Printable Version

Dear Fellow Investors:

In May of 2010 we wrote about how important it was for the companies which meet our eight criteria to have a strong vision and clear agenda for their business. When President George Herbert Walker Bush ran for re-election in 1992, he was criticized for not casting a vision for our country. In the aftermath, he called it “the vision thing”. We at Smead Capital Management (SCM) believe that every five to ten years those who manage money need to “cast a vision” of where they want to take investors and then backtrack from there to put a portfolio together to best take advantage of the vision cast. We believe there are three main roadblocks to the casting of a vision for the execution of a portfolio plan. In the absence of more attractive titles, we will call these roadblocks fog, bog and smog.

Vision is all about seeing clearly and fog inhibits the ability of folks to see anything other than what is right in front of them. The time frames used by today’s individual and institutional investors are creating fog. For example, Warren Buffett was uncomfortable with any six to twelve month projections about Berkshire Hathaway shares at the annual meeting last Saturday in Omaha. He was very confident about where they might be in five to ten years! Short-term predictions have a tendency to be foggy and long-term vision can be much clearer, in our opinion. To cast a vision for investing you need longer time frames.

Many in money management might have the vision for five to ten years, but they are stuck in a bog. They might have realized wisely in the early 2000′s that US common stocks were going to perform relatively poorly, so they moved to a position of wide asset allocation. The theory was that by spreading your nets widely you would always be catching some fish somewhere. This was a good idea early on, but now that it is being practiced by virtually every major financial organization and institution in the US, there is a great deal of net being used and very few asset classes catching fish. Worse yet, the five-year outlook for some of the normal fishing holes (think bonds, commodities, etc.) is downright dismal and disheartening. However, so much marketing, posturing and so many computer models have been put in place that the embarrassment of casting a new vision makes a money management professional feel like their legs are three-feet deep in mud.

The third roadblock is smog. Another description is pollution. Clients are scared from looking in the investment rearview mirror and they are allowing their attitudes to get polluted. They are attempting to limit the vision of their money manager by giving severe push back when vision enters the conversation. There is a cottage industry which exists today to pollute the minds of money managers and their clients. Go online, on TV or listen to the radio and you will hear a steady diet of negative smog and pollution. Most of it is concerned with the same one-year time frames that the vision caster must avoid. In many cases, these smog producers are part of one’s own research team or are a manager of a fund that you normally use to execute your long-term vision. We won’t name names, but in most cases these negative nabobs are becoming wealthy from other people’s misery. If that were the worst part things would be okay. Unfortunately, they have polluted the lungs and minds of financial professionals and their clients and shoved their legs deeper into the bog.

Our vision is that the best performing asset class of the next ten years will be large-cap US stocks. And we believe that domestically-oriented companies will significantly outperform those which depend more heavily on foreign revenue and profits. Lastly, we believe that most money managers are blocked from joining us because of fog, bog and smog. We’d like you to get elected and re-elected. Don’t forget “the vision thing”.

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. All of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in 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 within the past twelve month period is available upon request.

Printable Version

Dear Fellow Investors:

Berkshire Hathaway’s (BRK) Annual Meeting was last Friday and Saturday, May 4th and 5th. Our firm thought it would be useful to share the musings of Warren Buffett and Charlie Munger as I recorded them on Saturday. We hope you enjoy.

1. Buffett– We are bullish on BRK.

2. Buffett– Banks are in fine shape, remarkable improvement.

3. Buffett– We are more comfortable with the risk in the US.

4. Munger– If you’d have told us that there would be a 50 to one spread between oil and natural gas, we’d have thought it idiotic. It is idiotic to use natural gas at these prices!

5. Buffett– Always looking for ways to do insurance better.

6. Buffett– Business schools teach a lot of erroneous stuff on investing. Munger– Astounding focus on fads in finance theory, mathematically based.

7. Buffett– Bigger on wind than solar at Mid-American. Wind doesn’t work without subsidies!

8. Buffett– We won’t use our stock to make acquisitions now!

9. Buffett– My doctors own BRK.

10. Buffett– We are taking in annuity books in insurance, but only at the risk-free rate.

11. Buffett– I would do the same thing today if he were 26. I’d build my track record as fast as possible in the stock picking world. Then move into buying whole companies.

12. Why is BRK stock at distressed levels? Buffett– It has happened many times! Tom Murphy ran a great business for a long time and it spent time undervalued. Sometimes our price gets silly, Mr. Market analogy. Munger– The market is like a psychotic drunk!

13. Munger– Make decisions based on what the business is worth. The stock market is the most obliging, because you don’t have to do anything. Buy to hold.

14. Buffett– In 53 years, never talked about macro-economic affairs in investment decisions! My first stock was bought in 1942 when we were losing the war! We look to value not macro-factors.

15. Buffett– Railroads have improved their position greatly in 20 years. Efficient and environmentally friendly. Bought Mid-American at $34 per share, current value is $234 per share.

16. Munger– Our good fortune is not going away, even if Warren dies!

17. Buffett– We think about worse cases more than anyone else!

18. Munger– Ebitda Earnings come before every expense that matters!

19. Buffett– When we started Berkshire, gold was $19 and so was Berkshire. It’s now $1650 versus $121000 as of last Saturday.

20. Buffett– I like Wells Fargo stock better. I buy JPM because I can’t buy what I’m buying at BRK. Four hundred million shares of WFC, easier to understand. If I wasn’t running BRK, I’d own a lot of both.

21. Munger– Diversification is good only when it comes through something like BRK!

22. Buffett– As long as I have $20 billion around, I’m comfortable.

23. Buffett– Our stock will bob around and a dividend wouldn’t affect that bobbing.

24. Buffett– If we tell the truth about the value of BRK, we will end up doing well on it.

25. Buffett– On newspapers, the newspapers have three problems, two that are hard to overcome. News is what you don’t know that you want to know. Rent an apartment, getting a job etc. all of those things have other outlets for that information on a timely cost free basis. Now you don’t use a newspaper for many things. Lost primacy in important areas. But still have a lot of things to tell me about local things I can’t get anywhere else. Local sports, community news, etc. expensive to produce. Now going on web and giving away their content. Lately, many newspapers have succeeded in getting paid on the net. There is a future where there is a sense of community for newspapers. It’s not as bullet proof as it once was. As long as you don’t give away your content and have a strong sense of community, the economics will work out ok. We will look at more newspapers to buy! Munger– Not lollapaloozers.

26. Buffett– Would another leader run the risk of alienating the great managers? No. And no takeover of BRK. Munger– I said last night, “the first $200 billion was hard, the next $200 billion will be easy”.

27. Buffett– Cash consuming businesses are unattractive unless they provide a good return on the capital consumed! Very few capital consuming companies are interesting if you want to earn more than 12 percent.

28. Rate of growth to float? Munger– It will grow, but not as fast in the past. Current float $70 billion. Insurance is not a great business.

29. How do you value declining businesses? Munger– Not as valuable as growing businesses! Newspaper is a declining business, but the price we pay determines how we will do. A cigar butt type of business. Buffett– We are specialists in declining businesses. Textiles, shoes, department store in Baltimore. Diversified Retailing. We were masochistic and ignorant in the early days.

30. What about Google and Apple? Buffett– We stay away from what we don’t understand, I mean we can’t understand their next ten years of how they will earn money. I guarantee that in the thousands of potential ideas that the new issues won’t be the best one. We don’t have to do too many things well.

