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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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  • Financial AIDS

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    Dear Fellow Investors:

    At Smead Capital Management (NYSE:SCM), we have made it part of our work to take the psychological pulse of the stock and bond markets. When we can identify behavior and sentiment statistics which indicate an extreme crowd has been formed, we choose to be the contrarians and invest appropriately. We call these crowd extremes a “Well-Known Fact”. A “Well-Known Fact” is a body of economic information which is known to all market participants and has been acted upon by almost anyone who could care to do so. As we have watched, read and participated in the debate about the economy recently, it struck us that today’s psychology surrounding investing is similar to the psychology associated with the AIDS disease (Acquired Immune Deficiency Syndrome) back in the late 1980’s and early 1990’s.

    In the early 1980’s, young men in Metropolitan areas like New York City were beginning to get hit by a deadly disease. It ultimately was understood to be a virus which was passed through body fluids. The most common way these fluids were passed from person to person was either sexual contact or the sharing of hypodermic needles in drug use. The public became very aware of the disease in 1987 when actor Rock Hudson declared publicly that he suffered from the disease. The awareness reached a very high level when basketball great, Magic Johnson, announced in 1991 that he was HIV positive stemming from heterosexual contact he had with numerous women. Suddenly, you were worried about whether you had been exposed to AIDS, how you get exposed and a huge number of other unknowable issues. The psychology of the subject was incredibly creepy as projections and anecdotal evidence around us was horrific. A fraternity brother of mine and another good friend from college died because of contracting AIDS. Waiting to find out from a blood test whether you were HIV positive was scary for everyone regardless if you were an altar boy or an atheist.

    I was very fortunate during that time. While others, out of rational fears, were avoiding interaction with folks who were HIV positive, I had a conversation with another fraternity brother. He had worked in the emergency room at the University of Connecticut Hospital during his residency and was well informed about AIDS. He explained to me that the disease is highly unusual. It needs almost perfect circumstances to be transmitted, but if it gets the perfect setting and body fluid exchange, it is also successful almost 100% of the time. Therefore, you were free to be interactive with other human beings who potentially carried the virus as long as contact with them fell short of providing the perfect circumstances my doctor friend described. By the early 1990’s, Americans had modified their behavior and incorporated the risk they would run in this part of their life. Safe Sex (quite an oxymoron) became the nation’s most popular mantra. In the late 1980’s, we were all afraid of whether we had AIDS or whether our kids would someday get exposed to the virus.

    Fast forward to today. The US economy became infected with a disease between 1995 and 2005. We will call it Financial AIDS. Bankers became comfortable having customers borrow against their homes to buy boats and cars so that they could tax deduct the interest. Homes appreciated and everyone involved began to believe that homes never fell in value or if they did that the decline and length of time would be short. It all cascaded into a bubble in the early 2000’s in the aftermath of the attacks on September 11th of 2001. Our government felt that the recession triggered by the Tech bubble bursting would be exacerbated by the attacks and used monetary and fiscal policy to pull us out of the recession. Most of the stimulus was translated into the residential real estate markets and a bubble in prices with correspondingly higher and higher loan balances occurred. The perfect circumstances for a financial comeuppance were in place and it was 100% successful. It all ended up in the sub-prime lending fiasco, the derivatives debacle, the deep recession of 2008-09 and the stock market meltdown of 2007-09.

    We have all learned a great deal about the causes and the side effects of Financial AIDS. We pretty much know what caused it and who carries the disease. We know that millions of Americans have changed their behavior voluntarily through budgeting and better choices. Others have had their behavior changed involuntarily through foreclosure, short sales and bankruptcy. What we don’t know is how long the economy will take to cleanse itself. Is this episode of the disease as bad as the one Japan caught in the late 1980’s or as bad as the whole world got it in the Great Depression? The psychology of economists, business owner/leaders and government policy makers is completely dominated by trying to figure the timing of this disease out. THE EXTREMELY NEGATIVE PSYCHOLOGY BORN BY NOT KNOWING HOW LONG THE EFFECTS OF FINANCIAL AIDS WILL LAST APPEARS TO US AT SCM TO BE VERY SIMILAR TO THE PSYCHOLOGY WHICH SURROUNDED HIV/AIDS DISEASE BACK IN 1991!

