Interview

«The Inflation Wolverine Is Out Once Again»

Bill Smead, founder of Smead Capital, expects an aggressive inflation surge like in the seventies. In this interview, the battle-tested value investor reveals where he finds attractively priced stocks in today’s challenging market environment.

Christoph Gisiger
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Deutsche Version

The new year is starting with a bang: Bond yields have jumped sharply in the last few days. In the U.S., the yield on ten-year Treasuries is trending toward 1.8%, its highest level since the outbreak of the pandemic.

«When you’re buying Occidental Petroleum, you’re short bonds and long oil»: Bill Smead.

«When you’re buying Occidental Petroleum, you’re short bonds and long oil»: Bill Smead.

At the same time, a strong sector rotation has set in. Richly priced growth stocks are «out», cheaply valued value stocks are «in». So who better to ask about the current market environment than Bill Smead? The founder and Chief Investment Officer of Smead Capital has more than forty years of investment experience and specializes in value stocks.

In an in-depth interview with The Market/NZZ, which has been edited and condensed for clarity, Mr. Smead tells us why he believes the risk of sustained high inflation is significant and where the biggest risks in the stock market are. He also says which companies he believes have the most potential under today’s challenging conditions.

Mr. Smead, the stock market is experiencing a pretty rough start to the new year. How do you assess the current situation?

As an investor, what you’re trying to accomplish is the period when things are going your way. But today, the difficult part is that you’ve had a whole lot of really dumb, financial euphoria, momentum-based money chasing stocks. You knew at some point they were going to get into trouble.

Are you referring to the hype around «hot» tech names and meme stocks like AMC?

Unwinding a financial euphoria episode is difficult. It doesn’t happen all at once, it happens over stages. What’s pretty obvious so far is that the profitless total addressable market stocks are being ripped to shreds. That’s where the carnage started. It’s like Warren Buffett and Charlie Munger said in the past: You get into a phase where almost every single discipline has worked. So when the bell rings at 9:30 in the morning on the New York Stock Exchange, everybody lines up at the trough to be fed because they think that God has decided that they all should get rich together.

However, the broad market has so far remained quite stable. The S&P 500 has given up only 3% since its record high at the end of 2021.

In life, every single worthy endeavor is built around a small group of people gaining the success from that endeavor: There are only so many professional golfers, only so many top-football players in Europe’s premier leagues and only so many outstanding basketball players in the world: the cream of the crop. But at the stock market, every fifteen to twenty years, people drink the Kool-Aid and think that they all deserve to succeed.

So what do you think will happen next?

I think of it this way: In the United States, we have these community fireworks shows on 4th of July, and at the very end, you have a spectacular display. I wonder if the Omicron variant is this spectacular burnout, the shooting star of the show. In other words: It spreads way faster than the other strains, but it also seems to burn out faster, just like a shooting star. That may signify that the virus is running out of ways to cause the kind of permanent damage that the stock market is fearing. So the question is how will people feel in a month when that thing has come and gone already.

Where could investment opportunities open up in this respect?

In the old days, before we started our company, I ran separate accounts. When a new customer would come in, I would apply the most money in that account to the things that looked the cheapest to me at the moment. Looking at our portfolio today, what sticks out as some of the most screaming buys are our two shopping mall REITs, Simon Property Group and Macerich.

What makes you so optimistic about these two stocks?

Think about this: In mid-December, the new Spiderman movie opened in the U.S., and it scored the second-best domestic debut of all time. To me, that proves investors drastically underestimate the value of being a landlord of shopping, restaurant and entertainment experiences once we get past the virus.

What specifically speaks for Macerich and Simon Property Group in this context?

The virus scared everyone. Therefore, the market assumed that people would no longer gather in public places to entertain themselves. We think unequivocally that’s wrong. Also, the further away from the downtown cores in the metropolitan areas you are, the more attractive your assets are because your proximity will be closer to people’s houses. Simon Property Group and Macerich own wonderful suburban property in some of the most attractive suburban areas in the country.

Where else can you find investments with upside potential?

Compared to the oil price, stocks of energy companies are significantly lower than they have been in the past. That’s because of what I call the ESG discount: The enthusiasm people have for ESG. The massive amount of capital that’s been thrown at ESG friendly stocks is not dissimilar to the capital that has been thrown at profitless total addressable market stocks. But here’s the problem: There is no money to be made temporarily in buying into ESG companies because most of them are brand new companies. It’s just a giant «needle in a haystack» session. It always ends badly because nobody is good enough to find the right needles in the haystack. Thus, there is massive capital being wasted in a very careless and foolish manner.

