Due to the recent strength in the US stock market, we thought it would be helpful to followers of Smead Capital Management to understand the history of our core investment beliefs and where our portfolio is in relation to those core beliefs. A review of the ongoing tension between valuation mattering dearly and the enormous benefits of long-term business ownership is especially interesting after a significant upward move in the stock market. How do you keep turnover and trading expense low, while maintaining a meaningful margin of safety? How do you maximize long-term returns by practicing "long-duration" common stock investing?
Our core belief is three-fold. 1) Valuation matters dearly, 2) we want to be business owners, and 3) to be long-term business owners we need to own very high quality businesses. We execute our belief by using our eight proprietary criteria for stock selection which are listed below.
· Meets an economic need
· Strong competitive advantage (wide moats or barriers to entry)
· Long history of profitability and strong operating metrics
· Generates high levels of free cash flow
· Available at a low price in relation to intrinsic value
· Management's history of shareholder friendliness
· Strong balance sheet
· Strong insider ownership (Preferably with recent purchases)
I came into the investment business in 1980 with Drexel Burnham Lambert. The most admired mutual fund manager in the world at that time was John Templeton. He believed that valuation mattered dearly and he coined one of our favorite phrases, “the point of maximum pessimism”. He meant that you got the best price in buying a stock near the point where virtually nobody was optimistic about the company involved. Templeton went on to say, “If you wait to see the light at the end of the tunnel, you have already missed the bottom.” Long before Fama-French and David Dreman did studies on price-to-book and price-to-earnings ratios for their impact on forward results, Templeton had already incorporated it into his discipline.
Peter Lynch and Warren Buffett were the most famous stock pickers of the 1980’s. Both were interested in finding companies to buy which could go up more than ten-fold over the following decade or decades. Lynch called them “ten-baggers”. Lynch’s track record from 1977-1992 was dominated by holding huge multi-year positions in Fannie Mae and Phillip Morris. He liked to find a company which did great, but had some characteristic which stopped investors from falling completely in love with the stock.
Buffett started out as a John Templeton buyer via his work as a deep-value security analyst in the Ben Graham “high margin of safety” mode. As he got farther along and had larger amounts of capital to deploy, he began to point out the incredibly favorable taxation and low frictional cost of finding and taking ownership of a business and leaving it alone for decades. In 1989 Buffett said, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Do not be deceived by the importance of Buffett being the most successful investor of all-time and his willingness to stay away from market timing in relation to what he calls “great” companies! He bought in like Templeton, but he held on in a way that almost no one else has. He credits Phil Carret (the original manager of the Pioneer Fund) for teaching him about riding a great horse (stock) for a long time.
To practice the first two disciplines, we believe you have to do it in high quality businesses. Our discipline was heavily influenced by an unlikely stock picker named Barry Ziskin. Barry ran the Z-Seven Fund and used seven of his own criteria for selecting stocks. Like our eight criteria, they were dominated by qualitative aspects of a business surrounding the balance sheet and ability to generate free cash flow. He had a checklist for quality and a pricing discipline for acquisitions which forced him to make his original purchases at 10-times earnings or less. Valuation mattered dearly to Barry and John Templeton put a large personal investment under Barry’s jurisdiction.
Unfortunately, Barry had one criterion in his checklist that ruined the benefit of the other six. It was his rule that he had to sell the business if the stock reached a PE ratio of 20. In 1983, when I became aware of the Z-Seven Fund, Barry owned fifteen stocks. One of the 15 stocks was Nike (NKE). When it got to a PE ratio of 20, he sold it. From July 1, 1983 to today, Nike stock has produced a total return of 19.08% per year and the stock price has grown from $.55 to $65.53, a 119-bagger. Think of how many days that Nike hit a 52-week high in the last three decades. He would be one of the most successful stock pickers in the last forty years if he had not sold a single share, almost regardless of whatever else he’d have owned. The whole portfolio would be up six-fold even if he had lost all the other money on bankrupt securities and he hadn’t reinvested the Nike dividends in more Nike stock. If Barry practiced Warren Buffett’s favorite holding period, forever, he would be a household name in the money management world.
Now we need to put this history together with today’s circumstances to determine if there is value in this market and in our portfolio. Before we do this, we need to share a few underlying biases we have at the present time. First, since housing leads economic recoveries and our housing recovery is only about 18 months old, we believe the economic recovery is still in the early innings. Second, institutional and high net worth investors came into this market move in a deeply under-invested position and are in the early innings of correcting their asset allocation error. Third, it has been so long since we had a “good” economy, that most market participants can’t even remember what it looks like and how positively it would impact consumer and business confidence. Imagine what 6% unemployment and 2 million single family housing starts would mean to the customers of banks and consumer discretionary companies.
Fourth, a massive amount of money is trapped in very low interest rate instruments and it doesn’t appear anything will move that in the short run. Fifth, China’s charade of avoiding business cycles is coming to an end and with it is the long bull market in commodities. We believe the boom prices for commodities like Oil and Copper, created by China and emerging market group think, were a major drag on both the US stock market and the US economy. We believe a massive/secular bear market in commodities is in place and will last for 7 to 10 years. Lastly, sentiment is still very favorable as most people are more worried about another 2008 market hitting them than they are worried about missing a decade for stocks like the 1980’s. It is likely that this bull market will not end until the “seven lean years” and “new normal” people have admitted they are wrong or people quit listening to them. We don’t see this bull market ending until people cease using macroeconomic analyses as a primary tool for doing their stock picking.
Therefore, we are comfortable maintaining ownership of great companies in the 20-times earnings area like Cabela’s (CAB), Home Depot (HD), Starbuck’s (SBUX), Bristol Myers (BMY), Ebay (EBAY) and Disney (DIS). We don’t want to underestimate these companies ability to take advantage of a substantially better economy or end up looking foolish like Barry Ziskin did with Nike (NKE). We own very cheap stocks with either low price-to-book ratios like Bank of America (BAC), JP Morgan (JPM), Berkshire Hathaway (BRKB) and Wells Fargo (WFC) or low PE ratios like Aflac (AFL), Gannett (GCI), Mylan Labs (MYL), Pfizer (PFE) and Merck (MRK). Simple optimism continues to beat “brilliant pessimism” and we view our portfolio as a great way to participate in this massive re-allocation of capital.
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