Muscle Training or Muscle Memory? (Smead)

by William Smead, Smead Capital Management

Interest rates have gone down on US Treasury bonds off and on for 31 years. This means that the coupon you are being paid has been joined by significant capital gains. Jim Grant argues that the only thing going for bonds is how well handlers of money have done on them; Warren Buffett calls it “rear-view mirror investing”.

Grant actually goes further on this topic: on February 15, 2013, in an interview with Maria Bartiroma on CNBC, he casually remarked that muscle memory is “the most important unrecognized factor which drives investor behavior”. As evidence, he cited the mass migration to the bond market in the last three years as an example of investor behavior being dictated by muscle memory.

At Smead Capital Management, we believe common stock investing is mostly about muscle training, not memory. We trained ourselves to patiently wait for wonderful businesses to avail themselves at depressed price in relationship to both their history and the qualitative aspects of our eight criteria. Our favorite quote associated with muscle training comes not from Jim Grant, but from Wayne Gretsky, one of the greatest hockey players of all time. When asked why he had been such a great player he said, “I skate to where the puck is going to be, not where it has been”. In other words, he trained his muscles to spot new opportunity, rather than seeing the fad post facto. Compare Gretsky to eight-year old boys or girls playing hockey or soccer. Every kid goes to where the puck or soccer ball is. We call it “beehive soccer”.

In prior missives, we proposed that the “beehive soccer” mentality affects a number of investment categories. Jim Grant covered the bond market for us. So let’s explore some other topics. To begin, it seems that China has been booming for so long that investor muscles are trained to think it will never get interrupted. As a strong corollary to China, we think emerging markets and commodities have been terrific as a by-product of China’s success. Just think about how agriculture has boomed as the farmers have picked up millions of new customers in China and other emerging markets. Then there is gold, which has been outstanding since 1999; it has attracted individual investors, institutional funds, and hedge fund “bees”. Finally, there is oil, which seems to have an “endless bid” as it has gone from $11 per barrel on West Texas Crude in 1999 to $96 today. Can you hear the buzzing sound?

When you look at this landscape from an asset allocation standpoint it is easy to see why Ben Inker at GMO says, “The enemy is us”. What he means is that too many wealth managers have crowded around these long-term positive trends and by being crowded around them like eight-year old soccer players, they ruin the game. There is no more blood to squeeze out of these turnips. It seems Jim Grant is right–muscle memory becomes self-defeating.

Lipper reported that only US large cap equity funds were net liquidated in January. This marks the 44th consecutive month of net liquidation. Institutions and individual investors—acting on muscle memory—sold US large-cap equity to buy bonds and emerging market equities. Here is what Lipper reported:

- For the seventh straight month mutual fund investors were net purchasers of fund assets in January, padding the coffers of bond funds and stock & mixed-asset funds (+$34.2 billion and +$62.2 billion–for their strongest monthly net inflows in at least six years), respectively. Meanwhile, investors redeemed assets from money market funds, withdrawing a net $4.8 billion.

- Breaking a 20-month losing streak, the U.S. Diversified Equity Funds macro-group experienced its first month of net inflows (+$14.1 billion–for its largest inflows since at least December 2006). Large-cap funds (-$0.4 billion) witnessed their forty-fourth consecutive month of net redemptions.

- Exchange-traded funds (ETFs) posted their fourteenth consecutive month of net inflows at $29.4 billion, with $28.3 billion in net sales for stock and mixed-asset offerings.

- Bond ETFs reported net inflows of $1.0 billion for January.

We believe, therefore, that we must train our investment muscles to be optimistic over the next five years, despite sentiment indicators that show rising bullishness among investors. We believe the heightened bullishness is attached to the S&P sectors which have enjoyed the muscle memory. We must do this while the masses continue training themselves to love almost every other asset class available. Leaving the “buzz” behind, here are some of the names which look attractive to us based on “where the puck is going to be”.

Merck (MRK) has pulled back recently. It trades at 11.3 times 2013 consensus earnings estimates and pays a 4.2% dividend. We believe that reports on their blockbuster drug Anacetrapib will come over the next two years and think it could be bigger than Lipitor.

Aflac (AFL) is hated because of the weakness in the Yen this year. Still, it trades at 7.7 times consensus earnings estimates and pays a 2.8% dividend. As businesses save money by raising health insurance deductibles in the US, we think Americans will seek out supplemental health insurance to fill those gaps.

Walgreens (WAG) is a staple with no emerging market leverage. It trades at 11.8 times consensus earnings estimates and pays 2.7% in dividends. They are recovering Express Scripts customers, fighting flu and enjoying their new relationship with Alliance Boots in Europe. We believe there is major positive leverage in the US and Europe for WAG.

We have trained our muscles to be excited about these common stocks before everyone else does. We can’t hear the bees buzzing around them and think our optimism for them beats the heck out of muscle memory.

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. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

This Missive and others are available at smeadcap.com