Woody Hayes on Portfolio Management

Dear Fellow Investors:

“There are three things that can happen when you pass the football and two of them are bad,” observed The Ohio State University’s legendary coach Woody Hayes. All the Seahawk fans, myself included, know exactly what he is talking about since the Seahawks chose to pass the ball at the one-yard line. You can complete a pass, you can throw it for an incompletion, or you can throw it to the other team (an interception).

The same thing can be said for existing common stocks in your equity portfolio. If you sell them, three things can happen and two of them are bad. First, you can sell the shares of common stock and see them greatly underperform the rest of your equity investments (good). Second, you can sell the shares and see them outperform your portfolio (bad). The third thing that can happen is comprised of the first two; the expense of trading and the potential of capital gains tax are at best a necessary evil (bad).

We believe as a long-duration investor, you need to understand the mathematics of common stocks. When you buy a stock and pay cash, your downside is limited to the amount invested minus the dividends collected prior to bankruptcy. On the other hand, successful common stock holdings can go up by many times what you paid for them.

The Bible says that love covers a multitude of sins, and, in portfolio management, your best performing multiple-decade winners cover a multitude of underperformance by the inevitable common stock duds. Investing in common stock has been very rewarding over the decades because it has been a positive sum game. Nobody has to lose for you to win.

We at Smead Capital Management have argued that activity and its insidious cost is the enemy of the active management industry. Warren Buffett says, “Excitement and expense are the enemy of your portfolio.” A Financial Analysts Journal article from February 2013 showed that in the large-cap space, active managers averaged 62% turnover and incurred around 0.80% of annual expense. This rivals annual mutual fund expense as a cost. Every time you sell and buy a new security, you get one of the two bad outcomes, trading expense!

Since we have entered a corrective period in the U.S. stock market the last five weeks, it is extremely tempting for active managers to try and guess where the winds will blow in the next three-to-six-months. Doing this would be risking the possibility of two bad outcomes. One of the stocks you were going to do the best on the over next ten years could get thrown out in an effort to maintain your comfort or the comfort of your investors. Do you want to throw away one of your best long-term performers the way the Seahawks threw away the Super Bowl?

There are numerous examples in our portfolio where more active managers might trade out. Amgen (AMGN) has been a spectacular performer since the summer of 2011, rising from $52 per share to $150 as February 2, 2015. However, the biotech industry has been a very popular group and is likely overdue to disappoint investors. Racier and more exciting small biotech shares soared even more and are correcting more aggressively.

Amgen reported excellent results in the fourth quarter of 2014 and raised the dividend 30% for 2015. They guided 2015 earnings estimates from $9.05 to $9.40 per share. At today’s price, this splendid company trades for 16 to 16.5 times this year’s earnings and pays a fast-growing $3.16 dividend. Based on our eight criteria for stock selection, this is a clearly superior company trading at a market multiple. There is a better than average chance that a sale would ultimately include two negatives.

Home Depot (HD) has been a great performing stock the last six years. It trades for 20-times this fiscal year’s earnings estimate of $5.20 which ends February of 2016. They raised the dividend from $1.16 in 2013 to $1.56 in fiscal 2014. It is our expectation that above-average dividend growth will continue for a number of years.

The U.S. has been in a housing depression for the last seven years and household spending on home improvement is very low compared to the past thirty years. Residential fixed investment is as low today as a percentage of GDP as it was in the worst recession years of the 1960’s, 1970’s and 1980’s. Lastly, do you want to sell this stock before most Millennials, our largest population group, have bought their first house? Two bad things could happen!

We are going to stick with Woody Hayes and give the ball to a couple of meritorious businesses which have created great wealth in the past and not run the risk of making two mistakes. We are willing to explain ourselves later at the podium if one out of the three possibilities (a temporary price drop) makes us look foolish in the short run.

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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