Long Duration Common Stock Investing A Contrarian Manifesto Presentations/092215.pdfMar 31, 2015 · A Contrarian Manifesto Should everyone index everything? The answer is resoundingly

© 2015 Smead Capital Management, All Rights Reserved. www.smeadcap.com

Long Duration Common Stock Investing

A Contrarian Manifesto

Presented by: Chief Investment Officer Bill Smead

Source: http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm



Should everyone index everything? The answer is resoundingly no. In fact, if

everyone indexed, capital markets would cease to provide the relatively efficient

security prices that make indexing an attractive strategy for some investors. All

the research undertaken by active managers keeps prices closer to values,

enabling indexed investors to catch a free ride without paying the costs. Thus

there is a fragile equilibrium in which some investors choose to index some or all

of their money, while the rest continue to search for mispriced securities.

Should you index at least some of your portfolio? This is up to you. I only suggest

that you consider the option. In the long run this boring approach can give you

more time for more interesting activities such as music, art, literature, sports, and

so on.

William F. Sharpe, 2002



Passive Investing vs. Active Investing

Valuation Matters

Long-Duration & High-Quality

Why extend duration now?

Source: Vanguard “The case for index-fund investing” March 2015, Figure 8

Passive vs. Active Investing

Argument for passive management

Source: Common Sense on Mutual Funds – 10th Anniversary Edition, John C. Bogle, pg. 158


Percentage of General Equity Funds underperforming the S&P 500 index

A more apples-to-apples comparison

Source: Morningstar 2012 Annual Global Flows Report: Figure 51


Passive continues to take market share

Source: Morningstar via FINRA Fund Analyzer, 2013


On top of a tough expense ratio differential

Average turnover of the S&P 500 from 1992 – 2014 was 4.41% per year

Source: Standard & Poors. See disclosure


1.18%

2.64%

3.78%

5.00% 4.58%

4.92%

9.46%

6.16%

8.91%

4.43%

3.82%

1.45%

3.10%

5.73%

4.54%

5.21%

3.87%

4.48%

3.73% 3.64%

4.37%

3.27% 3.05%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

S&P 500 Turnover 1992-2014

Turnover %

Mutual Fund Portfolio Turnover was 105% in 2009



Source: WSJ “The Hidden Costs of Mutual Funds”, March 1st 2010


High turnover increases trading costs

The Center for Retirement Research at Boston College

study on Fees and Trading Costs of Equity Mutual

Funds used in 401(k) plans:

A universe of thousands of U.S. stock funds average trading

costs of 1.44% of total assets

Average of 0.14% in the bottom quintile

Average of 2.96% in the top quintile

These real costs are not reported in expense ratios

Source: Financial Analyst Journal Jan/Feb 2013 “Shedding Light on “Invisible” Costs: Trading Costs and Mutual

Fund Performance”, by Roger Edelen, Richard Evans, and Gregory Kadlec


High turnover increases trading costs Financial Analyst Journal, Jan / Feb 2013


Source: Financial Planning Magazine “What’s in a Name?” June 1st 2010


Investors of Stock Portfolios Benefit

from Long Holding Periods

S&P 500 Risk and Return Characteristics for select holding periods 1950-2009

Source – Oppenheimer Asset Management Investment Strategy March 8, 2010

Passive vs. Active Investing Investors Buy High and Sell Low

Flows to Equity Funds Related to Global Stock Price Performance

Monthly, 2000–2013


Source: Guide to the Markets, JP Morgan Asset Management, as of June 30, 2015, page 65




Valuation Matters



Valuation Matters

P/E to Predict Earnings Growth: A Great Indicator

Source: GMO White Paper – “The Trouble with Value”, by Ben Inker, July 2005

Valuation Matters

P/E to Predict Next Year’s Return – Inverse!

