Interview

«It’s Just a Given That We Will Win This War»

Bill Smead, founder of Smead Capital Management, is betting on a world after the pandemic. The value investor from Seattle anticipates a new boom in the US housing market, spots opportunities in Berkshire Hathaway and American Express, and explains why he’s avoiding allegedly safe names such as Coca-Cola and Procter & Gamble.

Christoph Gisiger
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«It is not a stretch at all to think that in the next ten years, home building will be the best business in America. Yet, no one wants to own a home builder stock»

«It is not a stretch at all to think that in the next ten years, home building will be the best business in America. Yet, no one wants to own a home builder stock»

Deutsche Version

Rarely have financial markets experienced such violent swings as in the past few weeks. After the fastest market crash in history, stocks have staged a strong rally. What remains is a queasy feeling that the pandemic will soon trigger some more turmoil.

Bill Smead points out that the crisis is not over. Nevertheless, the founder and Chief Investment Officer of Smead Capital has no doubt that the measures to contain the virus will sooner or later be lifted and economic activity is going to pick up strongly.

«That’s why you want to buy businesses that people come back to in droves when they’re done being isolated», says the renowned value investor from Seattle.

In this in-depth interview with the Market/NZZ, Smead explains why he spots opportunities in homebuilders like NVR and Lennar. In his view, American Express, Discovery Inc. and the energy giant Chevron are also attractively positioned for a revival of the economy. In contrast to that, he thinks that seemingly safe stocks like Coca-Cola, Procter & Gamble or Amazon are overpriced.

Mr. Smead, the past few weeks have been gut-wrenching. What’s your take on the wild mood swings in the financial markets as an investor with forty years of experience in this business?

Circumstances like that don’t get more attractive as you’ve gone through more of them. They are just as unenjoyable now as they were before. The only advantage you have is that you’ve got a lot more tread on your tires.

What do you mean by that?

When you have been trampled before, you know that you can survive and prosper after you get trampled. So understanding what it feels like to get trampled helps you to maintain your logic and to think in economic terms over longer stretches of time when the circumstances and the emotions cause you to want to narrow your time period and narrow your focus. It’s never a good idea to narrow your focus since success in common stock investing is really built around five- to ten-year outcomes. Yet, it is the hardest thing for people to say: «What would I do today to get the best outcome in five to ten years?» Instead of: «What would I do today to feel the best about myself in two or three weeks?»

Why is it so important to keep a long-term perspective?

Let’s think of World War II: By 1940, all of Europe was involved, and the Battle of Britain was going on in 1940/41. At that time, the United States had not entered the war, but just think of how hard it was to be in Britain when the bombs were falling on London. Then, the United States got involved because we were attacked at Pearl Harbor on December 7th, 1941. The moment we entered the fray, we got involved in the war in Europe and in Asia at the same time. So why would anybody think at that moment we are going to win a war on two fronts?

How does that compare to the situation we’re in today?

Today, we are trying to win a war on just a single front: We’re trying to stop the spread of this virus. Everyone in the United States has basically chosen to stop doing business for an indeterminate time period for the purpose of winning a war against this virus. In contrast to December 1941, it’s way easier to visualize what comes next. But in my opinion, people are acting immaturely. They are acting as if we’re fighting a war on two continents and we don’t know if we’re going to win. This shows how little Americans have had to suffer in the past. We’ve had the financial crisis, but that’s not war type suffering. That was a severe economic crisis, but it didn’t introduce mortality. In contrast, this is more like a war since it has mortality in it - and mortality seems to have scared people more than an economic depression.

What makes you so sure that we will defeat the virus?

It’s just a given that we will win this war. It’s just a question of how long it takes. In other words: To get the case numbers to turn down is really what this war is being fought to do: To reduce the peak number of diagnosis and the peak number of deaths. We’re bending the curve by isolating ourselves for an indeterminate amount of time. And, when you take all the most brilliant medical science experts in the world and give them a task for a year, you are going to get something good coming out of it.

The S&P 500 has lost close to 20% since hitting a record high on February 19. How attractively are US stocks valued right now?

There is a bifurcation in the market: Companies that require economic optimism are trading at fire sale prices whereas companies like Amazon which seem to be making it through this difficult stretch unscathed are high in demand. Yet, such stocks are likely to be poor performers over the next five to ten years. Here’s an example: Let’s say, around the world people are getting by purchasing necessities online and having them delivered at their house by Amazon Prime. So in two or three years, what’s the first thing you are going to think of when an Amazon Prime vehicle comes through your house and you see it at the door? The first thing that goes through your mind is: «I’m imprisoned in my own house» - and that’s not a pretty picture.