31. Munger– Rule of thumb-avoid large commissions! Look at what other smart people are buying!

32. Buffett– We own 8 companies inside Berkshire Hathaway outright big enough to be in the Fortune 500.

33. Buffett– We have 500 Dairy Queens in China!

34. Is Google inevitable? Apple? Buffett– They are extraordinary companies, I would expect them to be more valuable in ten years, but not for me to understand. The chance of being way wrong is lower with IBM than Apple or Google!

35. Buffett on BNSF Railway– I talk to Matt Rose about once every 3 months. Economics are overbearing politics.

36. Buffett– Relative performance of book value versus S&P 500. Our book value comparison is less flattering than our stock price change.

37. Do the units of Berkshire Hathaway share information? Buffett–We don’t! Munger– We want our managers to feel the same as before they sold to us.

38. Buffett– We would not consider synergies. We have never found a forest products company that the math was compelling.

39. Buffett– We think about the worst case and add a margin of safety! We don’t have to stretch. Your returns will be penalized by our over-conservatism. Munger– To a man with a hammer, every problem looks like a nail. Buffett– Mathematicians talk about fat tails, but they don’t know how fat!

40. Munger– I don’t think there is another insurance business more willing to shrink if the new business is unprofitable.

41. Buffett– Fannie and Freddie are a mess. We don’t have a structure yet to finance mortgages. It’s important that you have a market for secondary mortgages. Munger– We departed from sanity in the mortgage business in the US. Greenspan thought an ax murder in a free market was okay.

42. Buffett on Todd Combs and Ted Wexschler– We’ve seen hundreds of good records in money management and have hired very few people. Same pay system for Lou Simpson. They have a bigger universe than I do. Munger– Ninety percent of US managers would starve on our managers pay system.

43. Buffett– BRK is a good investment in every aspect of the company.

44. On allocating capital, managing risk, and executive compensation. Buffett– Charlie and I don’t need the money. We get to paint their own painting. So do our managers. We give them the paint and the paint brush. I am the compensation committee. Munger– Prostitution would be a step up for compensation consultants.

45. Buffett– 2.5 percent real growth is very remarkable for a country with one percent population growth. It would be nice to grow at 4 percent after what happened. The US has all kinds of strengths. If you’d told my parents that we’d have six times the output when I was 81 they would have been surprised. We’re a very mature economy with a strong social safety net. Munger– That’s what happened in the housing boom, we wanted more than the economy could provide.

46. Munger– The market is going to do what the market is going to do. If you are short term natured you aren’t very welcome in this room.

47. Buffett– If we paid dividends our shareholders would be worse off! Mid-American can use $100 billion in capital in the next 20 years and provide an attractive return.

48. Munger– Each decade Warren had to learn things that he had to learn to continue to succeed.

49. Buffett– We avoid mistakes which could hurt our ability to play tomorrow. I’ve learned more about people. I am a better judge of people than 40 years ago. Munger– We like to learn from other people’s mistakes.

50. Moats-Can they be created? Buffett– No, we buy them. Munger– One competitor can ruin a business!

51. Munger on BYD Company (BYDDY)– Fleets in California. BYD has 170,000 employees. We should subsidize electric cars. Charlie is not expecting a sudden revolution in electric car use.

52. Buffett– Our cost of float is negative and the chances are high of staying that way.

53. Energy independence and trade deficit. Buffett– If our production increases and price drops it helps a lot. Munger– We’d be much better off to use their oil and not ours. Single most precious resources are our hydrocarbons. I have the exact opposite opinion of everybody else on oil and of course I’m right.

As we execute our discipline for selecting stocks and managing our equity portfolio we were very encouraged by the thoughts of these two very successful investors.

Best Wishes,

William Smead

The information contained in this missive are notes taken by Bill Smead at the Berkshire Hathaway annual meeting. References are not direct quotes but paraphrased interpretations of the speakers’ speeches and should not be considered SCM’s opinions or individualized investment advice. Past performance is no guarantee of future results. Berkshire Hathaway is currently being recommended for suitable clients as of the date mentioned in this missive and does 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 within the past twelve month period is available upon request.

The information contained in this tv appearance 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 tv appearance 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.h5>

Warren Buffett tackles tricky question of succession
by Richard Blackden
For more information go to www.telegraph.co.uk.

The information contained in this article 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 article 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.

Buffett plays down health concern, mulled megadeal

by Ben Berkowitz
For more information go to www.reuters.com.

The information contained in this article 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 article 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.

The information contained in this tv appearance 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 tv appearance 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.

Buffett’s lieutenants see economy picking up

by Ben Berkowitz
For more information go to www.reuters.com.

The information contained in this article 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 article 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.

The information contained in this tv appearance 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 tv appearance 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.

The information contained in this tv appearance 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 tv appearance 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.

Printable Version

Dear Fellow Investors:

Peter Lynch went to the mall with his wife back in the days when he ran Fidelity Magellan. The purpose was to see what stores were getting good traffic and creating a buzz. For Lynch, this was the beginning of the research process. Peter felt this was an advantage the average individual investor had over the professionals on Wall Street.

At Smead Capital Management (SCM), we like to buy wonderful companies in the Warren Buffett-Charlie Munger tradition. We like to buy most of the position during periods of maximum pessimism ala John Templeton. We use our proprietary eight criteria for selecting stocks. Finally, we get super excited when the current evidence hints that we are onto something, getting good traffic and creating a buzz.

Here is one historical example and a few current ones. At the beginning of 2010, we began traveling around the US to talk to institutional investors and consulting firms about our stock portfolio. Every major city in America was supposed to be suffering from an anemic economic recovery, but we were seeing women everywhere sporting brand new leather boots and designer skinny jeans. During those same trips in 2010-2011, we saw long lines at coffee shops and at fast food restaurants all over the country. This was evidence that Wall Street was underestimating the consumer. As time went by these long lines spread to other categories.

Where does the traffic and buzz look interesting today? My wife and I stood in line with 3000 people to get into the grand opening of the new Cabela’s (CAB) store in Marysville, Washington about 20 miles north of Seattle on April 19th. First quarter earnings were up sharply, despite a fall off in catalog and online sales. They are opening stores in Colorado, Canada and near Yakima, Washington soon. Besides, you can’t buy hunting rifles online. We believe the balance sheet is stellar, free cash flow is gushing and their credit card operation is outperforming everyone in retail including Nordstrom. We didn’t see anyone in the crowd from Wall Street.

Have you used eBay (EBAY), PayPal, StubHub, Bill-Me-Later or Craigslist lately? You are not alone. PayPal has 110 million registered users and is available this year at 2000 Home Depot (HD) locations. eBay is seeing big traction from power-sellers. StubHub and Craigslist defend you from scalpers at sports events. Other than owning 28 percent of Craigslist, this is all a wholly-owned eBay phenomena. The fact that eBay trades for 14 times concensus 2012 earnings estimates, adjusted for net cash, is unexplainable to us.

Lastly, the front page of the Arizona Republic on April 27 included a story on a 20-percent increase in the price of the average Phoenix area home in the last six months. Since Phoenix was one of our biggest housing disasters (along with Miami and Las Vegas) in the US from 2006-2010, this is a huge piece of anecdotal evidence. It causes us to be interested in the traffic and buzz which could be coming for housing-related stocks like Wells Fargo (WFC), Bank of America (BAC), Home Depot and Gannett (GCI). Who knows, maybe being an optimist who looks at interesting store traffic and buzz could put us “One Up On Wall Street”.

