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Smead Capital Management is a registered investment advisor headquartered in Seattle, WA; founded in 2007. The company was formed to allow investors to benefit from long-term ownership of common stocks meeting the firm’s eight proprietary investment criteria. The firm manages a US Large Cap... More
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  • Money Manager Pride Goeth Before Destruction
    Printable Version Printable Version

    Dear Fellow Investors:

    At Smead Capital Management we have made it a high priority to pay attention to the investors who have proven over decades that their work proves worthy of great respect and admiration. In baseball, you can make the All-Star team with one great season, but to make the Hall of Fame, you need a long career at very high levels of success to be inducted. Our industry is wonderful because we can look very closely at the investments and writing of these people we have great respect for.

    All great money managers reach a point in their career where adulation and self confidence detracts from their better judgment. This interruption in judgment usually coincides with the discipline in use becoming the most popular discipline in the marketplace or the investing style being overdue for a three to five-year correction. Studies of the equity managers with the best long term records show that the best underperform the S&P 500 Index 35% of the time. The pride associated with multi-decade success and the reinforcement of an army of folks enjoying your work is probably the most dangerous thing that can happen in the money management business.

    To understand these phenomena, we will review the work of Warren Buffett, Bill Miller and Kenneth Heebner on a backward-looking basis. Then we will examine Jeremy Grantham and Bill Gross looking forward. Our supposition is the following. These men make up a short list of five of the best money managers of all time! However, there is a point in their career when their pride can get in the way of their better judgment and capital can get destroyed.

    Warren Buffett is the most successful money manager of all time, in our opinion. His long-term compounding of book value at a rate in excess of 20% is legendary. To this day, I’d rather be a fly on the wall in his office than one in anybody else’s office in money management. In 1998, he was uniformly admired by the media, by a slew of book writers and by a huge army of professional and individual investors. He wrote in his 1996 annual shareholder letter that stocks like Coke (KO) and Gillette (now part of Proctor and Gamble) were the “inevitables”. In Buffett’s eyes, these companies had such dominant moats, sustainable profit margins, strong balance sheets and other strengths that he could ignore the fact that they reached PE multiples of as high as 57 times trailing earnings. These stocks were “maniacal” and were trading at PE multiples which doomed their stock prices for ten years. Coke peaked at around $88 in 1998 and bottomed in 2009 around $38 per share. Warren’s big mistake list is so small that you need a magnifying glass to read it. I believe that everything going on around him in 1998, the adulation and the uninterrupted success got the better of him. His popularity dropped in 1999 as the Tech Bubble went into its highest gear. By early 2000, many writers were asking if Warren Buffett’s investment discipline was old-fashioned and out-dated.

    Bill Miller beat the S&P 500 Index for 15 years from 1991-2005. He has the unusual ability to recognize deeply out of favor stocks in widely diverse industries and then has the constitution to hold his winners for many years. He specializes in high reward and volatile positions and is unafraid to average down far longer than most admirable money managers. By the end of those 15 years his streak was followed heavily by the media, his parent company (Legg Mason) boomed and financial advisors nationwide poured billions of dollars into the two funds that he manages. We at SCM believe that he is as brilliant a thinker and money manager today as he was in 2005. He’s only out-performed the market once since 2005 in the year 2009. His five-year numbers are 99th percentile in his category. We assume that the circumstances brought pride into the picture and that these last five years have been incredibly humbling.

    Kenneth Heebner manages money in a way that is unfathomable to this writer. He takes concentrated positions based on strong opinions and analysis. He had the best 15-year track record among mutual fund managers in 2008. He produced stunning results in the first eight years of the decade of the 2000’s. However, he turns his portfolio over aggressively and constantly. In May of 2008, he was called “the best money manager around” and featured on the cover of Fortune magazine. Enormous adulation was heaped on him by the media and billions flowed into his mutual funds. At the top of the commodity markets in the late spring of 2008, Ken Heebner was massively over-weighted in energy, basic materials and heavy industrial companies. He immediately went from there to an aggressive over-weighted position in financials. His performance over the three years since the overwhelming adulation has been dismal. He is one of the most talented managers of money, but pride temporarily got the best of him.

