Dear Clients and Prospective Clients:
We know that we have been in an “economic coma” for the last three to four months and almost every business and individual household is retrenching. Since we are raising our savings rate and reducing our consumption, most businesses are reducing employment. Simultaneously, investors are hoarding low interest rate vehicles like T-bills, CDs and money market funds. They are also not being enticed by depressed stock prices and high corporate bond rates to make the investments they would normally make. Warren Buffett describes it as a “negative feedback loop”.
At Smead Capital Management, we have done a great deal of analysis on past major market declines coinciding with deep economic contractions. We believe that corporate survival and brand perpetuation are the most important issues. For that reason, we are focusing on owning three kinds of large capitalization companies:
- We own companies with no debt and billions in cash sitting on their balance sheet. Their earnings might be disappointingly lower than the previous year (Microsoft, Ebay, Starbucks), but since they are still very profitable, gush massive free-cash flow and have billions in cash on their balance sheets, the survival of the company is not a part of the discussion. For us this also includes companies like Accenture and Amgen.
- We own companies which have debt, but have massive amounts of cash on their balance sheet. They also have the ability through free-cash flow to retire their debt over a short number of years. This group includes Merck, Pfizer and Abbott Laboratories. Some of them will have impressive earnings, but most will be disappointing compared to last year at the same time.
- We own companies which have less cash than debt, but have such reliable businesses and customer bases that we feel their survival is not in any way threatened by the current circumstances. Disney, WalMart, AT&T and Verizon would be good examples. Let’s consider Disney for just a moment. They will definitely be hurt by attendance at theme parks in 2009. What could be easily neglected is that we are going to be staying home more and watching High School Musical or ESPN. Disney (which owns ABC and 80% of ESPN) rakes in a greater and greater share of advertising dollars as it dominates wholesome family entertainment through cable, movies and network television. For companies like AT&T and Verizon, cell phone service is probably the last expense cut in an unemployed person’s home.
We do not know when the bottom will ultimately be established in the stock market during this very difficult phase. We believe that those who focus on quarterly earnings reports and stock price declines will not enjoy the wealth creation that comes as the stock market leads us out of this “economic coma” . We believe this cleansing of epic proportion in both consumer and investor attitudes plants the seeds for a long and healthy bull market.
Disclosure: The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.