What does that mean in terms of your investment strategy?

The ESG discount is available to be taken advantage of. Let me give you an example: The first ESG discount was on tobacco. In 1968, the U.S. government mandated that cigarette commercials be taken off the broadcast networks. Philip Morris could no longer run the Marlboro Man commercials on television. In the next forty years, adult smoking in the U.S. dropped from 40% to 20%, and the price of a package of cigarettes went from 20 cents to $5. At the same time, the taxes went from 5 cents to $2.50 a pack. Yet, Philip Morris was the best performing stock on the New York Stock Exchange from 1968 to 2008. That’s because when you’re going from getting 15 cents a pack to $2.50, you don’t care that you have half as many smokers.

So what does this have to do with the energy sector?

That’s where oil and gas stocks are right now. They are the tobacco stocks of the late sixties. Sure, it’s likely that there will be dramatically fewer carbon transportation vehicles on the road forty years from now. But it’s not likely that there will be less total need in the world for oil and gas since they are the least expensive sources of energy. In the U.S., if we didn’t have natural gas and combustion turbines for generating electricity, we would be up a creek without a paddle right now. Wind and solar are still a couple of decades away from reaching critical mass. It’s just simple math: Our investments are contrary believes in how long it’s going to take for the energy transition, and how incredibly attractive gasoline and natural gas are in comparison to renewable sources of energy.

However, stocks of oil and gas companies have already recovered significantly since the low in spring 2020.

Let me put it like this: Today, the oil price is essentially where it was in the summer and fall of 2018. At that time, the shares of Continental Resources - which we own - were priced at about $60-65. Today, the stock trades at around $49. To me, that difference between that $60-65 and $49 is the margin of safety, the ESG discount. And that’s what you want to do: You want to invest with a substantial margin of safety.

In addition to Continental Resources, you also hold Chevron, ConocoPhillips and Occidental Petroleum in your portfolio. Why do you favor these names?

Conoco and Chevron have powerhouse balance sheets. In the case of Continental Resources, 82% of the stock is owned by Harold Hamm, the founder of the company. And here’s the bull case for Occidental Petroleum: For long-term investors, two of the best bets out there are long oil and short bonds - and that’s what you do when you invest in Occidental Petroleum. Similar to a short sale where you borrow shares, they sold bonds to acquire Anadarko Petroleum in 2019, and they likely can buy those bonds back later at a lower price. So when you’re buying Occidental Petroleum, you’re short bonds and long oil.

In essence, this is primarily also a bet on inflation. How serious do you think the risk is that prices for goods and services will continue to rise at an accelerated pace?

The economic profession is treating inflation like it is a friendly puppy dog. They think you can take it out of its pen and play with it for a while. The popular theory is that you bring it out in a severe dip in economic activity, and when the economy gets back on its feet, you kindly ask inflation to crawl back into its pen like any good puppy dog would do. Unfortunately, most economists aren’t old enough to have been conscious of the inflation of the 1970s. It was a wolverine, which was let out of its den. We believe that those circumstances are being repeated.

Why specifically a wolverine?

The wolverine is nature’s nastiest creature. It’s just a vicious, very strong, violent animal and it’s powerful way past its size. It’s not a domesticated animal. The wolverine lives in high-elevation mountainous and bitterly cold places. It’s also called a «skunk bear». It has no natural predator and it can kill other animals that are much bigger. So when we bring out inflation out of the closet on purpose to try to create an economically positive environment, we’re playing with fire.

Yet, the Federal Reserve is now stepping sharply on the brakes and has recently signaled three interest rate hikes plus a balance sheet rundown for this year. Are you worried that inflation is getting out of control?

In the late sixties and early seventies, the U.S. government provided the kind of northern terrain that the inflation wolverine likes to live in. We had very loose fiscal spending due to the Vietnam war and LBJ’s Great Society. What’s more, we saw the largest increase in the 25–45-year-old population in U.S. history as 79 million baby boomers replaced 44 million silent generation folks in that age bracket. That meant that too much money was chasing too few goods, the classic definition of inflation. On top of that, OPEC decided to embargo oil to the U.S. The price of oil exploded to the upside, and shortages developed quickly. In other words, the inflation wolverine was being fed by circumstances which exacerbated its damage to both the economy and the stock market.

And what are the parallels to today?

