"Dear Chairman"

by Cole Smead, Smead Capital Management

Dear fellow investors,

As the investors of Smead Capital Management know, we focus on the shareholder friendliness of the businesses we analyze because we believe it can differentiate their long-term returns. Warren Buffett has said, “Own a business a five-year-old can run. Just in case one does!” In today’s piece, we would like to share our framework of thinking about capital allocation and shareholder friendliness through an example that we have lost money on so far.

Luxury stocks have done poorly as the bud comes off the rose of conspicuous consumption among global consumers. We have not been subject to much of the punishment of this industry until recently. We purchased shares of Burberry (BRBY LN) in our international strategy as the stock price fell from a high of over 25 pounds per share to closer to 10 pounds per share when we purchased it. At that time, the business was not set up well for success. To explain why, we must start out with an important principle in the capital allocation framework. Regular dividends are considered a liability to the operators of a business. Once a regular dividend is announced, it becomes a liability on the balance sheet of the business. Investors could become addicted to these regular payments as it becomes a fixed obligation on the balance sheet into perpetuity.

Burberry is a London-listed fashion brand started in 1856 by Thomas Burberry. It has become known for a very British form of fashion, led by its iconic trench coats. The business hasn’t succeeded like other luxury brands, which have found far greater returns. The brand has also been looking for its longer-term leader. It changed CEO leadership in 2021 and now again with recent bad news in 2024.

Burberry isn’t just a British style, it’s also indicative of British establishment thinking when it comes to capital allocation. In the prior twelve months, the company had announced or paid dividends of 0.71 pounds per share for a yield of 6% to 7%. As mentioned above, we viewed this as a future liability to shareholders. This amount represented 60-70% of Burberry’s free cash flow at the time. For a stock that had fallen 60%, it seemed to us that it would have been a much better use of free cash flow to purchase these depressed shares.

The argument made for the large dividend was that there were certain income-oriented investors who really liked their dividend, which at the time was typical of British investors. When a stock market does poorly for a long time, people want more paid out in dividends. We humorously refer to these types of investors as the Gnomes of Zurich, as they are supposedly in existence in a company’s shareholder register. Once a dividend is cut, the theory says they should magically disappear from the shareholder base.

For some reason, stock buybacks are looked down on in Britain. We haven’t been able to figure out why this is true, whilst their American and European counterparts are showing great skill with the tool. Buybacks are not liabilities either as they are at the discretion of the company. Old businesses that don’t have enough need for the capital in their operating business and/or ones that can’t buy enough stock back (read: Berkshire Hathaway) might have a reason to return the capital via a dividend.

This is not the case in Burberry’s business. They are trying to grow market share in a growing category of the mass affluent. Growing businesses tend to pay little or no dividends as they need the capital to expand their business. Also, if the future of the business is bright and Mr. Market doesn’t think so, you’d want the company to purchase shares from investors who have a low opinion of the business.

The question is, who allowed multiple leadership changes and bad capital allocation via large dividends to cause pressure on the free cash flow and, thus, the capital structure of the business? The board, led by the current Chairman, provided this oversight. Why would this whole group not be flushed out from this lack of leadership? The answer is the same as the yield hogs that “supposedly” owned it. That’s very British. The idea that you change things to benefit shareholders, rather than your social circle or friendships, is one of the perverse incentive structures that belies board seats at large, but particularly board seats in Britain.

The company now has a new CEO, Josh Schulman. They have also cut that massive dividend to zero (goodbye Gnomes). The consensus of analysts believes that the business, while struggling, will produce about 235 million pounds of free cash, which is down over 30% from the year prior. More importantly, at a low point in a business like this, Burberry is still producing over 20% return on equity with about two years of free cash flow in debt. We consider this a strong balance sheet for our fellow Smead investors.

We buy common stocks, and we must trust management and board members because we are minority shareholders, relying on our eight criteria for investment selection. We believe Burberry should be looking for an entirely new board with Mr. Schulman as the Chairman to create leadership from a rudderless board and poor-performing executive leadership prior. While this improved structure wouldn’t guarantee success, it guarantees focus on the task at hand while not allowing for any laggards to doddle in Mr. Schulman’s vision of where Burberry’s business must go and how capital must be allocated. The last thing we would want to do is write a letter to the board that starts with, “Dear Chairman.” It may be the most valuable thing the prior shareholders could have done.

Fear stock market failure,

Cole Smead, CFA

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. Cole Smead, CFA, CEO and Portfolio Manager, 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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