Image source: Smead Capital Management.
Based in Seattle, Smead Capital Management is a dyed-in-the-wool value-investing shop, managing client assets using both separate accounts and a mutual fund. The Smead Value Fund, created on Jan. 2, 2008, now has more than $1 billion in assets under management, with an average of 25 to 30 holdings and about 20% turnover. Morningstar rates it four stars, noting that it's outperformed its benchmark in 83% of rolling three-year periods and that its annualized returns have beaten 99% of peers over the prior five years. As of Dec. 31, the fund's investor share class has generated gross five-year annualized returns of 16.1%, compared with 14.7% for the S&P 500.
During my interview with co-portfolio managers William Smead (who's also the founder, CEO, and chief investment officer), Tony Scherrer, and Cole Smead, I was struck -- and motivated -- by their intense commitment to their eight-point checklist. Their focus is on companies with high returns on equity (ROE) and insider buying at substantially discounted valuations, and they prioritize low portfolio turnover. The three are heavily invested in the fund, with William Smead at more than $1 million.
Smead Capital Management takes a contrarian stance and finds value in companies the market has shunned. Image source: Getty Images.
John Rotonti: William, you often include musical lyrics in your investing blog. [See here for Billy Joel, here for "American Pie," and here for Emerson, Lake & Palmer.] Are you a musician?
William Smead: No, I sang in the choir at church for years, but I just love music.
JR: How do you define a high-quality business?
Smead Capital: In our case, we view quality [as] a long history of profitability, a wide moat, consistently high levels of free cash flow, a strong balance sheet and a history of shareholder friendliness.
JR: How do you define a high-quality management team?
SC: We would rather know what the management team is doing with their money (insider buying and selling) than what they say. Everybody says that their business is going to do great. We have a tendency to own businesses like [Warren] Buffett [does], ones that a two-year-old could run.
JR: Can you please explain the investing checklist you use?
SC: We believe in three core tenets. First, valuation matters dearly. All the studies show that cheap stocks outperform average or expensive ones. Second, we want to own companies for a long time. We want to ride winners a long time and keep trading costs to a minimum. Third, to do that we need high quality. All companies have occasional struggles. Strong balance sheets and copious free cash flow are there to get you through any difficulties. These eight criteria get us to those core tenets.
Required over the entire holding period
- Meets an economic need
- Strong competitive advantage (wide moats or barriers to entry)
- Long history of profitability and strong operating metrics
- Generates high levels of free cash flow
- Available at a low price in relation to intrinsic value
Favored, but not required - Management history of shareholder friendliness
- Strong balance sheet
- Strong insider ownership (preferably with recent purchases)
JR: Growth does not appear to be one of your checks. Is growth something you look for, and if so, how do you define a growing business?
SC: Charlie Munger said, "Competition is the enemy of competence." We want companies with a growing market of addicted customers. The addiction gives our companies pricing power, and more people give them growth. If there is anything our companies have in common, it's that the customer couldn't live without them.
JR: Do you look for your holdings to grow earnings per share at a certain rate over time?
SC: We don't have fixed numbers or expectations. It varies based on the business and industry. But we do like high return on equity all of the time.
JR: Please explain how you narrow down your investable universe and how large that universe is.
SC: There might be only 80 to 100 companies in the U.S. which could fit our criteria and meet our valuation parameters. We look for big disappointments, years of neglect, Wall Street hatred, 52-week new lows and media torture for ideas among companies which meet our qualitative criteria. We bought American Express because they divorced Costco and got slogged down. We bought banks in 2012 because of political, regulatory, and media ridicule. We bought eBay because it has been hated every minute of the last 10 years.
JR: Are there any industries you tend to prefer or avoid?
SC: We like companies which are not capital-intensive and have addicted customers. We will buy a cyclical growth company, but not very often. Therefore, oil, utilities, basic materials, and heavy industrial companies have a hard time qualifying via our eight criteria.
JR: How do you think about valuation?