Source: GMO White Paper – “The Trouble with Value”, by Ben Inker, July 2005

Valuation Matters

Fama / French: Valuation Effects in the US – Annually 1927-2012

Source: http://www.dfaus.com/philosophy/dimensions.html

In US dollars. US value and growth research index data provided by Fama/French. The S&P data are provided by Standard &

Poor’s Index Services Group. US small market data provided by the Center for Research in Security Prices, University of

Chicago. Non-US developed markets value data provided by Fama/French from Bloomberg and MSCI securities data. Non-US

developed markets small data compiled by Dimensional from Bloomberg, Style Research, London Business School, and

Nomura Securities data. MSCI World ex USA Index is gross of foreign withholding taxes on dividends; copyright MSCI 2013, all

rights reserved.

Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the

management of an actual portfolio. Compound returns have an assumed rate of return, are hypothetical, and are not

representative of any specific type of investment. Standard deviation is one method of measuring risk and performance, and is

presented as an approximation. Past performance is no guarantee of future results.

Valuation Matters

Source: “Growth versus Value and Large-Cap versus Small-Cap Stocks in International Markets”; W Scott Bauman; C

Mitchell Conover; Robert E Miller. Financial Analysts Journal; Mar/Apr 1998

Valuation Effects Internationally - 1986-1996

Valuation Matters

Source: http://www.dreman.com/about-dreman/the-potential-advantages-of-a-contrarian-strategy/

Source: Francis Nicholson study – shown in “Contrarian investment strategies: the next generation”,

By David N. Dreman; Pg 143

Valuation Matters Story holds true over static holding periods

Source: Stocks for the long run: the definitive guide to financial market returns, By Jeremy J. Siegel (Fourth Edition),

Figure 9-4 page 151

Valuation Matters




Valuation Matters



Long-Duration & High Quality

SCM’s Definition

Meets an Economic Need

Strong Moat

High and Consistent Profitability

High levels of Free Cash Flow

Strong Balance Sheet


Business Success leads Long-Term Returns, not Short-Term



Relative Performance of High Quality U.S. Stocks vs. Low Quality


75% of the “Intrinsic

Value” of a stock is

determined by the

cash flows 11 years

out or later

50% of a stocks value

is derived from cash

flows 25 years out or

more of a companies

life




Valuation Matters




Source: NYSE Facts and Figures

Average holding period may be finding a secular low

0

1

2

3

4

5

6

7

8

9

10

11

12

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

NYSE Holding Period # of Years


Source: High-Frequency Trading, Stock Volatility, and Price Discovery, page 41, by X. Frank Zhang / Yale University December 2010

High-Frequency Trading in Dollar Volume from 1995 Q1 – 2009 Q2

Why extend duration now? Price growth has reached among the highest

10-year rolling return in 210 years!

Source: Stifel Nicolaus / Barry Bannister March 31, 2015

Past Performance is not a guarantee of future results

Source: Commodities 1795 to 1890 are the Warren & Pearson index constructed with farm products, foods, hides & leather, textiles, fuel & lighting, metals & metal products, building

materials, chemicals & drugs, household furnishing goods, spirits and other commodities. 1891 to 1913 is the Wholesale Commodities Price Index from the BLS and other agencies.

1914 to 1956 is the PPI for All Commodities, and 1957 to present is the CRB CCI Index.

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

1805

1815

1825

1835

1845

1855

1865

1875

1885

1895

1905

1915

1925

1935

1945

1955

1965

1975

1985

1995

2005

2015…

2025

E

War of 1812 & Napoleonic Wars (1814

peak)

U.S.Civil War (1864 peak)

World War 1 (1920 peak)

Cold War (1980 peak)