You’re saying a brand name like Amazon will be associated with negative emotions?

It’s like when teenagers get a driver’s license: The first thing they want to do is drive. So when everyone in the US and basically around the whole world is closed in their own homes and forced to stay there, what are people going to want to do? They want to get out as soon as this is over. Normal life is going to seem like a vacation: People are going to be so happy that they can go to work, that they can jump in the car and go to a movie. They are going to be thrilled that they can do what they want again.

Then again, with the explosion of online orders, Amazon’s stock is doing quite well.

Let me give you another example: When Saddam Hussein invaded Kuwait in 1990 and President Bush stared him down for four to five months, the Iraqis were firing Skutt missiles at Tel Aviv and Haifa in Israel. At that time, Raytheon had invented a missile that could shoot those Skutt missiles out of the sky. So the stock of Raytheon got very popular. But there was just one big problem: You couldn’t make any money on it. To make money on Raytheon’s stock, you had to sit down six months before that and say: «Jeez, if there is ever a bunch of fighting going on, these guys have a missile that can shoot down Skutt missiles.» That would have been a good time to buy, but when the Iraqis are already shooting down Skutt missiles, it’s way too late.

So what companies are the Raytheons of today?

The famous short seller Jim Chanos was recently on TV. So what’s he shorting? He’s betting against names like Peloton, Clorox and other companies that are perceived to be the beneficiaries of this misery. That’s why you want to buy businesses that people come back to in droves when they’re done being isolated. For instance, you want to assume that when people get the chance they want to go back to traveling. Therefore, you want to buy American Express. Or, you want to buy stock in companies like Discovery Inc. that people are afraid are going to get ruined by Netflix.

Nevertheless, isn’t it also possible that this crisis will change certain patterns in consumer behavior permanently?

The longer it takes us to get back to normal, the longer it’s going to take people to return to their normal spending patterns. A month from now, it looks like we’re pretty close to the all-clear in bending the curve in the United States. If that’s the case, you can see people returning to normal by mid to late summer. And, the truth is, people have very short memories. We are very bizarre: If it’s not our life that’s in danger we don’t pay much attention to mortality. For instance, us being quarantined for the last three or four weeks has caused the number of accidental deaths in the US to fall off a cliff. Traffic accidents and accidents of any kind are massively down.

Does that mean you aren't expecting any long-term implications of the pandemic at all?

We just figured out who can work from home. So why do we spend billions of dollars to build tall buildings in expensive coastal cities and jam everybody in there? This may be attractive for singles, but the reality is we don’t have to work in an expensive office building in Seattle, San Francisco, Los Angeles, Boston, New York, Washington DC or Miami. So if people get married and have kids, they don’t have to be in one of those expensive cities. They can go to a place where they can afford a house and buy a car - and thanks to the Saudis taking a page of Jeff Bezos’ playbook we are going to have cheap gasoline for a while.

What businesses will be profiting from this trend?

It is not a stretch at all to think that in the next ten years, home building will be the best business in America. Today, ninety million millennials are 23 to 40 years old, and many of them have not bought their first home. Yet, no one wants to own a home builder stock, even though the next ten years are likely to be as good as that industry ever gets. If you and I were 25 years old and we had inherited a couple of hundred thousand dollars and we were trying to find out what business to go in, we would go and find a town of 25,000 people that’s on its ways to get 50,000 people and we would build single family homes.

So what are your favorite homebuilding stocks?

NVR: We’ve owned this stock for a long time and made really good money on it. They run their balance sheet extremely conservatively, so they are very financially strong. We also like Lennar because they are in 26 states, and success in the home building industry will have a tendency to be congregated more in the less expensive parts of the country. We expect that there will be the most intra-country migration we’ve had probably since the coal mines shut down in the 1950s and 1960s.

On the other hand, there is stress in the credit markets and jobless numbers are skyrocketing. How will people be able to afford a new home?

Coming into this crisis, US households had the highest savings rate and the best debt service ratios of the last forty years. The banks are the most overcapitalized and the most conservatively positioned they have been at any particular time in history. Sure, there could be some corporate problems. There is a lot of corporate debt outstanding, and a lot of it is attached to private equity investors who are trying to take advantage of being out of the public markets. But other than that, if you had to have a crisis like this, we’re about in as good a shape as you can be.

What’s your advice for investors against this backdrop?