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. All 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.

Buffett’s cancer to be No. 1 topic at Berkshire meeting
by Ben Berkowitz
For more information go to www.reuters.com.

The information contained in this article 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 article 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.

Printable Version

Dear Fellow Investors:

Jeremy Grantham is a brilliant asset allocator, writer and thinker. He works for an organization (GMO) of great people in those disciplines. He released his quarterly letter to the public recently entitled “My Sister’s Pension Assets and Agency Problems”. In the process of describing the “career risk” of being a contrarian value investor in the asset allocation world, he left out a more important discussion about what we consider “real” career risk. At Smead Capital Management (SCM), we have been subject in our own careers to the career risk that Grantham described. We think that avoiding the career risk he left out is more important to today’s professional investors.

I come from a small town in the state of Washington. There are approximately 14,000 residents. Let’s assume there are three plumbing and heating businesses in town which employ 20 plumbers in their business. We will also assume that something causes a boom in the plumbing business in my home town and 100 plumbers move there. Seven of those 100 are the type of person who start their own plumbing company. You now have 10 firms employing 120 plumbers. The first thing that happens, even if the boom continues, is the existing pool of business gets divided and diluted. The second thing that happens is whatever caused the boom eventually disappears and those 120 plumbers are left to make a living in a town which only supported 20 plumbers in normal times.

“Real” career risk is too many people doing what you do for a living. Grantham’s problem is that every day three million brilliant people get up and spend most of their waking hours trying to practice wide asset allocation. Most of those three million brilliant people have incredibly strong backgrounds in economics and lean on their ability to make macroeconomic predictions. Too many people are doing the same thing at the same time for a living. Therefore, much like the plumbers who moved to my hometown, they need to either move to another town or wait patiently for most of the other bright people to take up another profession.

To understand how we got here you have to understand where we came from. A booming stock market from 1982-1999 in the US culminated in the tech bubble. By 1998, most financial professionals either picked stocks directly for folks or guided their clients to stock pickers via mutual funds and separately managed accounts. This reached a pinnacle of concentration in US equities which the world will probably never see again. Most of the great tech firms of that era were US companies, so capital came from around the world to get at the boom. The way to get the most out of the boom was to pick stocks and to concentrate your assets. In 1999, virtually every other asset class was starved for capital except US large cap equity. Returns of 20% compounded were realized in that category and quickly became expected. Three million brilliant financial professionals got up every day to think like George Gilder and figure out the next revolutionary technology and the company which was going to make you rich from it.

When the 2000-2002 bear market in US stocks stripped 80% of the value of the Tech-Heavy NASDAQ stock index and 45% out of the S&P 500 index, the financial professionals suffered “real” career risk. Nobody wanted them to do what they did for a living any more. They recognized the sin of concentration very quickly and between 2003 and 2007 morphed themselves into the world of wide asset allocation. Everybody wanted to be David Swensen or Jeremy Grantham and execute something similar to the Yale-Endowment model. Since the other asset classes were starved for capital, this created a multi-year bull market in everything from gold to oil and emerging markets to international bonds. It spawned the urge to reduce your equity risk through employing hedge funds. It caused institutional folks to move heavily into alternatives like commodity indexes and private equity funds (where prices aren’t printed in the newspaper every day).

As if the early decade bear market wasn’t enough to get the lesson, the financial meltdown of 2007-2009 reinforced the wide asset allocation urge and motivated those who do it to use a heavy dose of economic analysis. It was official. As an institutional or individual investor you had to practice wide asset allocation and employ some of the greatest macroeconomic thinkers in the world in the process.

Today, if you walk into the office of any financial advisory firm in any small town in the US, you are likely to get a similar set of macro-economically steeped advice and shepherded through the same kind of asset allocation which you would get from a brilliant man like GMO’s Ben Inker. My friends, in my opinion, there are too many wide asset allocation plumbers and it has ruined the forward returns of effective wide asset allocation. If you’ve been around 32 years like me, you can read the frustration in Jeremy Grantham and Ben Inker’s letter. “We (GMO) are going to play for mean reversion sooner rather than later”. They are avoiding risk because there is very little value to add by taking any in the late stages of a boom in your profession. There are too many smart people attempting to do the same thing that GMO does for a living!

In a recent piece called “Diversification Remains Difficult”, Richard Bernstein makes our argument in a slightly different way. He explains that US Treasury bonds are the only “uncorrelated” asset class. He included a chart that shows back in 2002, real estate, gold, commodities, high grade and municipal bonds were inversely correlated with US equities and today they move in tandem with them. Here is how he explains the current situation: “In particular, we remain quite concerned that investors appear grossly under-diversified,” he writes. “Diversification is not dependent on the number of asset classes, but rather it depends on the correlations among those asset classes.” By everyone in the institutional and individual investor world becoming closet economists and wide asset allocators, most of the ways to actually diversify have disappeared.

At our firm we are guessing that this is a very good time to be a long-duration stock picker or to employ good long-duration stock picking in your asset allocation process. We don’t believe there are even three thousand brilliant people who wake up each day in our profession and attempt to compete with us. In that way, we believe we are avoiding the “real” career risk.

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.

Printable Version

Dear Fellow Investors:

We at Smead Capital Management admire the great thinking and research done by people like Warren Buffett and Jeremy Grantham. We also admire thoughtful writing by professional journalists like Martin Hutchinson from Reuters and Charles Stein from Bloomberg. They’ve all written or commented on the affect that corporate profit margins have on stock price performance in the US. Buffett, in his speech to the Allen and Company gathering at Sun Valley back in 1999, and Grantham more recently, remind people that there are finite limits to corporate profit margins. They also repeatedly remind us that there are limits to corporate profitability as a percentage of Gross Domestic Product (GDP). Below is a chart of corporate profits as a percentage of GDP:

We first want to answer the question, “Is there something we should do in our portfolio to adjust if these historically high profit margins revert to the mean?” Second, we want to ask if there is a huge difference in what you do with this information if you are an asset allocator or a stock picker. Third, we would like to discuss the forces which might lead to a reversion to the mean in the ratio of corporate profits to Gross Domestic Product (GDP) on this chart.

Mr. Grantham has pounded the table on why the reversion to the mean on profit margins means significantly lower stock prices. As recently as late November, Grantham called for a decline in the S&P 500 index from the then 1158 to his estimate of fair value between 950 and 1000. As I review this piece on March 26th, 2012, the S&P 500 is trading intra-day at 1400. Even though Grantham seems to some investors to be permanently bearish on US stocks, this is a big disconnect for someone who is supposed to be among the most highly-rated asset allocators in the world.

Hutchinson made the same case as Grantham in a piece called “E Not PE”, which was repurposed on the New York Times online website. Here is how Hutchinson explained it:

“There’s a bubble in U.S. stocks – but it’s in profitability, not valuation metrics. The S&P 500 Index trades at 14 times historical earnings, so the valuation multiple isn’t excessive. But a measure of domestic U.S. profit margins stands 50 percent above its long-term average. Global profitability has soared even higher. This is unlikely to last long.”