    At the height of concern in the US about AIDS and being HIV positive, Magic Johnson made a comeback and returned to playing for the Los Angeles Lakers. One of the most outstanding players in the league, Karl Malone, refused to take the risk of playing against Magic. It forced him (Magic) to re-retire. Our economic future is almost completely tied up in the extreme psychology tied to Financial AIDS and the media spends most of its time analyzing the opinions of the Karl Malone-like economists, money managers and investors. Everyone from individual investors to the biggest institutional investors approach their investment choices and asset allocation like Karl did back in the early 1990’s. If there is any chance of getting Financial AIDS disease, they don’t want to participate. To be sure to avoid the disease, avoid risk. Massive amounts of money are being poured into bonds and bond funds under the assumption it somehow “protects” folks like some financial prophylactic. The public is a large net liquidator of common stocks and US equity mutual funds. Here is what the American Association of Individual Investors reported on the sentiment of their dues-paying members:

    “The number of individual investors who have a bullish outlook on the stock market for the next six months plunged to 21 percent, from 30 percent last week, according to a widely followed sentiment survey. What’s more, this is the lowest weekly reading from the American Association of Individual Investors since a March 2009 level of 19 percent, which occurred just before the S&P 500 collapsed to a 12-year low of 676.

     

    Source: CNBC

    So effectively, individual investors feel as good about stocks as they did at the very depths of the credit crisis, even though the S&P 500 is still more than 50 percent higher than that low.”

    We believe there are few humans and investors that aren’t aware of Financial AIDS. Financial AIDS is incorporated into gold prices, Treasury bond prices and common stock share prices. It has caused depressed PE multiples among the kinds of companies which fit our eight criteria for stock selection. It looks to us like a “well known fact” and that means we must avoid what the crowd is doing and invest under the belief that the best money will be made betting against the crowd. We are a nation of Karl Malones at the moment, but we believe that if you embrace some of America’s finest companies and/or take some financial risks in your business you will get well rewarded no matter how long it takes our economy to recover.

    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: No Positions
    Aug 31 2:47 PM | Link | Comment!
  • A Rodney Dangerfield Market

    Printable Version

    Dear Fellow Investors:

    I love to watch the biographies on CNBC and on the A&E Channel. Rodney Dangerfield’s biography was on last week. Born Jacob Cohen, Rodney worked as a comedian for years as Jack Roy. He floundered a long time, but he worked hard perfecting his jokes. He ultimately broke through nationally by appearing on the “Tonight Show” and on “The Ed Sullivan Show”. His agent gave him the name, Rodney Dangerfield, after a character in one of Jack Benny’s old shows. His career exploded when he came up with his trademark introduction, “I get no respect”. Most of his jokes were attached to less than great things which went on in his life whether real or fiction.

    At Smead Capital Management (NYSE:SCM), we go through phases when we feel a little like Rodney. We are a large cap value firm with a series of eight criteria. These criteria seek to guide us to companies which have demonstrated: 1) success in the past, 2) have strong balance sheets, 3) have wide moats to protect the duration of their profitability, 4) generate high levels of free cash flow and, 5) are available at below market PE multiples or are available for purchase at 30 to 50% below intrinsic value.

    When we go for an extended period of time with markets not recognizing the merits of our portfolio we can feel a little sick. Rodney went to the doctor because he felt a little sick. The doctor told him, “Rodney you are sick.” He says, “Can I get a second opinion?” The doctor replies, “Yes, you are ugly too.” We believe to make above-average returns in an expense minimizing and tax efficient way, you need long duration investments. Low turnover promotes low trading costs and lays the groundwork for the kind of wealth creation that only comes from having a significant part of a portfolio invested in stocks which garner long-term dividend growth and trade at many times original investment ten to twenty years later. Can we at SCM pursue anything more contrary to the conventional wisdom and popular investment approaches of today? Holding periods on the New York Stock Exchange are the shortest ever recorded in recent years and portfolio turnover among large cap equity mutual fund managers is close to all-time highs.

    Even if you have a reason to believe that you own superior companies and are patient enough to hold many of them for years to receive the long term benefits, you can temporarily feel ugly too. One day you come in and the market is down because of the fear of our economy collapsing. The next day investors are chasing the hot commodity or ETF of the day. Rodney would say, “It’s tough out there.” Based on trailing and consensus estimates of non-GAAP earnings, our companies trade at sizable PE discounts to the S&P 500 Index. This is despite having superior ten-year records of revenue and earnings growth in comparison to the S&P 500 Index. Rodney said, “I get no respect. I play hide-and-seek, and they wouldn't even look for me." Individual and institutional investors rarely seek out a portfolio when its style is out of favor and the most future success is available near the lowest prices.

