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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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  • 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!
  • Y2QE

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    Dear Fellow Investors:

    In 31 years of being in the investment business, I have observed a series of events played out in the late stages of what we call a “well known fact”. By our definition, a “well known fact” is a body of economic information which is known to all market participants and has been acted on by nearly anyone who has access to capital. These well known facts frequently form the basis of a bubble in investment markets. We define a bubble as the massive over-capitalization of a “well known fact”.

    A few examples might be helpful. The “well known fact” in 1929 was that new radio, automobile and airplane technology would lead to un-interrupted economic growth and prosperity in the US. We massively over-capitalized the US stock market, forming a bubble. In 1999, the “well known fact” was that the internet would change our lives. We massively over-capitalized technology stocks and large cap growth stocks to form a bubble. Recently, the “well known fact” was that baby boomers would want to retire to the warm weather states of Arizona and Florida. We massively over-capitalized residential real estate and that particular bubble helped torpedo the US banking system.

    My observation about these situations is that there are unrelated circumstances each time which perpetuate these “well known facts” long after the massive over-capitalization has occurred. In the middle of 1998, we owned a few large-cap tech stocks. They were fundamentally sound, but had gained maniacal PE multiples. We sold them under the theory that if there is going to be a hurricane in Miami, you don’t want to be in Palm Beach. They weren’t the heart of the tech bubble, but you could see it from there. We spent one year and nine months out of technology stocks while everyone around us was doubling their money on Initial Public Offerings (IPOs) of new tech companies and “lighting the candle” with dot-com favorites.

    What perpetuated the love affair with technology stocks long after the prices got maniacal was a boom in the purchase of software and hardware. These business purchases were spurred by fears of what would happen when January 1, 2000 or Y2K came and went. The fear then was that we would have all kinds of business and utility failure in the US because that date would fry the brain of existing computers. A massive amount of money was spent on new technology to avoid this calamity and the earnings growth it caused helped to prod the massive over-capitalization to bizarre heights.

    We believe today’s “well known fact” is that China is going to become the most successful economy in the world and the movement of one billion Chinese people from rural areas to urban areas will provide unending demand for new infrastructure. This new infrastructure, the story goes, will require a huge part of the raw materials, oil and commodities produced each year in the world. This has caused a bubble in the prices of those inputs and in the common stock prices of any company which is directly or indirectly involved in satisfying that seemingly insatiable demand. Simultaneously, these suddenly more prosperous former peasants will have higher incomes and be hungry. This has triggered an upside panic in the price of major food commodities.

    If you have been following our thoughts for the last year, you know that we believe that prices are already out of hand. However, just like in 1998, there has been an outside fundamental which has perpetuated the mania. China has prevented their currency from appreciating during their boom by pegging their currency to the US dollar. By doing so, they in effect are subject to the whims of our monetary policy. We are in the midst of Quantitative Easing II or QE2 for short. Even though China is tightening their own credit to try to get a “soft landing” from their “well known fact” driven bubble, it is undercut by the currency peg to the US. Therefore, QE2 has perpetuated the boom in China, commodities, Oil, Australia, Canada and many capital intensive common stocks like Caterpillar, Joy Global, Rio Tinto and BHP Billiton. This is coming long after they were over-capitalized.

    Within 68 days of the Y2K turnover in March of 2000, the tech bubble broke. We believe this China/Commodity bubble will break very close to the end of QE in the US. If QE2 ends up being the end of quantitative easing for the US in this cycle, the clock could start ticking by the end of June.

    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 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 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.
    Mar 29 1:52 PM | Link | Comment!
  • America: Not Built by Risk Management
    Printable Version Printable Version

    Dear Fellow Investors:

    After 31 years in the investment business, I have come to the conclusion recently that we have become a nation of risk adverse people being led by a risk adverse group of financial industry professionals. What would the US have been like if many of the best minds in the country had always been devoted to reducing risk or risk mitigation?

    British citizens moved to the American colonies in the 1700’s. After an extended period of time, these pioneers became frustrated by taxation without representation. Good risk mitigation would have argued for seeking political representation in England and possibly going long an exchange traded fund (NYSEMKT:ETF) which would appreciate if taxes rose. Why on earth would you want to give up the protection of the most powerful nation in the world with the most powerful navy? Instead, we fought the Revolutionary War with an undermanned army led by a General (Washington) who had wooden teeth and wore a wig full of lice.

    Once the US gained its independence, people were fool hardy and began to settle in the wilderness of America. My great-great-great-great grandfather and grandmother settled in Southeastern Indiana in 1796. It was called Indiana because it was controlled by Indians. They were allowed to buy property soon after for $3 per acre by an Act of Congress in 1805 called the Dufour Act. In other words, anyone foolish enough to risk their lives to settle there was given favorable terms. Today’s advisors would point out that the Case-Schiller Index of property prices indicated that prices can fall lower and that settling Indiana wasn’t a good idea because of the risk they were taking.

    In the 1850’s, strategic asset allocation would have argued the virtue of having one area of the country with legal slavery (the south) and one slave free (the north). The best financial move was to live in the North and stay long cotton futures in case slavery ended up being a bad business proposition. Why fight about it in the Civil War (1861-1865) and kill roughly one out of every twenty US males in the process? An ETF could have been created to be long the part of the country you disagreed with to reduce overall risk.

    Germany and Austria declared war on Europe in the summer of 1914. It became a World War. The US sent its “Dough Boys” over in 1917 and the Allied Armies defeated Germany to the tune of millions of dead soldiers. When Pearl Harbor was bombed in December of 1941, we entered World War II. We sat by for years and watched a totalitarian dictator (Adolf Hitler) oppress millions of innocent people and left our strongest allies (Britain and France) hanging on the edge of destruction. To reduce risk and save our soldiers lives we could have invested in the German stock market double long ETF. Imagine how much more profitable German companies would have been had they held control of Europe! Why would you want to risk American lives in those situations?

    Today, investors mitigate risk by investing in a country with a totalitarian communist political regime which prevents political, intellectual and religious freedom. This regime must present the façade that the GDP growth in their country is uninterrupted. In the process, China’s strategy has driven the price of commodities like Oil, Copper and Cotton through the roof. Investors hedge their risk by owning commodity index ETFs. If the 1.1 billion people in China who aren’t benefitting from “Red Capitalism” get exposed to the downside of capitalism (bouts of recession and depression), they might realize that there isn’t opportunity for those outside the political and military ruling class! Good risk management argues that we shouldn’t be the ones to tell them. Who cares if the myth the Chinese are perpetuating and the massive over-capitalization of the BRIC trade is probably the biggest hindrance to US economic recovery?

    Almost three trillion dollars sit in money market funds and US investors are over-weighted in bond funds at the lowest interest rates in fifty years. Sophisticated investors and institutions screen constantly for minor statistical advantages with trillions of dollars. They also go the extra mile to avoid the possibility of the next 2008 stock market meltdown. We are very excited about the fact that our country was made great by taking risks and betting on the future. We are even more excited about taking risks on outstanding companies and avoiding ones that would appear to be popular due to the current risk aversion. At Smead Capital Management, we think folks should be excited to take good risks, just like our ancestors did and spend a little less time, money and energy on risk management.

    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.
    Mar 08 11:23 AM | Link | Comment!
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