William Smead
Chief Executive Officer
Chief Investment Officer

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 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.

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.