the next year. Numbers below 11% existed in 1982 and 1992 at the beginning of extended periods of prosperity. What this means is that households could take on monthly payments comfortably and that bodes well for the employment rich automobile and housing industries.

2) Usually bearish firm, Grantham, Mayo, Van Otterloo (GMO), recently put out an extensive research piece indicating that US housing participants are making the “Error of Pessimism”. They are arguing that US housing is in position to become a bright spot in the US economy.

3) Commodity prices are plunging. In the same piece, GMO argued that China is making the “Error of Optimism” in residential real estate. If real estate activity falls off in China, commodities will continue to decline. No politician could duplicate the incredibly simulative effect of lower gasoline prices, not to mention the enormous psychological benefits in a mobile society like ours.

4) Pretty much all stock market participants are bearish. Mutual funds specializing in US Large-Cap equities have suffered huge net liquidations for months. Sentiment polls look similar to the spring of 2009, right before a huge gain in the following two years. Stock correlations are running at highs only seen in the 1987 crash period. This means that the professional traders are selling baskets of stocks simultaneously without regard to their quality. When low correlations come back in the future there is a lot of wheat to separate from the chaff.

5) We believe our companies have performed well in a less than stellar environment. The dividend growth the next five to ten years could set records as these lean powerhouses gush free cash flow. Howard Schultz pointed out, as an example, that Starbucks has $2 billion in cash on their balance sheet and might be interested in strategic acquisitions.

6) Insiders (officers and directors of public companies) have been as aggressive in their purchases of their own company’s stock as they were in early in 2009.

We believe many of our stocks have held up quite well in this environment, but some of them look especially attractive at this point. Financial stocks seem to be in a capitulation phase and Wells Fargo (WFC) and Aflac (AFL) look particularly attractive. The household debt ratio inspires us about Disney (DIS), Cabela’s (CAB) and H&R Block (HRB) in what we call our “staple” consumer discretionary category. In healthcare, Mylan Labs (MYL) is retesting its August low and saw significant insider buying at these price levels last month. We would be remiss to not mention that PayPal/ Ebay (EBAY) is preparing to become a major payment force in stores for the first time. It is nice to start a business with 100 million existing customers.

In conclusion, we have reasons for being the optimistic contrarians, even over the next one to two years.

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:

In a Gallup Poll last week, 75 percent of Americans said the nation’s biggest problem in their mind was an economic problem. Precious metals and most commodities have hit records in the last six months. At an institutional investor conference we presented to last week, the participants championed risk reduction strategies using either highly illiquid, risky private equity, emerging market equity and debt offerings. Or they bragged about loading up on a commodity index, commodity ETFs and/or gold and silver. Some were puffed up about diversifying away from China by pursuing “Frontier” stock markets in Pakistan, Indonesia and other unsavory places. The pinnacle was my nephew telling me that he had purchased five ounces of silver recently at $50/ounce. He’s 19 and it was his first attempt at speculative risk.

We at Smead Capital Management feel compelled to make a US stock market bullish case which feels as good to this writer as avoiding tech stocks did in late 1999. It is so lonely that it is divine. Andy Grove, former Intel CEO, said that the best advice he ever got came from his City College of New York professor. He said, “When everyone knows that something is so, it means that nobody knows nothin’.” John Maynard Keynes said, “Investing is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.” We have travelled the country over the last two years, spoken at CFA Societies, presented to numerous institutional, consulting, RIA and financial advisor organizations. We believe the majority has put their assets into investments that will provide defeat, insecurity and failure. Out of this knowledge comes a very optimistic bull case which is available to those who have the courage to look foolish in the short run and avoid today’s popular asset allocation.

Large cap growth stocks received the highest PE ratios in US history in the late 1990′s as the world crowded into the 25 most popular tech stocks. As large cap fund managers got deluged with money pulled from every other asset class, they attempted to reduce risk by bloating the PE ratios of large-cap growth names like Pfizer, Merck, Colgate and Clorox. At 40-50 times earnings and with the majority piled in for the ride, these mature company stocks were doomed for 10 years. Other asset classes were starved for capital and you could have thrown darts at them back then. Only a small minority had the courage to flee the crowd and widely diversify into other asset classes. Harvard’s endowment did, as did Warren Buffett. He stopped buying individual US stocks and sought to protect his capital by buying whole businesses and removing his large capital base from the judgment of public markets.

