As we come to the middle of 2009 there are a number of well respected economists and market experts who have identified what they think are the problems we are going to have the next two to five years. One group sees slow growth and prolonged economic difficulty. Another sees strong economic recovery followed soon after by high levels of inflation. At Smead Capital Management we believe that ownership of outstanding companies which are held for long periods of time can be a “great elixir” to whatever maladies the economy and markets might have. It makes us optimistic about the future as we consider how the markets might do in the second half of 2009.

Bill Gross is the Chief Investment Officer for PIMCO and manages more money in the bond market than anyone on the planet. He believes that the ongoing debt liquidation and repudiation over the next three years in tandem with the overhang of debt in the lives of U.S. household consumers will mute the strength of the economic recovery. Not that it is the key to our success, but we happen to agree with him in many ways and have even coined a phrase to describe the phenomena. We call it the “New Boomer Austerity”. Our theory rides on the fact that there are so many baby boomers as a percentage of our adult population in the U.S. and other industrialized nations. With a huge number of people nearing retirement or going through the process of retiring, these masses will make adjustments to their spending and saving patterns in a fairly permanent way. Adjusting from peak incomes to retirement incomes is very similar to the way all Americans “reset” their spending beginning in September of 2008.

If Gross is right, we might see low levels of economic growth (1 to 2%) for many years and it could take most of the next decade to return to a 5% unemployment level. It means excess capacity in manufacturing and services would exist for years. This would create an abundance of willing and inexpensive labor in the future. This probably includes interest rates at the lower end of the ranges seen in the last 25 years on mortgages, CD’s and short term bonds. This would come in the aftermath of the current upward adjustment in Treasury bond interest rates as we have moved away from staring into the economic abyss last fall and winter (see Outlook 2009 Newsletter). Gross differs with us in that he thinks that bonds are a much better bet than stocks in the environment he foresees. We would note that he has an inherent conflict of interest due to the fact that both his own income and his company’s compensation is directly tied to how much money folks pour into bond investments.

We think that these next ten years could be much like the late 1940’s and 1950’s. In that era our economy grew consistently, without high levels of inflation, while paying back the debt which the U.S. government took out to fight World War Two. Those debts hung over the economy’s head back then the way the Obama administration’s fiscal stimulus hangs now. The 1950’s were one of the best decades that the U.S. stock market has ever had.

In near total disagreement with Bill Gross are those who believe that the existing monetary and fiscal stimulus in the range of $2 trillion is assuredly a ticket to high levels of inflation and much higher interest rates. Jimmy Rogers and Julian Robertson are a few of the respected proponents of this scenario. They see a strong economic recovery driven by worldwide growth which quickly triggers demand for commodities and is led by China and the other emerging market countries of the world. They believe interest rates could soar in the U.S. as our currency gets devalued and creditor nations lose confidence in our ability to meet our debt obligations. They are short and betting against Treasury Bonds. They are also long Gold, Oil and other commodities they feel will be in short supply. We agree with these folks on the upward movement in Treasury bond interest rates, but only until they get into normal spreads in relation to interest rates on other high quality debt instruments like corporate and municipal bonds.

We strongly disagree with the positive view of Oil prices held by this particular camp of experts. Oil moved up from a low of $11 per barrel in 1999 to $147 one year ago. This fits the definition of a bubble by all historical standards, and that same history would suggest you can get a sizable bounce back after a bubble breaks, but it should be years and maybe decades before you ever see $147/barrel again. Additionally, we expect that by ten years from now that battery-operated and hybrid vehicles could dominate the road just as cars took the place of horse -drawn buggies between 1910 and 1925.

We’ve given you the two most popular economic diseases of the next five years and now you want to know what we suggest as a cure. Ironically, the eight buy criteria that we use in our discipline leads us to companies which have done well in the past in both scenarios and could prove to be a “great elixir”. We buy financially strong companies which have little or no long-term debt and generate massive amounts of free cash flow (EBAY, BEN, ACN, etc.). In this way they are neither crimped in Gross’s slower sales environment by finances or stuck paying high interest rates in the higher inflation/higher interest rate world. Our companies have wide moats (barriers against competition) and are usually the number one company in their industry. Folks would have to go without the product they make if they didn’t make it and would pay a higher price if they raise it (MSFT, T, VZ, etc.)

Many of our companies are international in nature and don’t really care where in the world people demand their products and services (MRK, AMGN, DIS, etc.). We believe that improved international drug distribution to countries like a China and India could cause a great era for major drug companies. They also have the price flexibility in an inflationary environment which comes from making products which improve the quality and length of life.

Our companies have strong brands and competitive positions. If Bill Gross is correct, selling cell phone service could be like legal cocaine and shopping at WalMart could become an obsession in even the highest income demographics. In an inflationary environment, who isn’t going to want to save on price or who isn’t going to pay the higher price for cell phone service? Teenagers would give up food before they gave up their cell phone. Business people have to be physically forced to turn off their phone as the plane pulls back from the gate at the airport.

We believe that our companies could be the “great elixir” of wealth accumulation over the next three to ten years and have confidence in whatever economic environment comes our way. Thank you for joining us on this expedition and referring investors to us who might not know what to believe.