The main forces which affect corporate profit margins are interest rates, labor, productivity enhancement-technology, globalization-emerging markets and commodity prices. We would hypothesize that understanding those forces could play a big part in being successful in either asset allocation or stock picking during the next decade. Most folks who are interested in this topic expect the mean reversion to be very bearish for the overall stock market. We disagree and believe profit margin mean reversion is at the core of our belief in a bifurcated US stock market over the next ten years.

In his Sun Valley speech, Buffett pointed out how massively important interest rates were to both profit margins and stock price performance from 1964-1981. Interest rates affect corporate profitability in multiple ways, but two obvious ones are by affecting borrowing costs for companies (a direct expense) and borrowing costs for customers (an indirect reduction in demand). Ultimately, very high interest rates greatly impacted economic growth by the late 1970’s. This all culminated in the very low level of corporate profitability in the early 1980’s.

When it comes to stock prices, interest rates instantly affect discounting models of future earnings and cash flows. The higher the rates, the lower the present value, the lower the rates, the higher the present value. Secondly, high interest rates on more secure “currency” investments like CDs, money market funds and Treasury Bills/Bonds proved to be stiff alternatives to common stocks. All of these corporate profitability and stock price forces peaked in 1981-1982. Interest rates hit their highs and stock market PE ratios hit their lows.

When comparing what happened in the US stock market from 1964-1981 to the period from 1981-1998, Buffett noticed that corporate profitability as a percentage of GDP rose from 4% to over 6%. He also noted that interest rates on long-term Treasury Bonds had fallen from 13% to 5%. He then talked about how ridiculously over-optimistic investors were at that time. The 30 PE multiple for the Fortune 500 was used as a reference point of how expensive and over-priced stocks were in 1999. Buffett argued correctly back then that equity returns would be historically poor going forward. The only way that he felt that he could be wrong was if a huge decline in interest rates occurred and /or corporate profitability climbed markedly to historical extremes. The irony of it all is that his prognostication was spot on even though the profit margins did soar and interest rates did plummet! This could certainly explain his recent bullishness on US large cap stocks when you factor in a trailing PE multiple of 14.1 on the S&P 500 index.

As we discuss the forces which could lead to a mean reversion for profit margins, we at SCM want you to know that we are in the camp which agrees that a reversion is coming. First, interest rates today are very similar to the early 1950’s, the last time that profit margins approached 10% of GDP. Long-term Treasury bonds have averaged 5.5% since 1926 (Ibbotson). With the ten-year T-bond at 2.28% and the thirty-year T-bond at 3.36%, there is plenty of reverting to do. We believe that interest rates will rise significantly over the next ten years. We’ve written about this in missives titled “Out of Bondage” and “Not in My Lifetime”. We believe bond prices will tumble once the fear of a new major meltdown dissipates. Profit margins would be impacted by the result of those higher interest rates.

Charles Stein, a writer for Bloomberg, wrote a terrific piece on November 27, 2011 discussing the forces which affect corporate profit margins. The discussion on labor resulted in this quote:

“The globalization of the workforce and a U.S. jobless rate of 9 percent last month have given management the upper hand in dealing with labor, Zandi said. Wages and salaries as a share of national income fell to 49.4 percent in the third quarter, the lowest since the government began collecting the numbers in 1948, Moody’s data show.”

High unemployment rates and high US government expenditures on unemployment compensation/welfare also contribute to high profit margins. A person who is unemployed and buying things anyway adds to revenue without being a labor expense. As a firm, we believe that an improving economy, lower government expenditures as a portion of national income and higher wages in the emerging world will help reduce profit margins absolutely and as a percentage of GDP.

We believe the number one thing affecting employment in the US is the depression in home building. Housing and related industries are blue-collar heavy. As “echo” boomer children of baby boomers turn 30 years of age in droves the next five years, we expect they will begin to buy houses without abandon. Rents have moved up dramatically, but the large stack of foreclosures and short sales has not yet been overwhelmed by household formations. In his 2011 shareholder letter for Berkshire Hathaway, Warren Buffett said, “Wise monetary and fiscal policies play an important role in tempering recessions, but these tools don’t create households nor eliminate excess housing units. Fortunately, demographics and our market system will restore the needed balance – probably before long. When that day comes, we will again build one million or more residential units annually. I believe pundits will be surprised at how far unemployment drops once that happens. They will then reawake to what has been true since 1776: America’s best days lie ahead.”

In a CNBC interview on the 27th of February, 2012, Buffett added, “Well, if I thought I was going to live-if I knew where I was going to want to live the next five or 10 years, I would, I would buy a home and I’d finance it with a 30-year mortgage, and it’s a terrific deal. And if I literally, if I was an investor that was a handy type, which I’m not, and I could buy a couple of them at distressed prices and find renters, I think that’s and again take a 30-year mortgage, it’s a leveraged way of owning a very cheap asset now and I think that’s probably as an attractive an investment as you can make now. But I think equities are very attractive compared to anything else.” Over the next two to three years, we see housing rebounding, labor participation rising and the government pulling back from its Keynesian demand strategy. This would put pressure on profit margins.

Technology improvements and the affect they have on productivity will be an offset to the totality of labor’s improved position. Whether using the “cloud”, allowing employees to work from home or using technology to reduce paperwork, productivity is being enhanced and profit margins are benefitting. We see it all the time in the results of the companies in our portfolio of stocks. Nordstrom (JWN) has seen a big part of its growth come from its online sales in the last five years. Online sales are labor and capital un-intensive. Many businesses are selling through smart phone apps like Ebay (EBAY). Imagine how many employees are getting usurped by these efficiencies.

The next two forces affecting profit margins are globalization-emerging markets and commodity prices. We at SCM like to refer to this as the “Global Synchronized Trade”. Emerging markets like Brazil, Russia, India and China have seen huge and relatively uninterrupted GDP growth the last ten years. The kingpin of this growth has been China. They appeared to even be oblivious to the steep recession of 2007-2009! With massive fixed asset investment stimulus, fed by the four large government-owned banks, China jumped right back up to the 10% GDP growth level in 2010 and 2011.

All the economic history we have studied and the history studied by professors like Michael Pettis from Peking University in Beijing, shows that most all emerging market nations get to the point where the only way they can maintain high growth rates is to manufacture GDP growth through unsustainably high fixed asset investment levels. Here are his latest thoughts in a recent NPR appearance:

“China’s economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.”

“In every single case it ended up with excessive debt,” Pettis says. “In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has.”

In the phase of heavy fixed asset investment, countries are incredibly inefficient in their level of commodity use as a percentage of GDP produced. Professor Pettis has estimated that China used nearly 40 percent of all the major input commodities consumed in the world in 2010 to produce 9.4% of the world’s GDP. Brazil and Russia effectively suckle on the “bounteous teat” of the China Boom, so their growth has been tied directly to the affect that China has had on commodity prices, especially oil. India’s growth has had a very large impact as well on commodity use as they have also built a great deal of infrastructure in the last ten years.

Therefore, any country like Australia or Canada which has also suckled on China’s “bounteous teat” or US company which has anything to do with designing, engineering and building infrastructure has had a boom themselves. Simultaneously, any US company which is involved in the production of commodities has not only had a boom, but they’ve had it while interest rates are historically low. Profit margins for these US companies are the backbone of the historically high profit margins. Here is what the 205-year chart of ten-year commodity price performance looks like from a US standpoint:

Source: Stifel Nicolaus Mid-2011 Macro Outlook Slide Deck, July 7, 2011

Without going into great detail, we believe that China’s coming recession will trigger a huge multiple-year bear market in commodities. The profit margins of those who have suckled will get crushed, in our opinion. Hutchinson might have written it best: “Globalization is one factor driving up profit for companies in the United States. According to a March 2011 paper by the Bureau of Economic Analysis, foreign earnings represented 40 percent to 45 percent of total profit between 2008 and 2009, against around 20 percent in the 1980s.”

