Chief Executive Officer
Chief Investment Officer
Dear Fellow Investors:
Ten-Year US Treasury Yield since 1/1/1871
My career started as a stock brokerage trainee at Drexel Burnham Lambert in 1980. As you can see in the chart above, interest rates at that time were the highest they’d ever been in the history of the United States. Businesses were starved for capital and the earnings yield on the US stock market (inverse of the PE ratio) hit a peak of 14.37% in 1980. Unemployment peaked at 10.8% and stockbrokers gathered around the Dow Jones Newswire machine on Thursday afternoon to find out what the M1, M2 and M3 money supply figures were the previous week. Our economic problems seemed unsolvable and a raft of very bright macroeconomic thinkers told us it was only going to get worse. The problem then wasn’t the existing amount of household debt which was inhibiting the economy; it was the absolute cost of borrowing money which held back economic growth in America.
One of the S&P 500 sectors most damaged by the high interest rates was the utility sector. The highly- regulated and highly-leveraged companies were trapped between rising commodity prices, squeezed customers and incredibly high interest rates on their corporate debt. The utility business is capital intensive with a capital I. AAA utility bonds yielded as much as 14%. The dividend and earnings yields on utility stocks was substantially higher than the rest of the market. The spread was the largest it had been since the post WWII period. In 1981, the NYSE new lows list was littered with utility stocks.
The need for capital in this highly-regulated industry forced the hand of the US Congress. They passed a law which allowed investors to reinvest their utility stock dividends and get the first $2,800 of reinvested dividends each year tax-free. Hardly anybody wanted these stocks despite the tax incentive, because of the pervasive fear of losing on negative price movements.
You might be wondering why we at Smead Capital Management bring this up. Today appears to be the antithesis of that circumstance. Capital, as measured by short-term and long-term interest rates, has never been less expensive in my lifetime. For those who are credit worthy, credit has never been cheaper and more abundant.
This helps you understand why our best choices for US long-duration common stock picking avoid these capital intensive sectors. They are the utility, telecom, industrial, basic material and energy sectors of the S&P 500 index. They are massive capital eaters and have enjoyed an amazing cheapening of the cost of eating capital. As interest rates rise over the next ten to twenty years, we believe their profit margins will be crimped by the higher and higher cost of capital and their price-to-book value and price-to-earnings ratios should suffer as a consequence.
We believe the winning sectors in a rising interest rate environment era are companies with little or no debt that generate high levels of free cash flow. This hits at the heart of our eight proprietary criteria for stock selection and gives us great comfort for the future.
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.