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William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

If there is any agreement out there among investors, it surrounds the measures being taken by the Federal Reserve to stabilize the financial system and prevent a 1930’s style contraction. These same investors agree that these actions to revive our economy will lead to high levels of inflation. We’ve rarely seen a future expectation get baked into the stock market as quickly as this topic. People from the political right (who bash Obama) and those from the left (who like Warren Buffett love him) are in agreement. Money could be made by playing the devil’s advocate. At Smead Capital Management, we’d like to make the case that this crowd could be wrong. To understand why, we have to take you back to childhood games of Monopoly.

In the winter when we were trapped inside or in the summer when baseball was over, my friends and I played hours of Monopoly. The game is played on a board representing four streets or neighborhoods. Each player starts with $2000 in cash and collects $200 for every time they pass Go. The bank exists for collecting payments for the purchase of properties and buildings. Its second function is paying rewards that can be reaped by landing on certain favorable squares. While one travels around the board, they can use their money to buy properties. If you accumulate two to three properties in the same neighborhood, you can buy houses and ultimately hotels to place on your properties. When an opposing player lands on your property, they pay you rent. The more real estate you own as well as the amount of additions (houses and hotels) to the property, the greater the rent that is paid. The object of the game is to create monopolies and eventually bankrupt your opponents.

To this point the actions of Fed Chairman Ben Bernanke and the Federal Reserve Board have been both systematic (backing money-market funds) and stimulative (dramatically growing the money supply). They sought to and succeeded in driving down interest rates and reestablished normal inter-bank borrowing in the process. Both conservatives and liberals are convinced that the huge increase in the money supply (printing of money) will result in an economic recovery which is followed soon after by very high levels of inflation.

Bernanke’s actions are the equivalent of doubling the amount of money held by the bank in the game of Monopoly. If the bank has twice as much money and you pass Go, they give you $200 just like when the bank had less. None of the bank paid rewards change because of the bank having more money. The only way to inflate the game or inflate the economy is to directly put money into the hands of the players. Ironically, to speed up the game as kids, we did just that and gave each player an extra $2,000 or stuffed the center area with thousands of dollars. The more money players had, the faster they bought property and buildings. The faster the Monopolies developed, the faster that everyone but the winner went bankrupt.

The Federal Reserve has increased the money supply immensely, but the institutions and systems for putting the money into the hands of the players are not functioning. Banks are building capital to meet stress tests and working hard to work through existing loans on the books. Non-bank lenders have practically disappeared from lending and securitization is nearly non-existent. Savers sit in CD’s and money-market funds at dismally low interest rates and borrowers cut spending to pay off prior debts and build meaningful savings. They are passing Go and getting the same $200 even though the bank has twice as much money as they did before. Investors have twice as much cash in money market funds as any historical low point in the stock market for forty years. The lower rates are great for getting through the existing debts, but are a big drag on the incomes of conservative fixed-income investors.

Unless the Federal Reserve starts paying $400 for passing Go or people who have learned all the negatives about borrowed money suddenly start borrowing again, the inflation fears are over-blown at best and possibly dead wrong at worst. We will see you at Boardwalk or Park Place if these fears prove incorrect.

Best Wishes,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

Full Disclosure: No positions in names mentioned

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

There are two opinions we hold at Smead Capital Management which are very contrary to the conventional wisdom in the marketplace. First, we feel that we are much closer to behavioral changes in the automobile and environmental world than most people think. Second, we believe we are about to enter a long stretch of outperformance among U.S. stocks by large capitalization companies which fit our eight criteria. We think our "gut feelings" on these subjects are correct, but once in a while you need a little encouragement when your opinion is especially contrary. Jeremy Grantham, of Grantham, Mayo, Van Otterloo & Co. (GMO) fame, is probably the most respected institutional asset allocator in the world today. He chose in the last few weeks to forcefully back us on our arguments and reasoning.

For our thoughts on Oil and Oil-oriented investments, see our recent Missive titled "Bull Markets in Oats and Hay”. Our thesis assumes that the change to electric and hybrid cars will be much swifter than most investors think (5 to 10 years). This swift transition could destroy the "Peak Oil" mentality which had developed last year as oil reached $147 per barrel. It took 25 years for the U.S. to move from horses to cars (1900 to 1925) and we believe everything changes much faster now than in the past. We are under-weighting Oil and Oil service stocks despite their recent popularity.

Grantham seems to be in agreement on the changes in autos, but his opinion is driven by climate change. In a recent interview with Smart Money he said this: "The people who move quickly in this market can make money. The people who invest in energy alternatives will make more. Alternative energies and combating climate change are the single most important economic initiatives over the next 10 years-really over the next 50 years. It will be a very exciting next 50 years." A victory for energy alternatives is a loss for Oil and Oil Service companies in our opinion.