The investments which were wise in 1999 and were owned only by the small minority of investors, brought victory, security and success. Unfortunately, it is 12 years later, and the same asset allocation that was wise in 1999 is now the majority, and is unwise today. These trades are so crowded that it has reached the deserts of Africa, the jungles of Indonesia and the Westfield Mall near my hometown of Washougal, Washington. To understand the bull case, you need first to believe that today’s popular asset classes are doomed to ten years of misery and those companies, sectors and countries which benefit from their misery could produce immense relative and solid absolute performance.

I am very fortunate to have been taught by my Econ professor that economics is a lot like physics. For every action there is an equal and opposite reaction. What will happen to make emerging markets, precious metals, oil, farm commodities, natural resource based countries, and US stocks in the energy, basic materials and heavy industrial areas turn incredibly sour? Lipper reported last week that April 2011 was the 23rd consecutive month of net liquidation of US equity mutual funds. This occurred in one of the biggest up moves in 23 months in US stock market history. What could reverse the direction of these flows?

The linchpin of the bull case is the violent economic contraction about to occur in China. We will not bore you with a rehash of prior missives, but let it be said that they have deceived investors into massively over-capitalizing these popular asset classes. China’s growth is behind all the over-confidence in every market I’ve mentioned. When the fact that China is hitting the wall becomes more clear, wide asset allocators who don’t take what I’ve written seriously will sit for ten years in misery, in our opinion.

Out of this comes the bull case. The US economy has spent four years cleansing itself. We’ve recapitalized our banking system by recognizing over $1 trillion in losses. We are foreclosing and short selling billions of dollars of real estate. Housing is the most affordable in 60 years. We are learning to live inside our means and US households are close to Household Debt Service Ratios similar to 1982 and 1992. These were the start of five-year prosperity periods where the Gallup Polls showed numbers like they are today. We are in control of the keys to the virtual reality economy and have all the best companies who are helping us to maximize interactions between the virtual and real economy. Think Ebay/PayPal, Apple, Facebook, Linkedin, Groupon, Fedex, UPS, Amazon, etc. We feed the world, keep it secure, invent a large part of the best medical science and share productivity/higher living standards with anyone who wants to interact honestly with us. Our greatest days are ahead of us.

We are all frustrated by how long this cleansing is taking. What will trigger our next great prosperity period is a collapse in commodity prices and a reversal of all the misery which asset allocators are set to profit from, but missed by ten years ago. Less money leaving to pay for oil and the repatriation of emerging market money will set off a bull market in the American dollar, in our opinion. The rising confidence will force short-term interest rates up. Businesses will be rewarded for how they participate in our bright future and how well the business throws off free cash flow. Capital intensive industries and countries will see profit margins plunge as they are in no position to produce free cash flow unless commodities are soaring and China is building projects which have no rental income!

We are playing the bull case by over-weighting consumer discretionary powerhouses like Disney, Nordstrom and Cabela’s, domestic financial heavy weights like Franklin Resources, Wells Fargo and Berkshire Hathaway and over-weighting the geniuses of medical science like Merck, Amgen and Mylan Labs. We at SCM can’t wait to get to the future because we are in a lonely minority and making the bull case nobody wants to even admit to.

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:

When I was eight years old I caught the Pro Wrestling bug. Stan “The Crusher” Stasiak, Lonnie Mayne and Tony Borne were the big stars of the Portland, Oregon area wrestling scene. For years they wrestled at The Armory on NE Chautauqua every Saturday night. I was glued to the television set.

Once in a great while they would hold a “Battle Royal”. Twelve wrestlers would enter the ring and they would throw each other over the top ropes until there was only one wrestler left in the ring. The last man standing in the ring was the champion.

As investors, there is a great deal of wisdom to gain from a “Battle Royal”. This format was super entertaining for spectators, but only rewarding financially for the winning wrestler. There was only one winner and one paycheck. It is why one was not held very often, even though the crowd was the biggest at the armory when they did.

