Dear Fellow Investors:
What do Obamacare, Federal Government debt/budget deals, Quantitative Easing and jobs data have in common? To us they are all types of macroeconomic factors on which most investors focus. We believe the reason most investors focus on these types of news stories is because they can influence the US stock market over the next six to twelve months instead of the next 10 to 20 years. In this missive, we would like to challenge everyone’s thinking about their ultimate goal for investing in the stock market and the behaviors which lead to wealth creation. In other words, who wants to be a wealth creator?
Billionaire investor Warren Buffett describes investing this way:
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
At Smead Capital Management, we look at our partial ownership of businesses the same way we believe the buyer of a stand-alone private business would. The free cash flow of the business is the portion of the business profit which the outright owner is free to do with whatever he or she wants. In theory, how much the business is worth ten years from now, for an outright owner, is determined by the present value of the future stream of free cash flow. Free cash flow is the equivalent of rent for the long-duration common stock owner.
Over ten years, will Obamacare even be an important variable in the value of Merck (MRK), Amgen (AMGN) and Walgreen’s (WAG)? To us, these three companies meet an economic need which will exist in ten years (the need for medicine) and have proven over decades that they generate massive free cash flow in the process of meeting that need. Jim Collins, in his book Great By Choice, reminds us that “great” companies make the best of difficult exogenous circumstances and the best of favorable ones. Will Obamacare be any different?
The US government has the highest percentage of debt to GDP since after WWII. The political parties currently appear to be at loggerheads because it seems that one party believes that taxes need to be raised to balance the budget, while the other seems to believe that spending is the problem. When one party gets the upper hand, taxes go up and when the other party gains power, taxes go down. Did I just describe the best possible scenario for the country’s largest tax preparation firm, HR Block (HRB)? From our view, this company feasts on changes in the tax code and generates high free cash flow. We believe that housing will make a huge comeback in the next five to ten years and blue-collar employment will soar. It would seem to us that HRB is the tax preparer of choice for blue-collar Americans.
From our vantage point, it appears that most investors in the US stock market fear the elimination of the Fed’s Quantitative Easing (QE) program and the normalization of market interest rates. In the short run, these fears could be useful, but in our opinion could block you from behaving like a wealth creator.
Three of the major US banks are Wells Fargo (WFC), JP Morgan (JPM) and Bank of America (BAC). We believe that if QE disappears and interest rates normalize, it will be because of a sustained and un-aided recovery in the US economy. These banks stand to gain from this in three obvious ways. First, their moat has grown because there are far fewer banks than six years ago. Second, they are over-capitalized and would love to make loans to 86 million US echo-boomers as they marry, have kids, buy houses and buy cars which will fit a car seat. Third, we contend that higher interest rates can rejuvenate the free cash flow of these financial behemoths by expanding the spread between deposit rates and loan rates.
Demographics will drive the jobs data in the US over the next five years and they are very favorable. The US had 220 million people in 1977 and was seeing the baby-boomers come of age in 1978-88. In 1978, we had 1.4 million single family housing starts in the US, even though interest rates were at double-digit levels. How many single family housing starts could be needed over the next ten years to meet “pent-up demand” from 25-35 year old Americans whose lives were postponed for five years by the 2007-2009 financial meltdown? WE HAVE 315 MILLION PEOPLE IN THE US TODAY, SO WOULD 2 MILLION SINGLE-FAMILY HOUSING STARTS IN A SINGLE YEAR BE OUT OF THE QUESTION IN THE NEXT FIVE TO SEVEN YEARS?
Based on research from Bank Credit Analyst, demographics could overwhelm policy makers and economic forecasts in the next 10 to 20 years. Homes are built by domestic blue-collar workers. The inputs are created domestically for the most part (think paint, lumber, concrete, etc.) by blue-collar workers as well. The multiplier effect of housing starts could overwhelm the subjects of “income inequality” and minimum wage levels, as blue-collar trades people and workers at input companies get paid handsomely for meeting the demand for their products.
We believe the free cash flow of companies like Berkshire Hathaway (BRKB), which deals directly with housing, could be immensely higher in ten years. Mr. Buffett has said that he considers his company an “all-in wager on the economic future of the United States.” They own a paint company, a carpet company, a railroad, a residential real estate brokerage, big banks, a manufactured-housing manufacturer and we could go on and on. We also believe that blue-collar trades people (whose incomes have been stagnant, but stand on the doorstep of a better era) like to shop at Cabela’s (CAB) and will join the already enthusiastic folks frequenting the store currently. They and people from many other walks of life who have been negatively impacted by the financial meltdown could shop at the Nordstrom Rack division of Nordstrom (JWN) when confidence rises and incomes improve. Both of these companies intend to rapidly expand the number of stores over the next four or five years to meet the demand and they are financing this expansion out of free cash flow. We believe that those are the kinds of things we should think about rather than macroeconomic factors.
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 www.smeadcap.com.
© Smead Capital Management