We always like our investment style of seeking out high quality "blue chips" companies which are out of favor, but once every 10 to 15 years they get especially attractive relative to all the other places people can put their money in the U.S. Grantham and his firm run intense mathematical models to try and determine which asset classes should perform the best over the next seven years. They now manage directly over $80 billion in assets. Here is what Grantham said in a series of interviews at Morningstar's recent investor conference and Forbes magazine:

Grantham expects a subset of U.S. stocks -- those he labels "high quality" -- to produce after-inflation annualized returns of 11.5% over the next seven years. Five-and-a-half percentage points on an annualized basis is an enormous difference -- and gives investors plenty of incentive to identify those "high quality" stocks.

Although Grantham doesn't directly define "high quality," he provides some clues in an interview with Forbes in which he said, "And the best bet, for my money, then and now, a year later, was to buy the great franchise companies, the great quality companies." This suggests that he favors companies that possess a moat -- a sustainable competitive advantage -- and that earn excess returns over their cost of capital.

At Smead Capital Management we have solved Jeremy Grantham's dilemma and have come up with the eight criteria below to define high quality and use it to create our common stock portfolios.

1) Strong Balance Sheet – Preferably more cash than debt, the ability to pay off debt in the next couple years out of free cash flow or companies with debt that have very consistent customer bases

2) Long History of Profits and Dividends (or stock buybacks)

3) History of Shareholder Friendliness - Making shareholder friendly choices with available capital

4) Strong Insider Ownership – Preferably with recent purchases

5) Easy to Understand – Business meets a sustainable economic need

6) High levels of free cash flow

7) Wide Moat – High levels of profitability maintained by barriers to entry

8) Low Price in relation to the fundamentals of the business (price-to-earnings/sal... flow/book value) in comparison to the last five years

Grantham believes as we do that economic growth could be muted by the debts over-hanging the economy from the last ten years. He thinks that China and India can't grow as fast without the U.S. returning to our prior spending levels and he doesn't foresee that in the next seven years. We believe a huge number of retirement age baby boomers could result in sustained high unemployment figures. This "New Boomer Austerity" or attitude could cause the existing spending "reset" (like what we've seen since September of 2008) to last for as long as a decade. In that environment, competing with financially strong and well entrenched companies like WalMart, Microsoft, Merck and Disney could be difficult at best and impossible in many cases. The ultimate irony of all this is these "quality" companies trade at or below market P/E ratios and pay above average dividends for the most part. Numerous years of under-performance and reversion to the mean is driving GMO's computer models and Jeremy's opinion. Our stomachs are strengthened!

Stay thirsty for investment success my Friends,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

Full Disclosure: Long WMT, MSFT, MRK & DIS

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Clients and Prospective Clients:

We at Smead Capital Management are not afraid to admire people who disagree with us. If someone sincerely believes that the stock market is going to do poorly over the next two years, puts their money where their mouth is and sticks to their guns, we have nothing against them. We don’t agree with them, but we can accept their position. They are Bears on the market and they most likely believe that price earnings ratios didn’t get low enough in March to justify a bottom or they believe that the debt accumulated in the last ten years will stifle economic growth and retard the financial system. They go by names like Roubini, Faber, Tice and Rogers. We have no problem with them and we think that the way they have scared everyone is going to make long-term buy and hold investors like us a ton of money.

However, there is a second kind of Bear in the marketplace and we consider them to be dishonest Bears. They are the hedge fund managers, mutual fund managers and individual investors who temporarily own some stocks, but own them with one foot out the door the entire time. This is the “Fast Money” crowd and they are looking for something to own for six weeks to three months. Jim Cramer is there poster child and the discount brokers and stock exchanges are their sponsors. They are the worst kind of momentum investors. We consider them bears because the way they are organized and postured makes for very little likelihood that they or their clients would gain the benefits from holding common stocks for many years. After all, over long stretches of time a significant part of what you make from owning common stocks comes from dividends. In affect they rent stocks rather than own them. They whip around ETFs, are attracted to momentum markets like Gold and Oil and love high levels of volatility. Included in this category are the hyper-inflation folks who are invested in commodity oriented common stocks and think they are going to make a great deal of money from an economic comeback that ruins everything with high levels of inflation like in the late 1970’s and early 1980’s.

We normally wouldn’t really care about these “Closet Bears”. Unfortunately, in this market cycle, they have ended up with way more of the existing capital than normal. It makes sense because after the decline from October of 2007 to March of 2009 most humans who have the courage to participate want to get out of the way quickly if things turn sour again. So you have the “Real Bears” who are in cash and short stocks, mortified from what happened this year. Then you have the “Closet Bears” long stocks for two months at a time with one foot out the door all along.

To be a “Real Bull” you have to be fully invested in quality stocks which are selected based on how well they might do over the long term. Peter Lynch is our poster child. He was asked in early March about the stock market and he said, “I’m the wrong guy to ask because I’m always bullish.” Watch on T.V. and in what you read. If you see a hedge fund or mutual fund manager say that they are bullish on the market and then explain that they are long Oil, Gold and Basic Materials, you are staring a bear in the face!

Warm Regards,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

Full Disclosure: Long Blue Chip Quality Stocks