    We believe difficult markets are a great time to hone your craft and patiently wait for the benefits of buying and holding well-chosen common stocks. They were many times when Rodney felt like giving up, but ultimately he attained wealth and fame at the highest levels of the entertainment industry. His on-stage persona and trademark lines differentiated him from other comedians and caused him to bond with a large group of fans covering three generations. We believe that many of our portfolio holdings could have very bright long-term futures, even though at the moment, they are a little short on respect.

    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: No Positions
    Aug 10 3:58 PM | Link | Comment!
  • God of Carnage

    Printable Version


    Dear Fellow Investors:

    As a reward for executing a hectic east coast business trip, we went to a play called “God of Carnage”. Jeff Daniels and Lucy Liu starred in this four-actor, one-act play about two couples seeking to deal with a fight between their two 11-year old sons. The 90 minutes of conversation originally centered around how to deal with Lucy’s son punching the other boy and breaking two teeth. It was amicable at first, but then ultimately descended into arguments. The conversation exposed most of the individual flaws of all four parents and definitely exposed all the cracks in each marriage. It was very humorous.

    Lucy’s husband played the part of an attorney who represented a drug company. He was on the cell phone constantly dealing with a crisis related to the side effects of one pharmaceutical product. His dishonest attitude and lack of ethics were on display as he interrupted the discussion on how to deal with the consequences of the fight between the two boys. Since art is a reflection of the culture of the day, the inherent evil of this man and the company which he represented were one of the main centerpieces of the play.

    At Smead Capital Management (NYSE:SCM), we are especially interested in what John Templeton called “the point of maximum pessimism”. To understand pessimism you have to look to the media, to the arts and to what we call “the well-known fact”. This is a body of economic information which is known to all participants and has been pretty much acted on by anyone who would care to act. As the City College of New York professor told former Intel CEO Andy Grove, “When everybody knows that something is so, it means nobody knows nothing.” Our politicians, media and artists know that “Drug” companies are evil. Investors know to stay away from them. The major pharmaceutical companies all trade in the lowest Price/Earning (NYSE:PE) ratio quintile in the S&P 500 Index, and are the cheapest compared to the other sectors of the US stock market as we have seen in 20 years. Drug stocks haven’t been this small a part of the S&P 500 Index since 1984.

    This reminds us of the documentary in 2003 about McDonald’s called “Supersize Me”. A young man ate three meals a day at McDonald’s for six weeks and agreed that he would supersize his meal every time an employee asked him if he would like to. He gained a great deal of weight, saw his cholesterol shoot through the sky and was well on his way to killing himself through food over the longer haul. The “well-known fact” in 2003 was that McDonald’s sells unhealthy, high fat foods and doesn’t care whether they are going to kill you in the process. Investors were sure that there would be a big backlash and McDonald’s business would be damaged for years. The stock bottomed out around $15 per share, way down from prices above $30 per share just a few years before.

    Pharmaceutical companies make vaccines, treatments and cures by manufacturing medicine. They seek to profit from improving the health of human beings and extending the quality and duration of life. The barriers to entry in their industry are very high because it costs about $1 billion to produce a blockbuster drug. They receive patent protection because many of the medicines they attempt to create never make it to the market and only end up creating expenses. These companies maintain fortress-like balance sheets and earn very high returns on unleveraged capital. In the process, they generate massive levels of free cash flow and pay generous dividends.

    The point of maximum pessimism associated with the makers of medicine is tied to four main beliefs. First, they are an easy punching bag for politicians (including the President of the US). Most studies put pharmaceutical sales at around 10% of what we spend on healthcare in the US. Second, they’ve been feasted on by litigators. The Vioxx settlement shows that whatever downside risk there is associated with a medicine will get exploited to the maximum until we get tort reform. Third, the FDA is scared to approve new medicines at the expense of thousands of people who lives might be hugely impacted by use of a drug not yet approved for sale. Lastly, a number of major existing blockbusters are losing their patent in the next four years and investors can’t visualize where these once admired companies will get future revenue growth.

    Today, McDonald’s is around $70 per share and has been one of the best large cap performers in the S&P 500 Index since the documentary was released nationwide in theatres. They have added healthier choices to their menu, but they still make most of their money selling clean, inexpensive, high-fat content food all over the world.

    At SCM, we believe the makers of medicine have very little downside risk as the result of the attitudes exhibited by the play “God of Carnage”. As we drive up to the New York Stock Exchange window to order our common stocks, we ask for pharmaceutical manufacturers and say, “Supersize 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 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: Long MCD


    Disclosure: Long: MCD
    May 18 1:16 PM | Link | Comment!
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