We believe that foreign earnings could back off to closer to 30% of profits by ten years from now. This would come from the combination of the slowdown around the world coinciding with the rebound in US housing and the explosive affect lower commodity prices would have on US economic growth and confidence.

Therefore, a summary of the forces affecting US profit margins over the next ten years is needed at this point. We believe that interest rates will rise. We believe the unemployment will decline as the economy picks up steam. This will negatively affect margins, but be somewhat offset by significant GDP growth. We also see productivity enhancement through technology maintaining some of the profit margins reduced by other factors. Lastly, we see international fixed asset investment declining rapidly and commodity prices plummeting. The positive side of this would be the stimulative affect it would have on US GDP growth.

What do we think this means for asset allocators? Currency investments (interest bearing) have trapped investors both institutional and individual. They will prevent another 2008, but they will volunteer you to lose purchasing power over the next ten years. Commodities are a ticket to losses, in our opinion, led by oil and gold. Emerging markets will be a big disappointment for both stocks and bonds. Once the bloom comes off the rose, a number of the emerging markets like China and their suckling countries will see their credit quality questioned. In the US, stocks and residential real estate should outperform, as long as you avoid the companies who have benefitted from the prior boom.

From a stock picking standpoint, we believe the US should be a great place to be in retail sales and consumer services. We like Ebay (EBAY), Nordstrom (JWN) and H&R Block (HRB), as examples. Banks, which are loaded down with under-water residential real estate, should rebound. Higher interest rates could help spreads for the likes of Wells Fargo (WFC) and Bank of America (BAC), two very domestically-oriented banks. The media companies should enjoy a more prosperous US economy and benefit stocks like Disney (DIS), Comcast (CMCSK) and Gannett (GCI). Lastly, Americans will be able to afford quality healthcare though the most inexpensive part of the healthcare system, pharmaceuticals and biotech. We like Merck (MRK), Pfizer (PFE), Amgen (AMGN) and Mylan Labs (MYL) in that area.

We feel investors should avoid capital intensive companies which are tied to commodities or emerging markets. As interest rates rise and capital becomes dear, those who eat capital lose and those with strong balance sheets and who generate high and consistent free cash flow, win. As Buffet, Grantham, Hutchinson and Stein pointed out, someone loses in the reversion to the mean of profit margins when compared to GDP. Lastly, don’t be fooled by those who are bearish on the stock market because of their belief in profit margin reversion. The Dow Jones average rose from 260 in 1952 to nearly 1000 in 1966 while profit margins plummeted from near 10% of GDP to 5% in the recessions of 1953-54, 1957-58 and 1960-61. Profit margins dropped to 5% when our economy melted down in 2008, but stocks have rebounded nicely.

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.

Printable Version

Dear Fellow Investors:

When I was in college, the hardest concept for freshman and sophomore economics students to understand was that bond prices fall when interest rates rise and bond prices rise when interest rates fall. Most of my classmates just memorized the concept without understanding why it happens. Since 1980, when I came into the investment business, the hardest concept for investors to understand is that stock prices rise when the Federal Reserve Board practices “easy” money policies during very poor and anemic economic growth periods. When normal business does not use the newly created money supply, it sloshes around and finds its way into the stock and bond markets. Stocks also have a tendency to perform poorly when the US economy grows at rates above 6% for an extended time. See the chart below:

Source: Liz Ann Sonders, Charles Schwab, Market Outlook February 2011

We at Smead Capital Management are very excited about the next three to five years because we believe it is likely that Main Street will start to compete with Wall Street for capital and economic growth will accelerate. Unemployment rates would fall in that scenario and “pent-up” demand for goods and services could come out of the woodwork among average American households. What we mean by saying this is that capital will begin being demanded for business activities. As capital gets demanded for business activities ranging from housing to business expansion, the cost of capital will rise and bond prices would fall.

In a better Main Street economic environment where capital is being demanded, investors would be put in a position of having to differentiate between companies. As the US stock market rebounded from the once in 50-year fears of another great depression, almost every boat was floated by the wave of money created by the activities of the US Treasury and the Federal Reserve Board. Commodities rebounded, gold went parabolic, corporate bond prices soared and common stocks of all shapes and sizes moved in tandem off of the March, 2009 lows. This culminated last fall in the highest correlations among S&P 500 index stocks in the last 25 years at around 86% in October of 2011. The tide came in and all boats floated. As we wrote in July of 2011, we had reached what we call asset allocation “Nirvana”.

The question for those of us who like to “skate to where the puck is going to be” is which sectors of the S&P 500 and which companies are likely to be strong investments in this coming environment? This would include economic growth at 3-5% and would likely allow the Fed to let short-term interest rates gravitate to market rates. This new environment would also see those historically high correlation levels disappear. Lastly, improved economic growth, higher interest rates and less government dole could severely impact corporate profit margins.

In a normal economic cycle, the energy, heavy industrial and basic materials sectors of the S&P 500 index are slow out of the starting gate in the early stages of a bull stock market. They don’t begin hitting their stride until economic growth accelerates, because their attractiveness usual coincides with capacity becoming scarce. It makes sense, because sales usually pick up before inventories are replenished and before new capital goods are required. However, the globalization of large-cap US cyclical stocks like Caterpillar (CAT), Deere (DE), Schlumberger (SLB) and Joy Global (JOY) has caused them to be much more sensitive to the international economy and much less sensitive to US economic growth. Caterpillar only gets 27% of its revenue from the US and we believe the US is the least reliant on commodities and most energy efficient it has ever been. For example, energy consumption per real dollar of Gross Domestic Product was 18% in 1970 and was 7.3% at the end of 2011. The US is the largest economy in the world. It is as big as the next four country GDP totals combined, yet commodity prices have increased more in the last ten years as in any ten-year stretch over the last 205 years. This is despite the fact that commodities matter the least to the gross domestic product of the US as they have ever mattered.

Therefore, we believe that the normal bull market in cyclical sectors has been spent on the excitement that China and the BRIC-trade related countries have created the last ten years. We also believe that the slowdown in the emerging world and acceleration of the US economy is the death knell of the commodity bull market of 1999-2011. Finally, utility and telecom companies should enjoy some positive effect of the rebound in the US economy, but that is offset by potentially higher borrowing costs for these capital intensive industries. We are avoiding all five capital intensive sectors of the S&P 500 index.

This leaves us consumer discretionary, financials, healthcare (Pharmaceuticals) and technology. We believe all of these sectors stand to benefit from the next stage in the US economic recovery. Consumer discretionary companies would benefit from the unleashing of the pent up demand, while financials would prosper from the rebound in housing and lending. Pharmaceutical companies would gain from lower unemployment and greater prosperity and technology profits would be driven by meeting the capital good needs of these commodity efficient industries. We believe this is especially true for companies with the best balance sheets and those which have the best free cash flow, because they won’t have to fight with Main Street for borrowed capital as it makes its comeback.

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.

