by Bill and Cole Smead, Smead Capital Management
Most of our work at Smead Capital Management is tied to stock selection. Therefore, our eight criteria for stock selection and our willingness to ride winning stocks to a fault have been our differentiators over the last 15 years. However, market extremes show up once every five to ten years. These extremes can be pessimistic (1987 Crash, Savings and Loan Crisis 1990, Financial Crisis 2007-2009 and Covid-19 Crisis) or unwarranted euphoria (DotCom Bubble 1999, Residential Real Estate Mania 2004-2005, B.R.I.C. Trade 2011 and Growth Stock Insanity/Meme trades/High price-to-sales stocks 2021).
We are paid to be, as Warren Buffett used to say, “greedy when others are fearful and fearful when others are greedy!” We thought it would be helpful to discuss the most extreme point of maximum pessimism of my 45 years in the industry and how it played out. We will share what we knew in the process that helped us be greedy when almost nobody was. In turn, we will then look at the same kind of evidence that exists today. We hope you will understand why we are fearful of the tide going out on the passive market capitalization-weighted S&P 500 Index and why we believe we are positioned appropriately! When stocks have done terribly in the recent two years, we looked for reasons to be optimistic.
We call these reasons “markers.” Most stock market participants ignore them because they are primarily concerned with how they will do in the next six months, not the next six years. By the fall of 2008, the fallout from ridiculous speculation in residential real estate from 2003-2006 had poisoned the U.S. banking system. Stocks had fallen sharply beginning in July of 2007, when we formed the company. By September 30, 2008, everyone knew how disastrous these circumstances were and had seemingly given up on the S&P 500 Index:
Source: Bloomberg.
Our first marker back then was provided by Warren Buffett himself. He showed that stocks, as represented by the Wilshire 5000 Index, reached 80% of the GDP of the U.S. He effectively said, “The long-term investor can begin buying at these levels and get good long-term results historically.” He said, “Buy American, I am,” in an op-ed in The New York Times dated September 30, 2008. The second marker was provided in November of 2008 by reading Amity Shlaes’ book The Forgotten Man about the Great Depression. Our portfolio team concluded that what caused the Great Depression and 12 years of bear market circumstances was a lengthy and painful transition in the U.S. from agricultural employment to manufacturing employment. The fallout of no deposit insurance in the banking system and the land and houses defaulting in the agricultural areas of the country exacerbated the Great Depression.
In 1900, 45% of Americans were employed in agriculture and by 1970, 2% were employed there. The fastest and most painful change in employment in U.S. history! By the way, America was feeding the world with that 2% agricultural employment by then. Cole suggested that we examine what part of U.S. employment was tied directly and indirectly to residential real estate and lending. We concluded that we could bottom out (or top out) with 10.5% unemployment.
This number was likely to scare almost everyone because that was the worst number other than 1980-1981 when I started in the investment business and the Great Depression numbers. It took World War II employment and fighting a war on two different continents to pull us out of that one. Baby Boomer family emergence brought us out in the 1980s and 1990s (AKA, we had no choice). Last, but not least, was the third marker, which came from O’Shaughnessy Asset Management.
Their research showed that the 40-year look-back returns in February 2009 had only been this bad two prior times since Ibbotson started tracking the S&P 500 Index. This was among over 500 40-year lookbacks. In the other two cases, forward returns were spectacular at 17% compounded over the following ten years in the U.S. large cap value category. We had our third marker! So, how did we do for our investors in the Smead Value Fund from the third marker forward? Here are the results from March 16, 2009 to the end of 2015:
On top of great returns and beating the S&P 500 Index, we also spent those years as lonely optimists sharing our positive view to many investors through our communication. As an example, we went on a major wirehouse platform in early 2012 and we were lonely supporters of buying U.S. stocks at the height of the B.R.I.C. trade mania. Senator Elizabeth Warren was having a very significant campaign against investment firms called “Occupy Wall Street.”
The pressure on investors was intense. So, where are we now? First, the Wilshire 5000 trades for around 220% of GDP and we can almost hear Buffett whispering the first marker, ‘Hold a massive amount of cash, I am!’ The second marker comes thanks to Time magazine. The publication just came out with its “Person of the Year” where they named nine top executives and business leaders associated with artificial intelligence.
If you have any reason to doubt this marker, take a look at the December 27, 1999 issue where Jeff Bezos was named Time “person of the year” right before a year and a half long decline in his stock price of 95%.
The third marker, and the scariest one of all, is the current 40-year S&P 500 lookback at over 9% compounded gains before dividends. This is the highest 40-year lookback recorded since 1965. It breaks the all-time records from, you guessed it, 1998, 1999 and 2000.
Source: Birinyi Associates So, let’s put this all together. We are at the antithesis of the fall of 2008, because we expect to make our money while the S&P 500 produces negatively compounded capital losses like it did from 1998-2009. We believe the cap-weighted S&P 500 will go from the easiest money in U.S. history over the last 15 years to a ticket to miserable returns over the next ten years. For those many investors who have mentioned to us that there could be more runway in this euphoric era, notice that the end of 1998 forward returns were -3.03%, even though 1999 was a big positive S&P 500 year. In other words, if you caught the last part of the party, you were likely to be a volunteer in the massive bear market that ruined things. As money leaves the passive index over the next ten years, we expect long-term bonds and lower mortgage interest rates to be where a great deal of risk capital goes! In the early years, deeply out of favor parts of the index like healthcare, energy and home builders could receive just a slice of the money coming out of the glam tech and growth stocks that have hogged up the stock market capitalization. We believe our returns will be relatively strong as compared to the S&P 500 Index and against active competitors who have bent the knee to this tech/growth mania! Therefore, we will continue to play the long game and fear S&P 500 Index failure. Play the Long Game,
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The recent growth in the stock market has helped to produce short-term returns for some asset classes that are not typical and may not continue in the future. Margin of safety is the difference between the intrinsic value of a stock and its market price. The price-earnings ratio (P/E Ratio or P/E Multiple) measures a company’s current share price relative to its per-share earnings. Alpha is a measure of performance on a risk-adjusted basis. Beta is a measure of the volatility of a security or a portfolio in comparison to the market. FAANG is an acronym for the market’s five most popular and best-performing tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google. Growth investing is focused on the growth of an investor’s capital. Leverage is using borrowed money to increase the potential return of an investment. Momentum is the rate of acceleration of a security’s price or volume. The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. Profit margin is calculated by dividing net profits by net sales. Quality is assessed based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet stability). Value is an investment tactic where stocks are selected which appear to trade for less than their intrinsic values. The dividend yield is the ratio of a company’s annual dividend compared to its share price. The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice. Smead Capital Management, Inc.(“SCM”) is an SEC registered investment adviser with its principal place of business in the State of Arizona. SCM and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which SCM maintains clients. SCM may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Registered investment adviser does not imply a certain level of skill or training. This newsletter contains general information that is not suitable for everyone. Any information contained in this newsletter represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. SCM cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of this newsletter bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice. SCM, its officers, directors, employees and/or affiliates, may have positions in, and may, from time-to-time make purchases or sales of the securities discussed or mentioned in the publications.
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