Dear Fellow Investors:

Since the stock market has done extremely well from its “abyss-like” low in March of 2009, many investors are worried about the risks associated with owning U.S. large-cap stocks. A cacophony of articles have been written which not only look for the stock market to correct, but also have an expectation of the kind of bear market decline which would set investors back for five years, like the declines in 2000-02 and 2007-09. Those declines each hit the S&P 500 Index for a loss of 40% or more.

We believe that investors should focus on the risk of “permanent” loss and frame their concerns today around their long-duration participation in the stock market. Permanent loss can come in two forms. First, can I lose all the money I have in a company or portfolio by it going bankrupt? Second, can I severely damage my liquid assets by not handling the emotional pressure of a big decline (20% or more) and sell at the depths of the market low?

At Smead Capital Management, we have a template for stock selection which takes the threat of bankruptcy into consideration. We screen for economic need, wide moats, high and consistent historical profitability, high and consistent free-cash flow, strong balance sheet and strong insider ownership. Taken together, these criteria go a long way to keeping us away from permanent loss on an individual common stock holding.

Separate from these criteria, we constantly ask the question, “Where are we wrong?” Being preoccupied with our poorest performers contributes to defending our capital on the way down. This is why we are stingy and picky about our new positions. For all intents and purposes, they are on probation during the first two to three years we own shares of our companies and are watched and monitored judiciously along the way.

In the bible, love covers a multitude of sins. In investing, stocks can go up many times your original investment and cover a multitude of 20-40% losing stock holdings. Allowing the math of common stock investing to be your ally is good “permanent” loss prevention, in our eyes, for the long-duration investor. Therefore, we own 25-30 individual company shares in the portfolio. Academic studies show that you get over 90% of the benefit of diversification at the 20th common stock.

The emotional side of getting into a terrible decline in the U.S. stock market and suffering your permanent loss through bailing out near the bottom is best exemplified by a true story. In 1987, I was excited about the Park Avenue Fund, which was only available to my clients in a variable annuity called the Value Guard II. I recommended it to my Uncle, who invested in it on Oct. 12th of 1987. If you know the history, you know where I’m going with this.

One week later, the stock market had already declined more than 20%. Since he was the owner of an annuity contract in the state of Washington, he had two weeks to turn it back and get his money returned in full. He did turn it back and was made whole. His short-term blessing became a long-term curse. The Dow Jones Industrial average was around 2300 the day he invested and three years later was 3000. Despite his poor timing, he would have earned over 13% compounded for three years (counting dividends) and even higher returns out to 2000.

It is very important to examine yourself and your clients (if you advise others) to determine whether bailing out deep into a decline in the market is a meaningful possibility. We seek out long-duration investors who expect a cage-rattling decline once every five years and a greater than 10% decline almost every year. We ask our investors to anticipate ten-year returns which reward them for their patience and are doled out unevenly by the circumstances of life. Our hope and expectation for them are index/benchmark beating returns and communication from us which reminds them in the middle of a decline why they are practicing the long-duration discipline.

The reality on the ground in today’s investment environment is that few investors are anywhere near as dependent on U.S. large-cap stocks as they were in years gone by. Institutions and wealthy investors have reduced overall reliance on large-cap companies in the last 15 years in a move toward private equity, hedge funds and other alternatives. We approach the partial use of our discipline in the same way we approach investors who depend on us with most of their risk capital. We need to defend against permanent loss in individual common stocks we own and run our portfolio to do the same. Lastly, we need to communicate to all of you in a way which contributes to uninterrupted participation in your long-duration common stock investing. We believe this combination could be a ticket for success.

Warm Regards,

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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