Royal Babies and Economic Growth

Dear Fellow Investors:

On a recent business trip to Europe, we noticed—anecdotally—a lack of hope in the economic future of Europe. There is a good reason for the lack of hope. Hope, we believe, comes in the form of new life. When all of the austerity being practiced in developed nations around the world is pretty much done, something else needs to happen for economic growth to take hold. At Smead Capital Management, we believe developed economies need rebirth and the birth last week of a son to the Royal family is a watershed event. In our view, this kind of hope could be a critical factor in the success of the US large cap equity market in 2014 and beyond.

A “watershed event” is an event that occurs at a critical time. In the genre of Malcolm Gladwell’s Tipping Point, these events can be a point in time where a major trend starts. We think it might be helpful to look at some historical watershed events to better understand this one and its importance.

In the late 1950’s the Russians completed a successful space flight with Sputnik. This encouraged a huge effort by the US in math and science under President Kennedy and resulted in man walking on the moon by 1969. President Nixon and his key foreign policy advisor, Henry Kissinger, reached out to the Chinese to do business in the early 1970’s, under the theory that some economic progress and freedom would lead to the urge for more freedom. Look at what has happened in China since then! Ronald Reagan stared down the air-traffic controllers in 1981 at the height of what economists called “cost-push inflation”. By 1984, inflation had dropped from 11% to 4%.

Why would the birth of a child be important both economically and from an investment standpoint? We’ve developed a few thoughts on this subject. First, population growth has been tied closely to economic growth in developing and developed nations. It only makes sense that more people equates to the production of more food, clothing, shelter, along with other goods and services. When it is a baby, it means a bigger or better organized home and a kid-friendly car will be needed. On top of that spending comes heavy spending during pregnancy and the toddler stage. Prince William and Lady Kate are affluent and he is 31 years old. Older and more affluent parents mean older and more affluent grandparents. If developed nation echo-boomers follow their lead, these babies are going to drive spending which could be equivalent to what two children caused thirty years ago.

In a presentation to investors recently, Home Depot shared the following chart of remodeling/home improvement spending as a percentage of GDP:

We believe babies cause existing homes to be reorganized and remodeled. Some call this “nesting”. We believe the spending on homes will rebound to at least historical averages over the next five to ten years. The US government reports that 2.75 times as much labor is used to build single-family home square footage as compared to the same square footage in multi-family housing. The US had 220 million people in the 1977 census and we built 1.4 million single family homes in 1978. The US has about 316 million people now. Should we expect anything less than a single family housing start peak of 2 million single-family homes in a year this time? What does this mean for blue collar employment? Trades people and those who work for the companies which provide inputs to housing could see their numbers grow and their wages rise. In the process, we could see income inequality narrow. I hate fighting traffic against these folks, but I love doing business with all them.

Second, leadership is critical to success in life. People all over the world saw and couldn’t help but get excited about the birth of Kate and William’s baby boy. In the US and Canada, where the special bond of heritage exists between the countries and Great Britain, the joy was so thick that you felt like you could be cut it with a knife. Just look at the USA Today front page story and the Wall Street Journal’s coverage to understand how pumped we are in the US for the birth of this child.

Third, all the smart policy and austerity practiced won’t mean a thing in developed counties unless the current paltry birth rates don’t pick up. Birth rates in Europe and other developed countries like Japan are closer to 1.4 kids per family than 2.0 and the deep recession of 2007-2009 help lead the US birth rate below two per household.

Lastly, the good news is there are a huge number of echo-boomer kids in the developed world which could follow the lead of Kate and William. In the US alone, there are 86 million people between the age of 18 and 37. The heart of that group is at an average age of 28. Fortunately for us, the average age for a woman to marry in the US is 26.5 and for men it is 28.7. The weddings and babies could become a “cool” thing to do and “cool” is what President Kennedy, Henry Kissinger and Ronald Reagan had in common. People follow “cool” leaders. William and Kate are a great couple and a wonderful example. We hope they fill their house with babies and ignite their continent.

The investment tie is very simple. The USA Today cover photos showed Charles and Diana hold Prince William right after he was born in 1982, alongside the picture of William and Kate holding the new royal baby. In 1982, it was the beginning of a strong period of economic growth which lasted for twenty years. If the economy’s of the developed world rebound in the coming years as a result of a wave of babies, the bull market in US large cap stocks is probably somewhere around the third inning or halfway through the first half of the soccer (football) game, depending on which side of the pond you live on.

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. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

This Missive and others are available at smeadcap.com

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