U.S.$ debasement, EM growth

Commodity Price Index, 10-Yr. Moving AverageData 1795 to 2015 TTM

World War II & Korean Conflict

Easy credit speculative

boom

U.S. Industrial revolution & overheating/gold surplus

Source: Michael Pettis on Business Insider May 5, 2011

http://www.businessinsider.com/facts-chinese-consumption-2011-5#ixzz1QUiemrZJ

Commodities Headed Down: Unsustainable Demand


Source: Thomson Baseline

Bullish Stock Market Pre-Conditions: Oil vs S&P 8/83 – 12/99



Bullish Stock Market Pre-Conditions: Oil vs S&P 1/00 – 9/15




US Economy Cleansing Itself: Debt-Service Ratio

Source: Barron’s Cover April 29, 2013 “On the Rise”


Millennials are On the Rise


Demographics Demographics Demographics

Source: The Bank Credit Analyst, September 2013 “The Coming Baby Boom in Developed Economies”

Developed economies are about to experience a baby boom that will be bigger and longer-lasting than

even the one that followed the Second World War.

The entry of the Millennial generation into their prime childbearing years, along with the recouping of

births that were postponed both due to the recession and by the decision of many women to delay

having children until their thirties, will drive the first leg of this new baby boom

Continued progress in creating more family-friendly labor market institutions in developed economies,

increased gender equality, rising incomes, as well as cultural and possibly genetically-driven shifts in the

composition of populations towards more fecund individuals will all power the second leg of the baby

boom.

Faster population growth implies stronger aggregate demand in the near term and more rapid supply

growth over the long haul. Equities, housing, and commodities should benefit.

Properly measured, U.S. fertility rates are already well above the baseline used by the government in

projecting future fiscal trends. Our estimates imply a fiscal surplus of 4% of GDP by the end of the

century, even if current entitlement programs are not scaled back.

- The Bank Credit Analyst, September 2013


Housing


Small Cap’s relative strong stretch is 10 years and counting

Source - Bespoke: “Large Caps vs. Small Caps” March 9, 2010; Thomson Reuters Baseline




Large disparity between High-Quality and Lower Quality

High-Quality long-duration companies are out of favor


Source – Thomson Reuters Baseline

S&P 500

MSCI Emerging Market

Stock Selection is hugely Out of Favor: High Correlation is Peaking

Source – http://systematicrelativestrength.com/2013/09/19/from-archives-inherently-unstable-correlations/




Advantages of Passive Investing

• Lower Trading Costs caused by Low Turnover

• Lower Expenses

• Longer Holding Periods (Benefit from the Fundamentals

of Portfolio Companies)

A Prescription for Active Investing

• Long Duration Companies (High Quality)

• Valuation Sensitive

• Low Turnover

Conclusion

Definitions

S&P 500 Index: A market-value weighted index consisting of 500 stocks chosen for market size, liquidity, and

industry group representation.

MSCI Emerging Markets Index: An index created by Morgan Stanley Capital International (MSCI) that is designed to

measure equity market performance in global emerging markets. The Emerging Markets Index is a float-adjusted

market capitalization index.

Fama French U.S. Large Value Index: Provided by Fama/French from CRSP securities data. Simulated strategy of

the upper-half market cap, upper 30% book-to-market NYSE, excluding utilities.

Fama French U.S. Large Growth Index: Provided by Fama/French from CRSP securities data. Simulated strategy of

the upper-half market cap, lower 30% book-to-market NYSE, excluding utilities.

Leverage: The relationship of debt to equity.

Beta: A measure of return volatility.

Earnings Volatility: A measure of earnings consistency.

Profit Margin: The ratio of net income to net sales of a company expressed as a percentage

Price/Earnings (P/E): the ratio of a firm’s closing stock price & its trailing 12 months’ earnings/share.

Price/Book (P/B): the ratio of a firm’s closing stock price & its fiscal year end book value/share.

Book value: is the net asset value of a company, calculated by subtracting total liabilities from total assets.

Free Cash flow: measures the cash generating capability of a company by adding non-cash charges (e.g.

depreciation) and interest expense to pretax income.

Price to sales ratio (P/S): is a tool for calculating a stock's valuation relative to other companies, calculated by

dividing a stock's current price by its revenue per share.

