Long Duration Common Stock Investing: A Contrarian Manifesto

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

Morningstar did some neat fund flow analysis recently which was picked up by a column written by Mark Hulbert on MarketWatch called, “Active vs. Passive”. In it he described how fund flows had moved toward passive or index investing among US equity funds and away from active managers in the last ten years. The amount of US equity assets which are indexed grew from 12% to 22% of the total pie. Theoretically the more that investors or their advisors index, the more likely active managers would be to gain the upper hand over passive investments in the S&P 500 Index (scarcity creates value). Unfortunately for the active managers, this was not the case as only 20% of active managers beat the market over the ten years. In the article, Hulbert concluded that all the added advantage that active managers might have received from greater passive participation was dissipated or offset by the increased portfolio activity (turnover) of stock mutual fund managers. At Smead Capital Management, we think these results and information are important to contemplate because it sheds light on what it means to be a wise contrarian investor in early 2010 and in the future.

The S&P 500 Index has obvious built in advantages over active funds. As a benchmark it has no management fee. Therefore, throughout the year the index will gain the advantage of not paying a management fee of .50%-1.00%. The active managers automatically have to overcome this difference through better performance. Second, there are no operational costs associated with the index. In the actively managed US equity fund universe this adds up to an average of 1.31% per year including the management fee. Third, the index has very low turnover historically. This means that trading costs and bid and asked spreads do little to reduce the returns of the index. Lastly, the S&P 500 Index is a market-capitalization weighted index. It means that the S&P 500 Index holds its winners to a fault while allowing the duds (like General Motors) to run their stock price into the ground. At SCM, we believe this is one of the index’s biggest built in advantages over active managers. The math is that you can make 10 times your money on a big winner, but you can never lose more than 100% of your money on a stock going bankrupt.

Academic research has shown repeatedly that long time periods allow value to get recognized in the marketplace. Eugene Fama’s work on efficient markets at the University of Chicago focused on low price to book value. Others like Bauman, Conover and Miller as well as David Dreman have shown clearly that buying the lowest P/E ratio stocks has soundly beaten the market averages if measured over a ten year or longer time frame. This shows that long durations produce better results for both passive and active investors.

Ben Inker, research director at Grantham, Mayo and Van Otterloo (GMO), exposed what is wrong with the high level of activity and portfolio turnover at the average actively managed fund. His work shows that 75 per cent of the current intrinsic value of a stock comes from cash flows earned more than 11 years from now. Why are short term business prospects receiving most of the professional investor attention when company durational success should be their focus? Ironically, in 2009 the average holding period for a stock on the New York Stock Exchange dropped below a year for the first time in 70 plus years. Not only have fund managers been more impatient, but individual and institutional investors have been as well! On top of all this is the fact that dividends and dividend increases make up a substantial part of long-term returns produced by participating in US equity investments. The average investor doesn’t stay around long enough to collect an entire year of dividend payments.

Let’s put this wonderful band of players together and see what we come up with. When stocks do poorly for a decade, investors are motivated to try to compact duration or holdings periods on stocks to gain an advantage. In the process they cede success to the S&P 500 Index. And by being impatient and too active they fail to take advantage of the kinds of under valuations provided by cheap stocks. We believe these advantages include dividends, dividend growth and companies with long duration business characteristics (wide moats and strong balance sheets).

It appears that good stock selection, with an eye on low PE’s and long duration business characteristics could be very successful for the patient US equity fund manager. It also appears to be quite contrary to the popular view and methodology of active managers in 2010.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and 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.

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