Printable Version

Dear Fellow Investors:

We at Smead Capital Management (SCM) have made the case that the poor performance of the US stock market from the end of 1999 to the end of 2008 has caused most institutional and individual investors to dramatically shorten the duration of their equity investments. In many cases, we are hearing that institutions and individuals want their advisors to help them insulate or “prevent” them from having another 2008. In a world of short duration common stock investing, sentiment polls have an increased importance. We like to say that an eye on the crowd is important if you have one foot out the door at all times. Professional investors have been forced by the power of the rebound in the stock market since March 9, 2009 to get invested, but they haven’t trusted the durability of this rebound along the way.

Individuals and financial advisors practice short duration through go-anywhere managers, exchange-traded funds and low-cost trading of individual common stocks. Institutional investors have done this by allocating a large part of their asset base to equity managers who attempt market timing and alternative investments in the hedge fund world. Studies show that the money in “alternative strategies” now dwarfs what is held in US long-only equity. See the chart below:

In a wonderful April 1, 2012 article in the New York Times, Julie Creswell presents the facts about pension fund performance in relation to how committed plans are to alternative investments:

“Searching for higher returns to bridge looming shortfalls, public workers’ pension fund across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds.

But while their fees have soared, their returns have not. In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.”

What Julie describes as “riskier” investments have also contributed to these very low levels of participation in long-only US stocks and especially long-only US large capitalization strategies.

When you breakdown the long-only participation, it is spread between US large cap, US mid cap and US small cap. Since small and mid-cap strategies have outperformed since the peak of the US stock bubble in 1999, it is safe to assume that institutions are the most committed to small-cap and mid-cap long-only strategies relative to the total equity long-only mix as at any time since the 1990’s. You can see this in Request for Proposal (RFP) mandate notices for small cap managers in periodicals like Emerging Manager Monthly. Institutional investors seem to like to close the barn door after the animals have run out. After ten years of outperformance by small-mid strategies, they are vigorously looking to increase their participation. Since small and mid-cap strategies are historically more volatile than large-cap strategies, this triggers an additional urge to time the market and has increased the importance of sentiment polls.

The Investor’s Intelligence (II) poll of investment newsletter writers is the oldest of the major sentiment polls and is the one I have followed during my nearly 32 years in the investment business. Our general view at SCM, as long-term investors by nature, is to not be interested in changing what we own based on 6-12 month stock market gyrations. For this reason, our view is that the sentiment polls are only useful at extremes. Therefore, everything that happens in between the extremes is just noise.

This week’s II poll showed that those writers who are bullish total 50.5% and those that are bearish equal 22.6% of the newsletter writers. Our observation is that it is very meaningful historically when the bullish sentiment reaches 60% or greater. In August of 1987, at the end of a run up in the Dow Jones Industrial Average from below 800 in August of1982 to over 2700, bullish sentiment broke 60%. By October 19th of the same year, the Dow fell to 1738. In February of 1999 and in February of 2001 at around 1240 on the S&P 500 index, bullish sentiment exceeded 60%. The S&P 500 index fell to 761 in October of 2002, a decline of 38.6%.

If history is any guide, it would take a large additional spurt to the upside in today’s US stock market to trigger a 60% bullish reading. We feel this could only come through a dramatic increase in long-only institutional large-cap US stock market participation and/or an end to the massive move into bonds made by US individual investors over the last four years. The bond market devotion would have to be replaced by a very meaningful move into US equities.

In 1987, institutions got heavily committed because of the comfort that derivative -related “portfolio insurance” provided many of them. The insurance was designed to protect against “normal” bear markets, not a drop in the Dow Jones average from 2700 to 1700 in 78 days! Both of these instances (August 1987 and February 1999), where the 60% bullish sentiment marker hit an extreme, saw price-to earnings (PE) ratios at historic highpoints. Warren Buffett, in his Allen and Co. talk at Sun Valley in the summer of 1999 mentioned that the Fortune 500 traded at 30 PE.

In our opinion, those who are very bearish about the US stock market need a substantial price increase to trigger historically extreme newsletter writer sentiment. Those who are optimistic should prefer a temporary correction or sideways movement to reinforce fear on the part of the crowd. This would cause the bullish and bearish readings to gravitate to toward each other and remove the risk of having some temporary “hell to pay” for those of us who seek to practice long-duration common stock investing.

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.

Printable Version

Dear Fellow Investors:

We saw Warren Buffett quoted the other day saying, “We like companies which buy a commodity and sell a brand”. We thought it would be very helpful to unpack his thought and put it into the context of today’s circumstances. We at Smead Capital Management believe these current circumstances are framed by the historical over-pricing of commodities, the coming economic contraction of China, the successful cleansing of the income statements of US households and the inevitable rebound in housing in the US. We will look at the makeup of our portfolio companies which buy a commodity and sell a brand to consider their upside potential in this interesting environment.

When non-economic investors load up on investments in anything which has had a big run up, please circle the wagons. When commodities were at their low point in 1999, it was hard to find any institutional investor or financial advisor recommending exposure in commodities for investors. As of the end of 2010, institutions are dedicating as much as 52% of their portfolio to alternative investments. This includes commodities, gold and energy. These investments are made today for diversification purposes and are simply bets on rising prices. These bets look good in a rearview mirror as we’ve had a once in a generation move into this asset class. We believe that commodities have never been more over-priced in the US and are entering a decade-long bear market.

We believe the reason commodities have been in a bull market for so long is the uninterrupted economic boom in China. When a country with 1.3 billion people grows at over 10% for a number of years without an occasional recession, it ends up relying on fixed asset investments for growth. When fixed asset investments dominate your GDP numbers, borrowed money prepares to turn sour and ultimately lead to a recession/depression. This is something that “getting rid of cable” can’t cure.

The Federal Reserve came out with their household debt service ratio (HDSR) last week. It shows that by the end of 2011, American households had brought the ratio down below 11% to 10.88%. This matches up with the levels seen in the early 1980’s recession and the “anemic” economic recovery of 1990-93. These earlier readings preceded two of the best modern economic growth periods since World War II. While the doomsayers moan about absolute debt levels, we feel they are missing the story on the health of the income statement of the average household. This has boded well for the economy historically. Also, if we continue to be slow to buy houses and cars, this HDSR could put discretionary spending into its most favorable position in decades.

Lastly, this current “anemic” economic recovery has been severely retarded by the boom commodity prices of the last two years, in our opinion. We’ve had to work off a huge number of foreclosed and short-sale housing inventories, while the deep recession temporarily crippled household formation (Jeff, Who lives at Home). It is rebounding as 20-somethings get sick of living with the parents and the parents get sick of living with Jeff. As Mr. Buffett said recently, “eventually hormones take over” and as Brett Arends pointed out in Smart Money,” renting is more expensive than buying in about 75% of American cities.” You add high lumber, copper, iron ore and oil prices to this mix and you get the worst depression in housing and blue-collar employment since the depression. All these headwinds are about to become tailwinds, in our vision, over the next five years.

Therefore, betting on the US economy and the US consumer looks very favorable to us, especially where the rebounds in employment and consumer confidence have an impact. In fairy tales, people are asked to spin straw into gold. We like to own companies which spin milk and coffee (SBUX), cotton (JWN and CAB), internet access (EBAY and ACN), tax returns (HRB) and chemicals (MRK, AMGN, BMY, ABT, PFE and MYL) into gold. Profit margins on commodity-related companies and companies reliant on emerging market growth could plummet in the near future. Just ask the folks at BHP Billiton. They announced March 20th, 2012 that they are seeing in a big drop off in demand from China. In turn, we believe margins could go up for anyone who is positively impacted by lower energy prices and/or commodity prices in general. This is especially true if you “buy commodities and sell brands”.