Book Value: A company's common stock equity as it appears on a balance sheet, equal to total assets minus

liabilities, preferred stock, and intangible assets such as goodwill.

Sharpe Ratio: A measure or reward-to-variability ratio is a measure of the excess return (or Risk Premium)

per unit of risk in an investment asset.

Definitions (cont.)

Dow Jones 30: This is the Dow Jones Industrial Average which is a price-weighted average of 30 actively traded blue

chip stocks, primarily industrials. It is one of the most widely used stock market indicators.

S&P 500 Growth Index: Each stock of the S&P 500 Index is categorized as being either value or growth companies

based on its price-to-book ratio and growth estimates. The S&P 500 Value Index contains those securities with higher

price-to-book ratios and growth estimates.

S&P 500 Value Index: Each stock of the S&P 500 Index is categorized as being either value or growth companies

based on its price-to-book ratio and growth estimates. The S&P 500 Value Index contains those securities with lower

price-to-book ratios and growth estimates.

Cash Flow: A revenue or expense stream that changes a cash account over a given period.

Debt/Equity: A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders'

equity.

ETF: a mutual fund that is traded on a stock exchange

Mutual Fund Portfolio Turnover: A measure of the trading activity in the fund's portfolio of investments. In other

words, how often securities are bought and sold.

Trading Costs: The amount of brokerage commissions paid for buying and selling securities.

Dividend Yield: The dividend per share expressed as a percentage of the share price.

Price to Cash Flow (P/CF): The price/cash flow ratio is a ratio used to compare a company's market value to its cash

flow. It is calculated by dividing the company's market cap by the company's operating cash flow in the most recent

fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-

share operating cash flow.

Russell 2000 Index: The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the

Russell 3000 Index.

Cap-Weighted Turnover: Portfolio turnover that is computed by taking the total market value change in a

portfolio/index and dividing that by the index/porfolio’s total market value.

Definitions (cont.)

Sharpe Ratio: A measure of the excess return (or Risk Premium) per unit of risk in an investment asset.

Standard Deviation: The statistical measure of variance from the mean representing the dispersion of data (distance)

from the mean.

Correlation: A measure of relationship between two mathematical variables or measured data values.

MSCI All Country Total Return Stock Index: The index includes a collection of stocks of all the developed and emerging

markets in the world, as defined by MSCI.

S&P 500 Turnover: Capitalization weighted turnover is calculated by adding the market value of company additions,

company deletions, share issuances, share repurchases, special dividends, quarterly share and investable weight factor

changes in the index during the year, divided by 2 and then divided by the average market value of the index over the

year. From 2009 inclusive the turnover calculation is slightly changed. All remains as was described above only the

calculation is done on a daily basis and summed for the period. The average of close and adjusted close market cap for

the day immediately preceeding the market capitalization change date is used in the denominator to calculate that day's

turnover.

200 day Commodity Chart: Source: Commodity prices are from Historical Statistics of the United States, a U.S. Census

publication, and Moody’s Economy.com (Thompson/Reuters CRB Futures). We use the PPI for All. Commodities from 1795

to 1956 (12-mo. Avg.) and the CRB Futures for 1957 to present (12-mo. avg.). The last data point is the 10-year moving

average from 2002 to 2011 of the y/y change, with the 2011 value being Feb-16, 2011 divided by Feb-16, 2010. The S&P

500 and long-dated U.S. stock market total return is from “A New Historical Database for the NYSE 1815 to 1925:

Performance and Predictability” written by the Yale School of Management, used with permission. This paper can be

downloaded without charge from the Social Science Research Network Electronic Paper Collection. Post-1925 data for

stocks are from Ibbotson/Morningstar and Standard & Poor’s. Note that the stock market return included dividends. Chart

formats and annotations are Stifel Nicolaus & Co.

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Long Duration Common Stock Investing A Contrarian Manifesto Presentations/092215.pdfMar 31, 2015 · A Contrarian Manifesto Should everyone index everything? The answer is resoundingly