At Smead Capital Management we try to avoid industries or investment sectors which become a “Battle Royal”. Let me give you an example. Ford is led by a very effective and successful CEO, Alan Mulally. Ford has survived the worst consumer recession in 70 years and is enjoying the consumer confidence and lead time this affords the company. However, my wife and I will be looking for a new car for her in the next year and have visited numerous dealers. We have been shocked at how many wonderful automobiles there are today made by so many manufacturers. Here is a partial list: Ford (Lincoln Mercury, Volvo), GM (Chevrolet, GMC, Buick, etc.), Chrysler (Jeep, Plymouth), Hyundai, Kia, Toyota, Honda, Nissan, Mitsubishi, Subaru, BMW, Mercedes Benz, Volkswagen, Saab, Porsche, Lexus, Infinity, Acura and Tata (Jaguar and Land Rover).

It appears to us that the industry is providing car buyers too many choices. It could also mean a number of them could be getting thrown over the “top ropes” into bankruptcy in the next economic downturn. On top of the competition from makers of a very similar product, this is a labor intensive and capital intensive business with huge sales swings. These swings have as much to do with exogenous events like gasoline prices, economic growth and labor patterns as they do with corporate execution. It only makes sense that an executive from Boeing would be good at running a capital intensive business which bets the ranch every 5 to 10 years on a new product cycle.

The “Battle Royal” effect is why investors like Warren Buffett avoid technology companies as investments. If you are Cisco, Intel, Microsoft and Apple, you wake up every day knowing that 3 million of the smartest engineers in the world are devoted to inventing a new technology which destroys your monopoly and/or profit margins. Look at how disruptive Facebook has already been to the way we advertise products and use technology. This is the reason you don’t see IBM making personal computers or hear the name Unisys or Burroughs or Digital Equipment very often.

Therefore, if “Battle Royals” are a bad thing in investing, what does a good thing look like? Corporate wrestling matches with as little as one or zero competitors are very preferable. We compare Starbucks to Coca Cola and McDonalds. Coca Cola makes the syrup and distributes it. They are the largest seller of beverages in the world. They have had one main competitor over the decades: Pepsi. In the land of anti-trust law it is nice to have one viable competitor.

McDonalds has spent the last thirty years wrestling with a few companies at a time like Wendy’s, Burger King, KFC and recently with Subway. Their ability to provide fast food in a clean atmosphere has caused them to know more about what the customer for food and soda pop wants better than anybody else. Mickey D’s brand recognition is maximal. They are the largest seller of Coca Cola products in the world and get their best profit margins from liquids. The fact that there are billions of people looking for food every day, allows their competitors to make some money along the way.

Starbucks makes the syrup like Coke and provides the product at the retail level like McDonalds. They sell an addictive legal drug (coffee) and they feature the beverages rather than the food. There is no other major worldwide gourmet coffee company. They don’t have a Pepsi or Subway or Wendy’s to compete with, and at the present time, there does not appear to be any major corporation which is even vaguely large enough to be a viable number two competitor. New product development for Starbucks is not labor intensive or capital intensive and this fast growing company produces all the free-cash flow it needs to grow its Seattle’s Best brand, packaged-product business (led by Via) and expand the core brand around the world. None of the other coffee-oriented companies around the world provide enough national or international competition to Starbucks to really amount to “a hill of beans”.

If you look into our portfolio, you will find numerous set ups similar to Starbucks. Disney dominates babysitting children and males (ESPN) with wholesome family entertainment. They get some competition in parts of their company, but have such dominant market share and mind space that there is profit for the others as well. We bet you can’t name the number two supplemental health insurance company in the US behind Aflac. Home Depot has Lowe’s, Walgreens has CVS and Wells Fargo has US Bancorp, but none of them face a capital intensive, labor intensive “Battle Royal” for the right to remain in the ring.

To create wealth by owning common stocks with long holding periods, you must avoid “Battle Royal” industries and sectors to succeed. We think you’d have to be lucky to have your company be the last wrestler standing.

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:

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.