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.

Printable Version

Dear Fellow Investors:

One of my favorite songs of the late 1960′s was “Abraham, Martin and John”. It reminded us that a number of our country’s leaders had been assassinated. Investments aren’t nearly as important as life and death, but the returns most investors have been getting the last three years have been murdered by a series of doomsday predictions.

“Has anybody here seen my old friend Abraham (wide asset allocation)
Can you tell me where he’s gone?
He freed a lot of people, (of stock market gains)
But it seems the good they die young.
You know, I just looked around and he’s gone.”

We wrote a piece last fall analyzing what goes on at the time very smart and successful money managers enter a period of under-performance. It is usually tied to too much popularity for them and their discipline. We believe wide asset allocation is overly popular. In our opinion the same basic asset allocation is being done by financial advisors in the smallest towns in America that is being done at the largest wealth management firms in the world. We at Smead Capital Management (SCM) believe that Malthus is being refuted once again and his theories are being used to justify risk aversion.

“Anybody here seen my old friend John (market timers)
Can you tell me where he’s gone?
He freed a lot of people, (of bull market participation)
But it seems the good they die young.
I just looked around and he’s gone.”

We feel market timing and economic analysis are great for avoiding once every 50-year stock market declines. You can’t create wealth with one foot out the door and a portfolio built around short-run assurance. Warren Buffett is fond of telling students that his worst mistakes have been sins of omission, not sins of commission. America did not become great by being preoccupied with risk prevention.

“Anybody here seen my old friend Martin (macroeconomic strategy)
Can you tell me where he’s gone?
He freed a lot of people (of stock market courage),
But it seems the good they die young.
I just looked around and he’s gone.”

We believe the “New Normal” concept was one of the best marketing jobs in history. We feel it caused institutional and individual investors to overload bonds and avoid stocks in the very normal bull market of the last three years. “It’s different this time” are words which once again have cost investors billions!

“Didn’t you love the things that they stood for?
Didn’t they try to find some good for you and me?
And we’ll be free
Some day soon, and it’s a-gonna be one day …”

Imagine that these doomsday people were around you when you were five years old. They would have scared you away from climbing trees or riding bikes or swimming. All for the sake of protecting you from risk. Steve Jobs said it best at Stanford’s 2005 graduation ceremony when he said, “We are all going to die, so take some risk”!

“Anybody here seen my old friend Bobby (commodity enthusiasts)?
Can you tell me where he’s gone?
I thought I saw him walkin’ up over the hill,
With Abraham (wide asset allocation), Martin (macroeconomic strategy) and John (market timers).”

Commodities have never been more popular or seen wider participation in my 32 years in the investment markets. The idea that more people existing is justification for higher commodity prices has constantly been refuted over the last 100 years. For example, we feel that if more people means perpetually rising commodity prices, they would have gone up all the time. In our opinion, China’s hard landing is already happening. When China’s debacle is obvious to everyone, commodities and stocks related to them will be the lepers of the investment world.

We at SCM always know that there will be a bear market in US stocks about once every five years and a 10 percent decline in stocks is likely once each year. However, stocks have been the best performing liquid asset class over the long haul and are much more likely to succeed when the masses are paying close attention to the purveyors of doomsday. Remember, they are just trying to find some good for you and me.

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.

Printable Version

Dear Fellow Investors:

A recent article in “The National” quoted Jim O’Neil as saying that current supply and demand for oil indicates that $80 to $100 per barrel for Brent Crude would be a fair price. For those of you who don’t recognize the name, O’Neil is a very savvy economist for Goldman Sachs (GS), who coined the phrase BRIC trade back in 2001. Since that qualified him as an investment “Wayne Gretsky” (he skates to where the puck is going to be), we believe his thoughts are worthwhile.

O’Neil argues that there are no winners in a war over Iran’s nuclear capability. Therefore, he argues that the $25-35 premium in the price per barrel, which comes from supply disruption fears, would disappear by summer. We agree wholeheartedly.

We also agree with his belief that Brazil and Russia don’t benefit from lower oil and commodity prices. In our opinion, the decade long bull market for commodities is held together by oil prices stubbornly acting on a ten-year old bull case and foolish asset allocators investing in the rearview mirror. Oil is 30 percent of most commodity indexes. It hangs on while natural gas, cotton, coffee, wheat and corn are firmly in bear market territory.

When oil and gold join the bear market, we believe the race for the exits will look like the tech stock bear market of 2000-2002. Those folks who were long tech lost 80 percent from March of 2000 to October of 2002. When a non- economic market crumbles, it is like the Tower of Terror at Disney’s California Adventure Park. You drop straight down without interruption!

We disagree with O’Neil in one way. He believes lower oil prices would stimulate China’s economy, helping to promote a “soft landing”. We agree with Michael Pettis, Professor at Peking University, on this subject. In a recent NPR broadcast his opinion was summarized as follows:

“For Pettis, China’s economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.

‘In every single case it ended up with excessive debt,’ Pettis says. ‘In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has.’ “

In our opinion, if China slows into a recession/depression, $30-40 per barrel oil is a possibility. Or if China doesn’t grow much in the next ten years, commodity exposure will be a noose around the neck of asset allocators. Add in the likelihood that there would be poor performance among the US cyclical stocks, which have suckled on China’s bounteous teat, and you have the ideal set up for an asset allocation “nightmare”!

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.

Printable Version

Dear Fellow Investors:

In his recent 2011 shareholder letter, Warren Buffett explained the purpose behind investing, the “real” definition of risk, and the three types of investments which congregate the marketplace. At Smead Capital Management, we believe Mr. Buffett struck at the core of the problem that most institutional and individual investors are having. They are defining risk primarily by what happens in the next twelve months, while the Oracle of Omaha is thinking in five to ten-year time frames, at a minimum. These short time frames are combined with eyes locked on the rearview mirror, inhibiting investors from participating in wealth creation as we look out into the future.

In Buffett’s mind, “investing is forgoing consumption now in order to have the ability to consume more at a later date.” In essence, that is the purpose of investing. Notice that Buffett never includes any physical or mental limitations on investing. As a former 5’ 8” left-handed pitcher and first baseman, I am very glad there are no physical limitations. You don’t need to be a Valedictorian in high school or among the Phi Beta Kappa’s in college. We believe investing is something that is done for the purpose of increasing purchasing power or wealth in reasonable time frames and in securities which make sense at very average IQ levels.

This leads us to how most of today’s market participants define risk. Short-term price movements or volatility are how most academics and current market participants define risk. Buffett refers to it as beta in the letter, “a Wall Street term encompassing volatility and often used in measuring risk”. Beta is how much the price of your security adjusts as compared to the price adjustments of its index. Recent (three to five-year) history, which includes the huge meltdown/liquidation of 2008, is fresh in everyone’s mind. Therefore, in our opinion, institutional investors have organized their asset allocation around surviving the worst possible 12-month price movements. This has caused high commitments to the bond market, commodity markets and emerging stock markets around the world. We feel individual investors are highly over-committed to the bond market after gorging on bonds for three consecutive years!