    Jeremy Grantham and Bill Gross are Hall of Fame money managers. Grantham leads the firm of Grantham Mayo Van Otterloo (GMO) which is a leading strategic wide-asset allocation firm. He has been unusually accurate in his long-term predictions in everything from lumber to large caps and emerging markets to energy. His firm is drowning in new money and his specialty area, asset allocation, is the darling of institutions, registered investment advisors, consulting firms and financial advisors. Even stock pickers like us pay attention to Grantham’s thoughts on asset allocation and GMO’s 7-year prediction for inflation-adjusted forward performance expectations. He has been spot on and his research director, Ben Inker, has done some of the best investment research in the marketplace. Grantham is currently known for his “7 lean years” thesis and in his latest quarterly letter titled “Danger: Children at Play” he nearly exhausted himself taking victory laps around the nine pages and an addendum. This comes just three months after Grantham boldly predicted that commodities were in a “paradigm shift” and had , in effect, reached a “permanently” higher plateau!

    Bill Gross is the most successful bond mutual fund manager in history. His company, PIMCO, manages over $1 trillion for institutions and individual investors. During the bull market in bonds from 1981 to today, he has handled every environment well and produced a market beating track record. His monthly missives are followed closely by the same crowd which feasts on Grantham’s quarterly letter. The bond bull market in the US has culminated the last three years in an avalanche of money drowning bond managers like Bill Gross. Those investors, advisors and institutions will recite statistics about how much better bonds have done than stocks the last 10 and 20-year periods. Bill Gross even has a very similar forward thesis to Grantham’s which he calls the “New Normal”. It is a relatively negative belief that the US has more than a decade of penance to pay for the financial and real estate sins of the decade from 1998-2008. His firm travels around the world explaining how they are looking for bonds in countries which benefit from emerging market growth to protect against both currency declines and to get a decent rate of interest. When Bill Gross and other major players at PIMCO are on CNBC, the world seems to stop to find out what the markets wisest players have to say. The adulation from all corners is thick enough to cut with a knife and the pride in PIMCO’s opinion continues to rise.

    If this piece were a trial rather than a missive, it is safe to say that Jeremy Grantham and Bill Gross are in a very similar and guilty position compared to the Hall of Famers we mentioned in the beginning. Buffett stumbled when his favorite kind of stocks (large-cap/wide moat/strong balance sheet/powerful brands) were wildly popular. Bill Miller became the most respected equity mutual fund manager at the height of eclectic stock picking. Kenneth Heebner headed into the tank right after he got unusual media attention and his “go anywhere” discipline squeezed every dollar out of the marketplace it could. They have been in Jeremy and Bill’s shoes.

    Therefore, what could happen to ruin the party for these two great money managers? They would have to have a very rough three to five years of performance and the thesis they are operating on would have to be wrong. We believe bonds will never be more popular in the next thirty years than they are now. We believe that so many people are practicing wide asset allocation that it will be a “nightmare” the next five to ten years. We believe that a bear market has started in oil and commodity indexes which will embarrass today’s bulls. Lastly, we believe that the ability of the US economy to heal itself is being badly underestimated by these two great money managers.

    As contrarians, we can’t run away from the opinion of these great money managers fast enough. This is not because they aren’t deserving of Hall of Fame status, but because they are trapped in today’s two most popular disciplines with all the same adulation and pride that our other great managers had before them. Both favor emerging markets over the US, have confidence in commodities, assume China’s economy will grow uninterrupted; both think the US consumer is dead for years and both think that the US is a political disaster area. We will still admire them when those who fawn over them today no longer have respect for them. This will be after the “pride that leads to destruction” turns into humility in the marketplace.

    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.

    Disclosure: I am long BRK.B, BRK.A.
    Aug 16 11:43 AM | Link | Comment!
  • Late in the Party
    Printable Version Printable Version

    Dear Fellow Investors:

    At the annual meeting of Berkshire Hathaway in May of 2006, Warren Buffett was asked to comment on the commodity markets in the US and here is what he said:

    "I don't think there's a bubble in agricultural commodities like wheat, corn and soybeans. But in metals and oil there's been a terrific [price] move. It's like most trends: At the beginning, it's driven by fundamentals, and then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end. With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.”