Think about this: Back in 1999/2000, at the height of the dotcom bubble, everyone «knew» that as an investor, all you had to do was to buy these spectacularly successful technology stocks. But if you bet on them, you paid a very high price for very low odds. On the other hand, all the other stocks were ignored, and for those you got very high odds. So the lesson is that if you consistently bet on low odds companies, you are going to be wrong a certain percentage of the time, and the numbers aren’t going to work out for you. But if you buy meritorious things that get high odds and you do it in some kind of systematic and wise way, your outlook is much better. That’s the whole concept of value investing: Out of any hundred companies you are going to get about the same amount of luck. So how you do performance wise is determined by what you have paid for your luck. To put it simply: The luck is random, the price you pay is not random.

Which are today’s low odds stocks?

There are a lot of what are considered to be safe growth stocks, including the FAANGs and the Coca-Colas, the Procter & Gambles, the Costcos, the Visas and the Mastercards of the world. They went up to 30- or 35-times earnings. But there are few very large companies that end up justifying paying 30- or 35-times earnings for. That’s because what you pay for your luck matters.

Where do you spot better odds?

Look at energy, for example: The best thing that the energy sector has going for it is that price regulates price. If the price is low a bunch of production gets shut down, significantly reducing supply, which leads to raising prices. It’s not very complex. That’s why we like Chevron. They got lucky and didn’t buy Anadarko, so they have a strong balance sheet and they are in a position to buy up oil properties from significantly weak and smaller competitors. I wish we had more energy stocks, but the problem is finding companies with good enough balance sheets to buy. A lot of the companies in that area are too leveraged.

Earlier on, you were also invested in Occidental Petroleum. What changed?

We’ve sold it on the way down. We bought the stock way before the Coronavirus and the Saudi Arabian stunt. So sometimes you just get your head beat in and tip your cap to whoever beat your head. Then, you say: «I will never try to do it again». And of course, you will do it again, but you’re going to try not to get beat up.

Stocks may still go down further in the coming months. How do you avoid catching a falling knife?

You can’t buy value right now without catching a falling knife. But value has never been cheaper relative growth. Small and medium sized companies have never been cheaper compared to large companies. And, insiders have never been heavier buyers of stocks in small and midsize companies and value companies relative to the rest of the market, as today.

Another position in the Smead Value Fund is Berkshire Hathaway. What’s the bull case there?

Berkshire is an all-in bet on the US economy - and what’s cheap right now is economic optimism. Berkshire came in this nightmare with $128 billion in cash, about one quarter of the company's value. If Buffett and Munger deploy that cash well that should add a lot of value.

However, this summer, Warren Buffett is going to celebrate his 90th birthday. Charlie Munger turned 96 in January. Isn’t that a reason for concern?

Buffett is no spring chicken, but the company is set up to go on in perpetuity when he is gone. I don’t think anything could hurt the stock more than everybody in the United States being forced to be a prisoner in their own home for a couple of months. So, Buffett and Munger going away is probably beginning to be priced-in into the shares.

Where else do you see opportunities of investors?

We own 26 stocks and we don’t change that often. So most of the stocks we already owned we like. We have a diversified portfolio of companies ranging from Amgen, Merck and Pfizer to outstanding financial companies like American Express, JPMorgan Chase, Bank of America and Wells Fargo. We also own Target and Home Depot. We like all of them. But the ones that are most attractive right now are the ones that have gotten beat up the most in these circumstances like Discovery Inc.

Bill Smead

Bill Smead is the founder of Smead Capital Management, where he oversees all activities of the firm. As Chief Investment Officer, he is the final decision-maker for all investment and portfolio decisions. Mr. Smead began his career in the investment business with Drexel Burnham Lambert in 1980. He left Drexel Burham Lambert in 1989 as First Vice President/Assistant Manager and joined Oppenheimer & Co., where he stayed until joining Smith Barney in 1990. Mr. Smead remained at Smith Barney until September 2001 when he joined Wachovia Securities becoming the Managing Director/Portfolio Manager of Smead Investment Group of Wachovia Securities. In 2007, he left Wachovia Securities to found Smead Capital Management.
Bill Smead is the founder of Smead Capital Management, where he oversees all activities of the firm. As Chief Investment Officer, he is the final decision-maker for all investment and portfolio decisions. Mr. Smead began his career in the investment business with Drexel Burnham Lambert in 1980. He left Drexel Burham Lambert in 1989 as First Vice President/Assistant Manager and joined Oppenheimer & Co., where he stayed until joining Smith Barney in 1990. Mr. Smead remained at Smith Barney until September 2001 when he joined Wachovia Securities becoming the Managing Director/Portfolio Manager of Smead Investment Group of Wachovia Securities. In 2007, he left Wachovia Securities to found Smead Capital Management.
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