Solving the Common Stock Mystery

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Includes: BMY, MCD, MRK, WMT
by: Smead Capital Management

A series of clues have been provided to long-term investors over the last five months and we believe these clues could solve the mystery.

Clue Number One: The Dow Jones Industrial Average and the S&P 500 Index are below where they were ten years ago.

Clue Number Two: Ben Inker's research for Grantham, Mayo and Van Otterloo (GMO) showed on a theoretical basis that 75% of the present or intrinsic value of a company comes from free cash flows and dividends occurring longer than 11 years from today and long-term economic growth gravitates to the mean. (See "Parable of the Stock Market Sower")

Clue Number Three: Companies with wide moats (favorable barriers to competition) stay profitable longer than companies with less wide or no moats. The longer a company maintains high levels of profitability, free cash flow and dividends, the higher its present value is today.

Clue Number Four: Holding periods have dropped precipitously over the last 25 years on the New York Stock Exchange from five years to less than one year--the lowest since the 1920's. (See "The Correction that Refreshes")

Clue Number Five: Consumer Staple and Healthcare stocks are the most over-represented in the S&P 500 Value Index in the last 15 years. We believe this is even more unusual at the end of a recession. (See "The S&P 500 Value Index Tells the Story")

Clue Number Six: Morningstar reports that based on their stock analyst's research that companies with wide moats are 15% undervalued in the market as of August 22nd, 2009 while those with narrow or no moats are either fairly valued or overvalued on average.

Most Popular Conclusion: Trade more often because long-term investing is for losers. Quality doesn't matter, because what matters is what is going to go up in the next three months. Why should we be interested in long-term profitability, because in the long run we are all dead?

Smart Money Conclusion: A terrible decade of stock performance could lay the groundwork for more normal returns at a minimum. More normal returns are dramatically better than the interest rates on lower risk bond investments.

We believe Ben Inker’s and Morningstar’s research could confirm/foretell that long-duration (aka wide moat) companies are prepared to provide serious out-performance over the next five to seven years. Holding periods could expand when wide-moat companies like McDonald's (NYSE:MCD), Wal-Mart (NYSE:WMT), Merck (NYSE:MRK) and Bristol Myers-Squibb (NYSE:BMY) regain the upper hand in the NYSE marketplace.

The best companies (as measured by balance sheet, brand power, returns on equity, free cash flow, etc.) could trade at their normal/historical premiums to the average stock. Our lives as portfolio managers could make sense again.

Why do we feel like Columbo?

Full Disclosure: Long MCD, WMT, MRK and BMY