    As we now know, the commodity bubble lasted until July of 2008 and ended up including agricultural commodities like wheat, corn and soybeans. I was in Walla Walla, Washington on July 15th in 2008 when wheat peaked out at around $10 per bushel. This coincided with oil hitting an intra-day high of $147 per barrel that same week. The folks who live around the area were benefitting from the fact that Southeastern Washington produces some of the best wheat crops in the nation. Even though the nation was in its deepest recession since 1981-82, you wouldn’t have known it by what was happening in Walla Walla. Speculation in commodities ran rampant in the spring of 2008 and drew special notice from the government’s main regulatory body, the Commodity Futures Trading Commission (CFTC).

    In 1999, a limited number of very smart people invested in the oil business and gold. Oil bottomed at around $11 per barrel and gold bottomed below $250 per ounce. With all the gas guzzlers which were being driven in the US, it was easy to see that at some point we would pay the price. I remember seeing an automobile industry survey at the time which had gas mileage listed nearly last on a list of the 25 most important factors to a car buyer in the US. At the same time, countries were selling gold holdings by necessity or choice. The wise men were buyers in the beginning during the time period between 1999 and 2004.

    Buffett’s thoughts appeared to have played out when the commodity markets broke in the summer of 2008. Oil dropped to $32 by March of 2009, wheat fell to $2.46 per bushel in October of 2009, and gold peaked at $1003 around March 14th of 2008 and bottomed at $712 in October of 2008. In the past when markets have boomed and busted in that kind of spectacular fashion it took as long as 5 to 10 years or more for those markets to get interesting again. Look at how long it took stocks to recover in the US after the depression and in Japan over the last 20 years. Commodities were hot in the 1970’s, but were incredibly dead from 1981 to 1999. It is usually hard to put Humpty Dumpty back together again.

    However, there has been an unusual and once in a lifetime phenomena at work in China. It started in late 2008 and it has caused this speculative phase to continue. The Totalitarian Communist Government of China recognized the politically unacceptable downside risk of going through a deep recession. China has the vast majority of its citizens in a position of not yet benefitting from the prosperity of “limited” capitalism. It is one thing to go through a recession when you can vote to “throw the bums out”, but it is entirely another one too go through economic contraction when your citizens have no voting power, free speech and freedom of religion.

    Once the decision was made to not run the risk of letting the Chinese economy cleanse itself, the government decided to massively increase the money supply and produce GDP growth through legendary construction stimulus..Residential real estate prices soared in China as a result of the confidence and the “easy money” this stimulus created. More than $2 trillion in loans for real estate development was made to special purpose entities at the municipal level to build condos, office buildings and even immense sports stadiums. These loans are equal to one third of the $6 trillion Chinese economy. A Communist Party Official, Yin Zhongqing, and other credible sources have estimated that as much as 70% of these loans will never be repaid. As a result of growing in an uninterrupted way, commodity use in China equals close to 40% of all the commodities consumed in the world each year, even though it is only 9.4% of the world’s GDP and 19% of the world’s population.

    With interest rates low and US investors trained for years to like commodities and trust the growth of emerging markets, the speculative fervor of 2008 was reborn in 2009-11. Speculative positions in major commodities like oil have exceeded those taken in 2008 by more than 50% as reported by the CFTC. We have described this explosive move since 2009 in commodities as “the greatest bear market rally” we’ve ever seen. Here is how Bloomberg reported the recent speculative activity on July 17th, 2011 in an article titled, Investors Boost Bullish Commodity Bets as Gold Demand Jumped on Debt Woes:

    “Speculators raised their net-long positions in 18 commodities by 15 percent to 1.09 million futures and options contracts in the week ended July 12, government data compiled by Bloomberg show. That’s the biggest gain since early August. Gold holdings surged the most since September 2009 as prices climbed to a record last week. A measure of bullish agriculture bets climbed the most in 11 months.”

    Buffett continued explaining speculative phases at the 2006 Annual Meeting this way:

    “Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing...Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins & mice. But you look around and say, 'one more dance,' and so does everyone else. The party does get to be more fun -- and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

    Therefore, the huge peak in commodity prices in July of 2008 occurred with a few hours left in Cinderella’s Ball. The long and spectacular move in commodity prices has turned into an institutional investment orgy in commodity indexes, while gold is the commodity of choice for the speculation of the individual investor masses. Commodities are being taken for “one more dance”, very much like college students who keep drinking beer at a party long after intoxication has set in.

