Unforgettable and Uninvestable

by William Smead, Smead Capital Management

One of the all-time classic ballad songs is Nat King Cole’s “Unforgettable.” The song gives us a great picture of what has been going on in the common stock market with meritorious companies which have been thrown in the bargain bin. What makes a company unforgettable? What makes a company uninvestable in today’s market? Where are the best opportunities in the current environment?

Unforgettable
That’s what you are
Unforgettable
Tho’ near or far¹

What makes a company unforgettable to Smead Capital? Unforgettable companies must have made investors wealthy over the last 20-30 years by maintaining a high level of profitability. To maintain high profitability, they likely have a strong moat or defense against competition, usually with major brand power. To be unforgettable, companies must be a generator of high levels of free cash flow. After all, we believe in the long run that you want to own a business that would have created great wealth without being traded in the public markets. Overall, unforgettable companies usually make a product or provide a service that the masses can’t live without.

Like a song of love that clings to me
How the thought of you does things to me
Never before has someone been more
Unforgettable in every way

We are value investors and value investing has been left for dead by many asset allocators and the business media. Our passion for value investing is “a song of love that clings to us.” The great Dartmouth Finance Professor, Kenneth French, spilled the beans in a recent piece on why you should reinvigorate your love for value investing. Here is what he explained:

The cheapest 30% of U.S. stocks, based on price-to-book ratio and weighted by market value, outpaced the most expensive 30% by 3 percentage points a year from July 1926 through May [2019], including dividends, according to data compiled by Dartmouth professor Ken French. Value has also beaten growth 69% of the time over rolling three-year periods, counted monthly, 74% over five years, 83% over 10 years and 87% over 12 years. The results are similar using other measures of value, such as price-to-earnings ratio and price-to-cash flow ratio.

As we finish up a 12-year stretch of growth outperforming value, French argues that “never before has someone been more unforgettable in every way” than value is now. Rather than being in the normal relationship to growth and the S&P 500 Index, the value investments are nearly twice as attractive on a price-to-book or price-to-earnings ratio as the average of the time period in the U.S. since 1926 when the cheapest 30% of stocks outperformed the index and the 30% most expensive stocks. How can this be and why isn’t this already playing out in the stock market?

And forever more, that’s how you’ll stay
That’s why darling it’s incredible
That someone so unforgettable
Thinks that I am unforgettable too

For value to be at this high level of discount in relationship to the S&P 500 Index, the markets had to decide that many normally more highly-valued industries and sectors are uninvestable rather than unforgettable. We have been finding many of our best new investments in those industries. The FANG stocks (Facebook, Amazon, Netflix and Google) are so popular that they have made many industries uninvestable. Almost nobody wants to touch unforgettable companies in uninvestable sectors like retail stores, traditional media, oil, pharmaceutical/biotech, medicine distribution, banks and homebuilders. Investors even find betting on powerful forward demographics is not useful because they fear that millennials will not spend money outside of their devotion to e-commerce, social media and advertising in search.

“That’s why darling it’s incredible that someone (companies) so unforgettable” is/are available in our portfolio. You can just go down our list. In a normal time, investors could love Target (TGT) for their current results and their bright future. Investors could love Amgen and Merck for finding potential cancer cures. They would be all over the popularity of Discovery (DISCA) channels like HGTV and TLC and shows like 90-day Fiancé or Dr. Pimple Popper. They would look at the P/E of Walgreens (WBA), Bank of America (BAC), Wells Fargo (WFC), Lennar (LEN), Cummins (CUM), Occidental Petroleum (OXY) and Discovery and consider themselves lucky to get such meritorious companies at such deep discounts to the S&P 500 Index.

It has been so long since value has reasserted its historical dominance that most investors have forgotten why price matters when you buy stocks. What happens to a company over the decades is going to happen, but the attitudes of investors fluctuate massively between fear and greed. When fear dominates the stock market, investors remember why free cash flow matters, dividends matter, assets matter and brands matter. Professor French would argue that we are pushing up against historical parameters that could cause uninvestable companies to become unforgettable.

Warm regards,

William Smead

¹Lyrics source: Nat King Cole “Unforgettable”

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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