Today, we have 90 million millennials replacing 65 million GenXers in the key 25–45-year-old age bracket. And, we fought the pandemic war, not the Vietnam war. We also borrowed $5 trillion because we had to shut down the economy for a while. And in early April 2020, the Saudis cut the legs of U.S. oil production by taking the oil price to almost zero. Putting all these things together, the inflation wolverine is out once again. It always shows up first in houses and cars, just like the deflation from 2007 to 2009 showed up first in houses and cars.

How can investors best position themselves in an environment of structurally higher inflation?

If the millennials just do something similar as prior generations, we are massively underbuilt homes in the U.S. We now have 90 million people that might want a home vs 65 million in the prior generation. And here’s the weird deal: When you buy a home at a 3% mortgage rate like today, you are effectively being given money: Inflation is running at 5%, so to be given borrowed money at 3% to buy an appreciating asset like a house is basically the same thing as being given the money.

The housing market is already experiencing a huge boom. Doesn’t this mean there is a risk of renewed excesses, as in the last real estate bubble?

Not adjusted for inflation and for population. Let me give you an example: In 1972, we built 1.15% of the population in new homes. And in 1978, we built 0.95% of the population in new homes. Last year, we built about 1 million homes in a 330 million population. That’s just 0.3%. That means there is a lot of room to growth for the homebuilders. On top of that, there are two big changes in that industry that aren’t well reflected in the share price of these companies.

What are those changes?

First, it used to be a highly fragmented industry. In 1994 for instance, the largest homebuilder, D.R. Horton, built 1% of the homes in the United States. Currently they’re building 10% of the homes. In our portfolio, we own three of the four largest home builders: Lennar, NVR and D.R. Horton. In aggregate, the three of them are going to build about 22% of new homes. What’s more, in an unfragmented industry, you gain a lot of benefits of scale. For example, at a company like Whirlpool which manufactures appliances like refrigerators, stoves, freezers etc., our big home builders get their pick of the product litter. Their scale makes them the beneficiary of the scarce stuff.

And what is the second change?

The home builders used to be property developers. They built a home on the property to get the land turned over. Their business model was similar to a restaurant: The more times in a day you can resell a table, the more money you make. In the same way, the homebuilders used to be land-turnover people: They would buy land, do all the work associated with getting the permits and development etc., kept the land five or six years, and then they wouldn’t recognize the gain from it until they put a house on it and sold the lot. As a result, at the top of each cycle they would end up with a whole bunch of lots and borrowed money to own the lots.

What does their business model look like today?

NVR doesn’t develop any of their lots. D.R. Horton only develops 24% of their lots, and Lennar only develops 40%. That means that the lack of fragmentation, and moving from being land developers to being home manufacturers makes their business drastically less cyclical. Also, their balance sheets are strong. Even though the price of houses has gone up a lot, they’re not borrowing money to buy new lots. Yet, their stocks are being priced as if they were the same cyclical businesses they always were.

There are virtually no tech stocks in your portfolio. Qualcomm is one of the rare exceptions. Why are you holding on to this name after the significant rally in the chip sector?

Qualcomm has an addictive legal drug: patented intellectual property. And they’re as good at that as anybody. The stock trades at an attractive valuation, and they are expecting pretty good earnings growth. In general, we hold our winners to a fault because of the math of common stock ownership: If you buy a stock at $30 in cash, the worst thing that could happen is it goes to zero. But there isn’t a best thing that can happen. In theory, there is no upside limit to a stock. That’s why we hold our winners to a fault compared to most money managers. But we could probably demonstrate that we could even hold them to a double fault and benefit our investors.

Then again, Disney is no longer in the portfolio of the Smead Value Fund. Why?

We just decided to get away from our growth stocks that were trading at very high multiples: Disney, Accenture and Starbucks. They all have nosebleed multiples and look maniacal to us. Also, somebody else is running Disney now. Bob Iger was to Disney what Walt Disney was to the company and what John Wooden was to UCLA basketball. So ask yourself: Which coach takes the place of the all-time greatest coach and has a lot of luck in the next few years? It’s the same thing if you are a weather forecaster: If you are predicting sunshine, you prefer it to be after an extended period of rain. You don’t want to come in after it’s been sunny for three weeks and predict sunshine.

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. The Smead Value Fund manages about $2.5 billion in assets. The European Ucits fund with the same positions has just under $215 million. 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. The Smead Value Fund manages about $2.5 billion in assets. The European Ucits fund with the same positions has just under $215 million. 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.