    At Smead Capital Management, we believe that the clock is very close to striking 12 midnight in commodity prices for three main reasons. First, China’s effort to manipulate history and economics with construction spending is being exposed. The inflation occurring in China and the complete recapitalization of the Chinese banking system coming from a real estate crash will cause a deep economic contraction, in our opinion. Second, it has taken so much more speculative firepower to get oil back up to this year’s peak at $115 per barrel, compared to how much was required to go to $147 per barrel in 2008. Any good technical analyst would tell you that a lower peak on much higher volume is a “death knell” for a market. Lastly, China must tighten credit aggressively to slow inflation or they are going to see a protest the size of a province, not one contained in a square (Tiananmen 1989).

    Commodity over-indulgence, like other out of control circumstances, get the most exciting towards the end and this one is no different from the others in that respect. We think the end of this one will usher in huge revaluations in the capital markets in the US and abroad. Scott Sprinzen, an analyst at S&P, pointed out in a recent report that a significant slowdown in China could cause commodities to fall as much as 75%. His research shows that commodities decline to their cost of production when they fall out of favor. If he is right, they would certainly qualify as “pumpkins and mice”. It all looks to us like time is running short.

    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.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jul 19 1:17 PM | Link | Comment!
  • The Exodus
    Printable Version Printable Version

    Dear Fellow Investors:

    A number of media outlets wrote recently about the explosion in prices of residential real estate in Vancouver, British Columbia. These articles concluded that over 70% of these purchases were from Chinese Nationals and had driven prices high. Compared to average household income, Vancouver is now nearly twice as expensive as New York City. The articles described numerous transactions of one million Canadian dollars or more for tear-down homes on Vancouver’s West Side. At first glance, it appears that folks are massively over-paying for these properties and whenever this kind of behavior pops up, we always want to know why.

    Thankfully, a few days later, Gordon Chang of Forbes wrote an article titled “Chinese Entrepreneurs Are Leaving China”. Here is how Gordon began to explain the phenomena:

    “China’s rich, primarily driven by a sense of insecurity, are taking money out of their country. Many are actually preparing to move elsewhere.

    According to a new study, almost 60% of China’s “high net worth individuals,” defined as those possessing more than 10 million yuan in investable assets, are either considering emigration through investment programs or are completing the emigration process. The survey, conducted by China Merchants Bank and Bain & Co., also reports that 27% of those with more than 100 million yuan in investable assets have already emigrated and 47% of them are thinking about leaving the Motherland.”

    There is an exodus of the best and brightest business people coming out of the country of China. This country, China, is supposed to be the most successful economy in the world over the next 20 years. It is reportedly going to surpass the US as the most important economy in the world. It is using a disproportionately large part of the world’s commodity production and had been enjoying a building boom that appears to rival other historical building booms. In fact, one of the few building booms in history which comes close to China’s occurred in Egypt when they built the pyramids to honor Pharaoh. Here is how Gordon backed up these statistics:

    “The stunning results correspond to reports that the U.S. Treasury unit monitoring illegal money flows has, since the beginning of last summer, detected a surge in hidden cash transfers out of China.

    Almost all of the funds supporting emigration applications were spirited out of China in violation of Beijing’s strict rules. The country leads the world in illicit fund transfers, according to Global Financial Integrity, a nonprofit. The estimated total of China’s outbound flows from 2000 to 2008 was a staggering $2.18 trillion.”

    Since the uninterrupted growth in China has been so integral to success in asset allocation decision making, we at Smead Capital Management will share our opinion. We pay very close attention to insider buying and selling for the same reason that Gordon Chang is paying attention to these illegal fund transfers. We want to own companies where the insiders have confidence and avoid an exodus out of the stocks from those same insiders.

    Chinese Nationals have been getting their money out of China in a variety of ways. First, they’ve taken advantage of foolish US investors by dumping billions of dollars of Initial Public Offerings (IPOs) onto the New York Stock Exchange and the NASDAQ. I was a guest on the floor of the NYSE last fall and a Chinese IPO rang the bell on both exchanges that day. Please refer to our Dec. 13, 2010 missive titled “Dang, Dang”. We described how unhappy folks would be when they realize that they got taken by Chinese insider sellers.

