Market Undervalue of Long Haul Companies

Jason Stipp: I'm Jason Stipp for Morningstar. After a one-year anniversary of
the market bottom in March 2009, and a 60%-plus run up in the
S&P 500, investors may naturally be wondering where are the
values today. Bill Smead, CIO and CEO of Smead Capital, and
also the portfolio manager of the Smead Value Fund, says some of
the values are right under our nose in some of the best-known
American companies. He's here with me to tell us a little bit more
about that.

Bill, thanks for joining us today.

Bill Smead: Thank you.

Jason Stipp: As I'm looking over your portfolio, it reads like a who's who of
American companies. There's Microsoft, eBay, Starbucks, Merck,
Disney. These companies are very well known, nobody would say
that they're under-followed, but you're saying that you're able to
pick some of these companies up at good values.

So that basically means that you're taking a position that the
market seems to not agree with. In your thinking, when you're
looking at such well known companies, how do you get
comfortable with the fact that you're buying them at a value and
that the market is wrong?

Bill Smead: Two things. Ben Inker at Grantham Mayo did some wonderful
research that shows that 75% of the intrinsic value of a business
comes from cash flows more than 11 years from now. So in a 10-
year time period, when the stock market goes down, people have
compacted the duration of how long they want to own a stock. And
as they compacted the duration, they more and more undervalued
the long-durational businesses.

You folks do some great work on moats in your stock research and
your mutual fund research. Moats are the kind of thing that cause a
long duration. So long duration characteristics are dramatically
undervalued in the marketplace, and if there's a theme in our
portfolio, you can see long duration companies.

We think that their earnings leverage going forward from the
economy coming back, and then their 20-, 30-, 40-year histories,
the intrinsic value today is way above the current stock prices.

Jason Stipp: I think it's surprising, the fact that these are very stable companies
in a market environment that we just went through over the last
two years. It seems like the market would be looking for
companies that would be around for so long. So why such short
term, what's behind that?

Bill Smead: What's behind that is the rearview mirror. Everyone invests in a
rearview mirror, and the last five, or six, or seven years, the
rearview mirror said commodities, basic materials, heavy
industrials, oil. And so investors have been trading that, trading
that, trading that, and now it's a very crowded trade. Everyone is
heavily invested in energy, basic materials, and heavy industrial.
And while they got heavier and heavier in that, they got lighter,
and lighter, and lighter in recession-resistant, durational companies
that provide products and services that people use every day.

Jason Stipp: Another thing that investors seem to be doing very much these
days is they're very jittery. It seems like any little bit of news that
comes out that could be negative, they think, oh, the sustainability
of the recovery is in question now, and the market has been
bouncing around, especially since the beginning of the year.
What's your take on this so-called, "Wall of Worry," and the
opportunities that it may present? And is it just very short-term
thinking, or what's behind that?

Bill Smead: There's a whole group of people that are participating on the long
side of the stock market that we call "closet bears." They've got
one foot in the market, and they've got one foot out of the market.
For example, in our opinion, since they're not long durational, if
you're heavy in cyclical right now, you've really got one foot out
the door. You're just saying, OK, I'll play these stocks for the next
six months while the U.S. economy strengthens, but as soon as any
sign of hurt, I'm out.

Or, they and advisors of folks who are using ETFs because of the
ease with which you can get in and out of the market are basically
participating with one foot out the door. So, what you don't see, is
you don't see inflows to long duration managers who are buying
long duration companies and holding for longer periods of time
with low turnover, which of course is really what helps beat the
market. If you want to beat the market, select outstanding
companies and keep low turnover, and keep your costs down.

Jason Stipp: Take advantage of that so-called time horizon arbitrage.

Bill Smead: Exactly. Match the duration of the companies with the duration of
time you need to be invested.

Jason Stipp: A lot of your philosophy seems to be in line with Warren Buffett,
and Berkshire Hathaway is one of your holdings. Buffett's annual
letter a couple of weeks ago mentioned, "Hey, look guys. Best
days for Berkshire may have been in the past. We may not do
much better than the market going forward."

Now, he may be being a little bit humble there, but if that is the
case, if it's true that we won't see the same kinds of returns in
Berkshire that we've seen, what's the investment case for holding
that today?

Bill Smead: Well, of course, it's less of a case than it was at the start of the
year, because by being added to the S&P 500 Index, it caused a
pretty strong rally in the stock.

We have one industrial company, one small holding in an oil
company, and other than that, no economic sensitivity. Warren
Buffett has a beautiful conglomerate of economically sensitive
companies that have great management.

So, for us, it's a little leverage on the economy improving the next
couple of years. So, it's been a Hall of Fame company in the past,
if Warren Buffett lives another 10 years, it will probably continue
to be a Hall of Fame company, but are we buying it today in
expectation of holding it for 20 years if it works the way some of
our other companies are? I'd say no, but it's a great way to play the
economic recovery the next couple of years.

Jason Stipp: Sure. Bill Smead, portfolio manager at Smead Value. Thanks for
joining us today.

Bill Smead: Thanks, Jason.

Jason Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.