SC: We are free-cash-flow junkies and use price-to-earnings (P/E) and price-to-free-cash-flow ratios most of the time. We don't have hard and fast rules and treat each industry based on their history. A bank is expensive at 20 P/E, but we'd love to pay 20 P/E to buy more PayPal.
JR: Do you have a preferred measure for the returns a business is generating? Return on assets? Return on equity (ROE)? Or return on invested capital?
SC: We like high and sustainable ROE and love to buy stocks in the doghouse which have long histories of producing high ROE.
JR: I know that no one metric is appropriate for all businesses. But do you have a particular measure of cash flow that you prefer when analyzing most businesses? Operating cash flow less capital expenditures? Owner earnings?
SC: We use Value Line and Bloomberg. My favorite is to subtract capital spending from cash flow from operations, because they (Value Line) use GAAP numbers.
JR: Is there a single best measure or proxy for growth of intrinsic value? ROIC plus organic revenue growth? Free cash flow yield plus organic revenue growth? Free cash flow per share? Something else?
SC: Buffett says, "All you need is an IQ of 125." Our discipline is based on buying meritorious businesses in a 25- to 30-stock portfolio and leave it up to the companies to decide who succeeds.
JR: How do you evaluate a company's balance sheet? Do you look for a particular coverage or debt ratio?
SC: We prefer no debt or more cash than debt. If a company has debt, we'd like to think it could be paid off via free cash flow in a short number of years. We adjust these parameters for certain land-intensive companies like homebuilder Lennar.
JR: One of my favorite blogs you've written was on "The 70-20-10 Rule." Can you please explain the rule to our readers?
SC: Part 1 of the rule says that [over] 12 months, the return you get on a stock is 70% determined by what the U.S. stock market does, 20% is determined by how the industry group does, and 10% is based on how undervalued and successful the individual company is. Part 2 of the rule says that over 10 years, 70% of how you do will be determined by the valuation and success of your company, 20% by how the industry does, and 10% by how the stock market does. In other words, stock market movements and industry popularity drive one-year price movement. Company performance drives 10-year returns.
JR: Millennials are the largest generation (or age cohort) in America, and personal consumption drives more than two-thirds of the U.S. economy. How are you investing behind this trend?
SC: We are of the belief that we can significantly outperform the S&P 500 Index by owning the companies who best meet the needs of 35 to 44-year-old Americans (See the chart below):
Image source: BofA Merrill Lunch Global Research, Euromonitor.
This means marriage, babies, household formation, homebuilding, banking, etc.
JR: When should a company pay a dividend or repurchase stock?
SC: When a company has consistent and growing free cash flow, they should share it with their public owners.
JR: Do you have any performance metrics that you prefer management compensation be based on?
SC: No, but we like strong insider ownership and prefer recent purchases.
JR: When do you lean on insider buying the most?
SC: We lean on insider buying when stocks are getting blasted on the downside. It is a form of courage. Think Jamie Dimon buying J.P. Morgan after the "London whale" incident.
JR: Do you meet with management of the companies you are invested in?
SC: Sometimes, but we don't consider it a big positive. We consider ourselves to be good poker players, but everyone thought Michael J. Pearson was a genius that met with him. I'm glad we didn't meet him.
JR: What step(s) should investors take to try avoid value traps?
SC: We are big advocates of prayer (ha). We are bothered by incredibly low P/E ratios. We got out of Gilead Sciences for this reason.
JR: When do you sell? Will you hold a high-quality company that is fairly valued?
SC: We sell for three reasons: when our qualitative criteria are violated; during the first three years of owning a stock because of poor price performance; or when longtime holdings get "maniacal" (two standard deviations away from the company's normal or historical multiple).
JR: How do you think about position sizing and portfolio diversification?
SC: We start with a 1% to 2% position and add as we become more convinced by insider buying or price declines. Average positions are about 3.5% and we will trim those which get to 7% to 10%.