    Second, investing in common stock inside China is problematic at best. Interest rates are well below inflation in China and for those reasons residential real estate and gold have been favored investments of the newly wealthy. We don’t believe it’s a coincidence that gold has moved up dramatically during China’s uninterrupted boom. It is very hard for the Chinese government to keep track of physical gold owned by Chinese Nationals. Lastly, these Chinese Nationals have been buying residential real estate in Vancouver, BC, London and in the US. All of these countries have large Chinese National populations and cities where new immigrants can form large Chinese communities (little Hong Kong’s)!

    To understand this exodus of people and money let’s examine one of the biggest people movements in history. The people of Israel had come to Egypt to buy grain during a great famine in the Middle East. The Prime Minister of Egypt, Joseph (a Hebrew), wisely had Egypt store huge amounts of grain while the prior prosperity existed. One thing led to another and the people of Israel stayed in Egypt for hundreds of years. Unfortunately, the Hebrew people became enslaved by the nation of Egypt and ultimately were the primary workforce and engineering brains behind the building of the Pyramids and infrastructure of Egypt.

    Whether you are well versed in the Old Testament or are just a fan of the movie “The Ten Commandments”, you know that the Hebrew people lost a great deal of their personal, spiritual and community freedoms and pleaded with God for a way out. A man raised in Pharaoh’s household, Moses, was chosen by God to move back to Egypt from the Deserts of Sinai to lead his people out of Egypt. Through Moses, God brought a series of plagues on Egypt to convince Ramses to let his people go. His heart was hardened and he didn’t relent until the final plague came.

    The final plague was the death of every first-born male in every household and stock yard in Egypt. God sent the “Angel of Death” into Egypt and the only way to avoid losing your first-born son was to have sacrificed a spotless lamb and smeared its blood over the top of the door to your house. In this way, God’s wrath would “Passover” your home. When Pharaoh was awakened to find his first-born son dead, he relented and allowed the Hebrew people to flee Egypt. They fled the most prosperous country in the world to have their personal, spiritual and community freedoms.

    Gordon Chang writes that the exodus of these successful entrepreneurs has accelerated since the Chinese government renationalized in late 2008 and put its massive stimulus plan into place to avoid the downside of the worldwide economic contraction of 2007-2009. This was done, almost exclusively, by force- feeding loans from government-owned banks to special purpose vehicles. In this way, developers could build expensive buildings and infrastructure whether it was needed or not. It sounds very much like the Pyramids to us at SCM. Chang thinks more government control and a more “rapaciously” negative environment for entrepreneurs is on the way:

    “And the situation is bound to get even worse if Xi Jinping becomes the next Party general secretary at the end of next year, as just about everyone expects. Xi will undoubtedly bring his fellow ‘princelings’ into positions of political power.

    The princelings, descendents of former leaders of the People’s Republic, will surely use their new political clout to consolidate their grip on the economy. This means, among other things, that others, especially owners of private domestic enterprises, will have even fewer opportunities than they do today. ‘We can only hope the rich people stay out of patriotism,’ says Xia Xueluan of Peking University. Patriotism, these days, may be the only thing keeping Chinese entrepreneurs in China.

    And, from the look of things, it is not enough. The country’s wealthy are going on shopping tours for U.S. real estate and, if they have not done so already, are moving their families abroad. There has, in the last five years, been a 73% increase in Chinese investment immigrants to the United States. Countries, like Canada, are raising their minimum investment requirements for investment-immigrant candidates due to the sheer size of the tide of Chinese cash.”

    Whether this is analogous to Egypt or not, it is a picture of what seems to be happening in China. The people who know what is going on and have the financial wherewithal to do something about it are getting their money and, in many cases their family, out of China. They are doing this while US investors plow money into China and other BRIC- trade related sectors of asset allocation. As always is the case, the only way to avoid the downside of what comes after a boom (the bust) requires a sacrifice on the part of the people involved. Lastly, it is a good idea to be part of those who make their exodus before the need to get out is obvious to the masses.

    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.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jun 14 1:35 PM | Link | Comment!
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