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Long-Haul Companies Look Undervalued

Jason Stipp

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.

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?

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 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.

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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?

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.

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?

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.

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

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

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?

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.

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

Smead: Thanks, Jason.

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