JR: What common characteristics or patterns do you recognize in some of your biggest winners?
SC: There is something about them which stops the stock price from getting maniacal. We bought some eBay in 2010 for about $19 per share, and we determined that the sum of the parts was $32. The market hated them. Today, the two pieces [eBay and PayPal] add up to around $70 per share and everyone still hates them. So, some of our biggest winners have had steady success with non-parabolic episodes in the stock prices. There seems to be something that holds down unabashed enthusiasm so the business value continues to grow, the stock price follows, but the valuation remains reasonable so we can keep it compounding in the portfolio for long periods of time.
JR: What lessons did you learn or patterns do you recognize from some of your losers?
SC: Only that it is a guarantee that they will happen. It is like Cy Young and Babe Ruth. Cy had the most losses and Babe had the most strikeouts.
JR: Can you discuss the research process at Smead Capital Management? Are the analysts generalists or specialists? How often does the investing team meet to discuss new ideas? What is the process for a stock to make it into the portfolio?
SC: We are generalists, and the three portfolio managers sit together and are in constant communication. We add two to three new ideas each year. The key isn't research wizardry, it is patience.
JR: You serve as chief investment officer and Tony Scherrer serves as Director of Research. How do the roles and responsibilities of the Director of Research and Chief Investment Officer differ at your firm?
WS: Tony has a great background in portfolio management and the institutional side of money management. He caused our discipline to improve by adding that institutional discipline. Tony knows more about where to dig and who to talk to in research. I have the 36 years of stock-picking experience and lived history. This is all I have done as an adult. Although you didn't ask, I should mention Cole Smead, who is the third member of our three-person portfolio management team. His millennial age perspective and years of practice in our discipline help us have a mix we like.
JR: Which qualities should great analysts have? What about great portfolio managers? Are they different?
SC: Analysts need to use multiple models and consistent discipline to form opinions based on the numbers. Portfolio managers need to have immense patience, a weird combination of confidence and humility, and [to] look at the world from a contrarian angle.
JR: Amgen is one of your largest positions. Would you mind sharing your brief investment thesis?
SC: Amgen might be one the best companies in the S&P 500 Index. It fits our eight criteria very closely. It trades for about 12.5 times 2017 earnings, a big discount to the S&P 500. It's a big position because of how well it has done since 2011. Management went from no dividend to $4.60 in five and a half years and has shrunk the company's float by 40% in 15 years. All along the way, they spent close to 20% per year on R&D.
JR: What is your investment thesis on Home Depot?
SC: See the chart of 35- to 44-year-old Americans. Two kids and a nest that needs improvement. The home is what the next 10 years are all about.
JR: Starbucks recently announced its updated five-year growth plan and the looming retirement of Howard Schultz from the CEO role. Would you mind sharing your investment thesis on Starbucks?
SC: SBUX was our largest holding from 2009 through 2011 and peaked at 8.2% of the portfolio. We have trimmed it, because the stock price appeared maniacal. The P/E is coming down, and we would probably get interested in building the position if it fell to lower than 20.
JR: What is your thesis on Accenture?
WS: It is a money machine and fits our eight criteria, but it's fully valued currently. My college roommate worked there from 1982 to 2006. He became independently wealthy while it was private, and it has done the same thing as a public company.
JR: Would you mind sharing your thoughts on the large publicly traded "active" asset management companies, some of which have historically generated very strong free cash flows and returns on capital but are currently being pressured by poor performance, outflows, lower fees, and the growth of passive strategies and robo-products?
SC: We had owned Franklin Resources and sold it at $45 per share. We wonder if they can adapt to the world dominated by index investing.
JR: What are your thoughts on current stock market valuations?
SC: We are very nervous about the higher P/E ratios and the glamour and arrogance surrounding tech. We did our own research below and came up with a picture a few months back, in early August.
Image source: Smead Capital Management.
This is the biggest spread between the most expensive and least expensive stocks since 2000.
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