William Smead's  Instablog

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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 (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.

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.

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Dear Fellow Investors:

Heart disease has been prevalent in our family. About three months ago we started to develop better eating habits. We are trying to avoid many of my favorite foods (chocolates, hamburgers, fries, pizza, etc.) by replacing them with fruits and vegetables. We are bringing down our cholesterol in the process and a positive side affect is that I've lost some weight as well.

As Frank the Tank said in the movie, Old School, "It tastes so good when it hits your lips". I miss the wonderful flavors of dark chocolate Mounds bars or the blending of the tastes in a Burgermaster cheeseburger with a big slice of Walla Walla sweet onions. They give me a big boost of energy, but years of eating these favorites can layer my arteries in plaque. This is the main cause of heart attacks and strokes.

It is amazing how similar long duration investing is to long duration living. At any given time, there are tasty and exciting industries, sectors and countries which can give you short-term delight. Imagine the pleasure of folks who bought gold three years ago or commodities like copper or cotton or sugar. This burst of price appreciation has raised investor confidence the way my blood sugar level goes up right after Thanksgiving Day dinner! The benefits are in the short run and the problems come much farther down the road.

Investors were excited about gold in 1980 when I started in the investment business. It peaked above $700 per ounce in 1981 as investors were sure that the double-digit inflation would be a fixture of the future. Today, investors are excited about it at $1400 per ounce as an alternative to paper currencies. These currencies have multiplied in the deep recession through the remedies governments are using to prevent deflation. Gold has doubled in price in 29 years. This means that despite all of the recent excitement you have received about a 2.5 percent average annual return during those years, even though it has been on fire for five to seven years. The Dow Jones Industrial Average rose from 800 to over 11,000 in that same time period. Those who used gold as a long duration investment had hardening of their financial arteries.

How about commodities like copper, cotton and sugar? The most widely followed commodity indexes, like the Dow Jones-AIG Commodity Index, show that commodities have dropped in price on an inflation adjusted basis fairly significantly over the last 70 years (see chart below). Therefore, their only use is for the kind of short-term highs that I get from the fresh cooked chocolate chip cookies or the barbecued ribs lathered in sweet sauce. Better technology and human productivity are a curse to commodity investing! Compare that to all the wealth creation which long duration companies like Disney or McDonald's or Nordstrom or Merck produce from those same factors. As an investor, do you want better technology and human productivity to be your friend or your foe?
The current investment landscape is loaded with sugar highs. All things China and BRIC trade are smoking hot including the commodities we've mentioned. The blood sugar level has taken heavy industrial stocks like Caterpillar, Joy Global and Cummins off the charts. The taste of mining basic materials in Australia and putting them on a boat to China is mouth watering. The GDP growth numbers in China are as exhilarating as drinking a couple of craft beers while washing down hot wings.

Our bodies are subject to heart disease and those events usually come in shocking fashion. In the investment world there are business cycles with recessions and depressions mixed into history. When these negative events follow a boom, markets collapse and can lead to paralysis and permanent damage. Cyclical and commodity oriented common stocks trade at historical discounts for this very reason. Our current circumstance is that cyclical stocks and more economically sensitive small cap stocks trade at big premiums to recession resistant large cap non-cyclicals! History shows that investors in the cyclical stocks get crushed and profits many times turn to losses in the down cycles. Holding for the long-term is not an option which human investors have been able to handle.

As disciplined long-term value investors, we at Smead Capital Management are patiently waiting for time to put things back into order. We believe long term financial health goes to those who defy short-term flavor gratification. Much like the fable of the Tortoise and the Hare, you only make the long-term success in investing if you avoid the busts that follow the adrenaline of today's excitement. We wish you all health and wealth in the upcoming New Year!

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.

Printable Version
 

Dear Fellow Investors:

The folks at Smead Capital Management (SCM) are admirers of the journalists who follow our industry. We'd like to expand on a piece written by Kelly Evans titled “‘Dumb Money’ Returns to Stocks”. The thesis put forward was that a recent tiny trickle of buying interest from US equity mutual fund investors and evident optimism in recent investment sentiment poles might be an indication that the dumb money is back, in the opinion of the Wall Street Journal headline editor. The conclusion was beware.

Our problem with the article is it lacks historical precedent. John Maynard Keynes was a very successful money manager in the 1920s until the late 1940s. He said investing “..is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.” Therefore, Keynes would argue that in the long run the majority is dumb and the minority is smart.

For the last 19 months it has been "dumb" to be out of US stocks. The minority bought and the majority sold. Individual investors in the majority bought bonds and net liquidated stocks. How can the first positive flows after years of net liquidation qualify as a majority? The only enthusiasm for equity funds from US investors has come through net inflows into emerging market and commodity related funds. They are in the majority also.

We at SCM do not market time. If you are a long-term timer, you want to get out when individuals and institutional investors are falling all over each other to buy US equity mutual funds. This would mean multi-year, massive net inflows. We are a long way away from there. We believe the finest US companies are the minority investment and we have eight criteria for selecting them.

John Paulson was an unheralded hedge fund manager in 2007. He was in the minority thinking that the mortgage market would meltdown. Institutional and wealthy individual investors invested with him to hedge their long positions in mortgage-backed securities and over-exposed financial stocks. We believe that US large-cap recession-resistant quality is a good hedge for the majority of gun-shy individual investors who have chased bonds. They are also a good hedge for over-diversified institutions who think BRIC-trade related investments aren't in the majority. Andy Grove, former Intel CEO, was asked in a Fortune magazine article what was the best business advice he'd ever received. He replied, "My professor at the City College of New York said, ‘When everybody knows that something is so, it means that nobody knows nothin’." What people know is how strong the emerging market economies have been. What they don't know is how much better the minority is going to do over the next five years as compared to the majority. We believe that over the long haul the minority will look smart.

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.