Fortunately, Mr. Buffett has been kind enough to breakdown the three categories of investment. Those categories are currency based investments (money market funds, CDs, bonds, etc.), unproductive assets (gold, art, collectibles, etc.) and productive assets (common stocks, farmland and real estate). We at SCM believe he did this because of the popularity of the first two categories. We think the popularity has ruined them for use in five to ten- year time frames.

Buffett is very strict in that he asks for an increase in purchasing power above and beyond inflation. Mathematically, if history is any guide, currency investments have very little chance of increasing purchasing power over the five to ten-year pull. We believe the only chance would be a prolonged period of deflation which a number of doomsayers are happily promoting. Here is Buffett’s take:

“Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as ‘income’.”

Currency investments are for money which has a reason to fail the risk test. The owner agrees to give up purchasing power in the long run to have more stability and certainty in the short run.

The second category of investments is what Buffett calls “unproductive assets”. Here is his description:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.”

In his book, “A Short History of Financial Euphoria”, John Kenneth Galbraith explained, “by 1636, a tulip of no previously apparent worth might be exchanged for ‘a new carriage, two grey horses and a complete harness’.”

Buffett chose to focus on the “granddaddy” of all periods of unproductive asset euphoria to shed light on the current mania for gold. Turn on the TV for any extended time period for 24-hour news or business news and you will get bombarded by offers to sell you gold. Our rule at SCM is to sell what the majority of promoters are promoting. Right now that is spelled G-O-L-D! Buffett uses the last two major US bubbles to take a serious punch at gold:

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end’.”

The third category is productive assets like ownership of a business, farm land and real estate. Meeting an economic need and getting compensated with cash profits or rent. Thanks to the commodity bull market of the last ten years, farmland appears over-priced (see chart below).

Here is a picture that is worth a thousand words:

Source: blog.agnetic.com, October 24, 2011 “Black Swans are Landing on Your Farmland”

These are the categories which historically have increased the purchasing power of folks over long-term stretches. Buffett says it best:

“Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

Our nation is dominated by retiring baby boomers in the 50-65 year-old age range who need their money to last 20-40 years and institutions in need of increasing purchasing power for perpetual asset bases. Ownership of businesses, especially common stocks, has dropped dramatically since the stock market bubble peaked at the end of 1999. At SCM, we are willing to accept the possibility of loss in the next 12 months to gain significant purchasing power over the next ten years. We would assume a minority of investors are postured that way currently because of the way they define risk.

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.

Printable Version

Dear Fellow Investors:

We have been traveling around the world delivering a talk to CFA Societies on why passive indexes beat most active equity funds. We start the talk with the following William Sharpe quote from 2002:

“Should everyone index everything? The answer is resoundingly no. In fact, if everyone indexed, capital markets would cease to provide the relatively efficient security prices that make indexing an attractive strategy for some investors. All the research undertaken by active managers keeps prices closer to values,
enabling indexed investors to catch a free ride without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities.

Should you index at least some of your portfolio? This is up to you. I only suggest that you consider the option. In the long run this boring approach can give you more time for more interesting activities such as music, art, literature, sports, and so on.”

Jason Zweig of the Wall Street Journal wrote a blog last week titled, “Simple Index Funds May Be Complicating the Stock Market”. In it he explained how passive investments have risen to 33% of the money in equity mutual funds. He theorizes that all these agnostic investments might be adding to the volatility and the high correlations in the marketplace:

“Recently, leading investing experts—including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University—have been warning that index funds could destabilize the financial markets.

The rise of trading in index funds, these researchers say, is causing stocks to move more tightly together than ever before—as if they “have joined a new school of fish,” as Prof. Wurgler puts it. That is reducing the power of diversification and could make booms and busts more likely and more extreme.

Unlike conventional funds run by highly paid stock-pickers who seek to buy the best securities and avoid the worst, index funds—including most exchange-traded funds, or ETFs—effectively buy and hold all the securities in a market benchmark such as the Standard & Poor’s 500-stock index.”

Let us unpack Sharpe’s theory, Zweig’s hypothesis and our manifesto on “Long Duration Common Stock Investing”, to see if we can make sense out of today’s stock market environment.

William Sharpe was an efficient market believer in 2002. His beliefs are predicated on two ideas. First, “All the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs.” In his research on intrinsic values in February of 2009, Ben Inker at Grantham, Mayo and Van OtterLoo (GMO) concluded that 75% of the intrinsic value of a company comes from cash flows starting 11 years from now and that 50% of the intrinsic value is from cash flows that come more than 25 years from today. Since there is almost no long duration equity research analysis done on Wall Street, the market can’t possibly be efficient. The stock market and its participants have been compacting the duration of their equity investments constantly since the stock market topped in early 2000. Holding periods are down to historically low levels on the NYSE, institutions are heavily committed to hedge funds with very high turnover and active equity fund managers have average turnover around 100%. A manager with 50% turnover is considered a low turnover manager!

Second, Sharpe was expecting that those who get paid to asset allocate would never get so heavily involved in indexing as to ruin the goose that laid the inexpensive and consistent “golden eggs”. Indexing success is predicated on being a small minority of the marketplace. In effect, its popularity is dooming the strategy and making the market even more inefficient than it was before! Between short-sighted active investors and agnostic indexers dominating the market, Zweig explains that you get very high correlations and extreme volatility. The volatility drives potential long duration investors away from the marketplace.

“Considering that index funds charge annual fees about one-10th of those levied by actively managed funds, it isn’t any wonder indexing has become a money magnet. A decade ago, 278 index mutual funds and 119 exchange-traded funds held $347 billion, or about 16% of all assets in U.S. stock funds. Today, according to Morningstar, 336 index funds and 1,148 ETFs hold $1.24 trillion, or fully one-third of all the money in U.S. stock funds.

That worries some analysts. “Markets work best when people think and act independently, not all together,” Mr. Sullivan says. When investors add money to an index fund, it generally will buy every security in the market that it tracks—hundreds, sometimes thousands at a time, regardless of price. When investors pull money out, the index fund has to sell across the board.”

We believe the solution to these times is at the heart of our manifesto. You need to analyze companies with a special focus on characteristics which contribute to long duration. We like wide moats, sustainable high profitability, high free cash flow and strong balance sheets. GMO likes low beta, low leverage, high sustainable profitability and low earnings volatility. These are all factors which contribute alpha over long stretches of time.

In our opinion, you either need to be a low turnover stock selector or hire one to be your equity representative. Warren Buffett is quoted as saying, “The stock market serves as a relocation center at which money is moved from the active to the patient.” The main attraction to the S&P 500 Index is it has low management fees in a mutual fund or ETF form and very low trading costs due to turnover that averages below 5% per year. Boston College’s Center for Retirement Research found that the average US equity fund spent 1.44% per year on trading costs. Add this to management fees and operating expenses in the mutual fund world and you need the equity manager to beat the S&P 500 Index by at least 2.5% per year just to keep up. We strive for turnover in the 15-25% range and seek miniscule trading costs.

Scarcity creates value in economics. In our view, what is scarce today is an equity manager doing long-term/long duration equity analysis and institutions/individual investors willing to employ them. Since 33% of the stock market is indexed and most of the other 67% works in very short analytic time frames, we believe the market must be as inefficient as it has ever been. Time is the ally of the long-duration common stock investor and we believe more so now, because indexing is getting too popular and investing in short durations is at epidemic levels. We wonder what William Sharpe would say today.

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.