Pinnacles of Confidence

by William Smead & Cole Smead, CFA, Smead Capital Management

For better or for worse, we at Smead Capital Management have very long memories. One of our favorite pinnacles of confidence is the financial euphoria in 2011 surrounding the Brazil-Russia-India-China (BRIC) trade. China’s command economy was growing 10% per year and helping to create momentum, which grabbed hold of the economies of nearby countries, as well as the companies and countries providing natural resources. It also captivated U.S. investors as they poured money into funds which gave them access to the momentum stocks.

It seemed at that time that Western Australia was being dug up, put on barges and sent to China. When you went to major investment conventions, the double booths at the center of the convention were mutual fund companies that focused on China/Asia/natural resources. Here is what the ten largest cap stocks in the world looked like at the pinnacle of confidence at the end of 2010:

Beginning in the late 1990s, the Chinese government, which was led by seven Politburo members, decided to practice capitalism under the umbrella of a communist command economy. They unleashed the entrepreneurial spirit of more than one billion people with the backing of national and local governments. Foreign governments reasoned if the Chinese citizens got economic freedom, they might ultimately want political freedom. My first exposure to this subject was a talk George Russell of the Russell Corporation gave at our Seattle Rotary Club in 1998. He was astounded by what he saw firsthand on the ground in China.

Before this recent attempt by the Chinese government to stimulate the economy, we don’t think we had ever seen investors more bearish on China. However, there are some very good lessons for today from how that pinnacle of confidence played out in 2011-2016 and parallels to consider with today’s most popular stocks.

First, to be excited about Chinese stocks and the BRIC trade in 2011, you had to make some assumptions. First, you had to hope that the seven 70+-year-old men who were making these national economic decisions would get things right. We dug into this subject back then and found that these men had mostly graduated from elite Chinese Universities comparable to the U.S. colleges where our Federal Reserve Board members serving today matriculated. Not only is China one of the oldest civilizations in the world, but it also has a multi-millennia tradition of scholarship excellence. Ironically in 2011, investors didn’t trust the U.S. stock market in part because they didn’t trust the members of the Federal Reserve Board to succeed in reviving the economy.

Second, investors in the Chinese BRIC trade were ignoring the trouble brewing underneath the service. The National Chinese government was mandating 10% economic growth to the regional government, which was in turn handed down to local governments facilitated by aggressive government stimulus. This liquidity came through the majority state-owned banking system. As the famous retired short seller, James Chanos, warned at the time, this was a ticket to today’s economic problems. A number of Ghost cities were built, and a number of shopping malls were built with no evidence of any customers (SBS Dateline).

Third, sentiment on commodities and international investing centered on the BRIC trade reached historical pinnacles of confidence. An attempt to revive the BRIC trade in 2014 failed when oil prices peaked, and the over-investment in real estate and related commodity-sucking industries evidenced a future struggle.

What is the moral of this story? Today, our Federal Reserve Board members are unlikely to thread the needle on the trade-off between inflation and economic growth any better than their Chinese counterparts handled things in 2011-2014. Extremely popular stocks in extremely popular industries get over-invested and doom the double booths in the center of the convention. Today’s double booths are in ETFs and mutual funds which invest in the S&P 500 Index, technology, and quality growth. One year ago, Buffett observed that the kind of wide-moat, high-quality companies with sticky customers that he would be interested in “have been endlessly picked over!”

Ironically, we like the oil and gas business which did extremely well from 1969 to 1981 and from 1999 to 2011. These were the last two commodity super cycles that required enduring levels of volatility similar to the ones we experienced this year. The pain of swift and violent corrections in energy shares during a growth stock bull market is something “only the lonely” can participate in. Since we fear stock market failure, we don’t mind being lonely; after all, “only the lonely can play” is a mantra we started our discipline with and maintain today.

Fear Stock Market Failure,

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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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