William Smead
Chief Executive Officer
Chief Investment Officer
Dear Clients and Prospective Clients:
Benjamin Graham wrote the most important book on the analysis of common stocks (Security Analysis), as well as the most important book for stock market investing and portfolio management (The Intelligent Investor). His pupil, Warren Buffett, has repeated one of his main concepts many times for us and it has probably never been more valuable than today.
Graham compared the stock market to a partner you have in the ownership of a business. This partner would voluntarily set a price everyday at which you could buy his half of the business or sell him your half. You never asked him to establish this practice. He did it on his own volition. When business conditions were poor, he would set the price very low because he was concerned that you would stick him with the other half of the business. At the time the business is booming, his price is very high because he is afraid you will take his bright future away by buying his share of the company.
Mr. Market is on barbiturates (downers) right now because we are in a once in sixty year business coma which includes a deep, long recession and credit crisis. He is setting a very low price on the greatest businesses that have ever graced this planet because the business climate has contracted, households are pulling back and companies are reducing expenses. The most effective tool for reducing expenses is to reduce staffing. We now have a negative feedback loop and we wonder whether we are going to do business with each other anymore. He is setting the price very low.
Let me help you understand Mr. Market by looking at his behavior ten years ago on a couple of companies which he reduced his price on last week. In 1999, Microsoft traded at 60 times profits and Mr. Market envisioned back then that they would grow their profits immensely in the next ten years. A deep recession was nowhere in sight back in 1999. He was afraid that his partner would buy it away from him, so he set a price over $50 per share. Last week the stock dropped to $17 and the price to earnings ratio dropped to 9. The earnings did grow immensely the last ten years. He is afraid you are going to stick him with the other half of the business even though they have $20 billion in cash on their balance sheet and gush $12-15 billion each year in free-cash flow. He is afraid that our economy won’t make a comeback like it did from the other deep, long economic contractions of the last 233 years.
Mr. Market is even more depressed about his Ebay ownership. Back in 1999, he thought that by 2009 this small but profitable auction website business could dominate its category and produce massive free cash flow from facilitating the movement of pre-owned goods from buyer to seller at auction prices. The stock traded at $80 per share and well over 100 times profits. He was very concerned his business partner would buy it away from him, so he set a very dear price. All of his belief in the company was justified as they produced free-cash flow of $2 billion in 2008. However, the current business coma has caused sales activity to contract at even the bargain counter for items like pre-owned golf clubs. Mr. Market is afraid things won’t ever improve and he has set a price for the stock around $12. This gives them a price to earnings multiple of around 8 and a free-cash flow multiple around 7.5.
They own PayPal, the most successful payment system on the internet and five of the six largest online classified ad businesses in the world. In their spare time they own Skype and 25% of Craigslist. Did I forget to mention that have $3 billion in cash, no debt, no inventory, no pension liability, zero stores and own Bill-Me-Later? Mr. Market needs to go to Joel Osteen’s Church (the author of “Your Best Life Now”) for awhile and get his attitude rearranged. So what if business is crummy for a year or two? When my kids are my age, everyone will be tech savvy and PayPal could rule the world as the ultimate toll bridge.
At Smead Capital Management, we want investors to understand the enormous opportunity this market is offering participants to buy him out of his half, and implore those on the sidelines to hit the low bid of Mr. Market!
Best Wishes,
William Smead
