Contrarian Manager Wins by Buying Newspapers, Avoiding China

Bill Smead
Bill Smead, of Smead Value Fund. Source: Smead Fund, via Bloomberg

The classic contrarian investment strategy is to buy what everybody hates and sell what everybody loves. The trick is to uncover valid reasons for why the consensus is wrong. Bill Smead has proven expert at doing just that. The manager of the Smead Value Fund, which holds just 26 stocks, has delivered a 15.2 percent three-year annualized return, besting 97 percent of his large-cap blend peers while investing in such hated industries as newspapers. Unlike many of his rivals, he’s bullish on the U.S. while avoiding companies exposed to China. Lewis Braham spoke with the Seattle, Washington-based investor.

Q: You’ve had better performance with less downside risk than peers, even though concentrated funds like yours tend to be volatile. How do you manage volatility?

A: We have several criteria for screening stocks that reduce volatility. We like companies with strong balance sheets, wide economic moats in industries with high barriers to entry, long histories of profits and dividends, price-earnings ratios below their 10-year average, strong insider ownership and shareholder friendliness with regard to allocating capital. Insider ownership helps align executives’ interests with investors. When you invest alongside savvy millionaire executives, it’s amazing how they’ll want to make you wealthy while they become wealthy themselves.

Q: Why have you outperformed?

A: The biggest reason is we're overweight consumer discretionary companies and are bullish about the U.S. economy. We want to own U.S. companies with addicted customer bases, which have a lot of leverage in unemployment dropping to 4 to 5 percent over the next four or five years. We own Disney, Starbucks, EBay, Cabela’s, Home Depot. These stocks benefit most from an improving economy. If you look at other value managers, they’ve leaned heavily on consumer staple stocks because they’re defensive and assume the U.S. will have a hard time. Very few highly thought-of managers are optimistic about the future like us.

Q: Why are you optimistic?

A: The U.S.’s cleansing of its credit problems started over four years ago. Europe’s cleansing is about 1½ years old and China’s is just starting. In what endeavor of life does it not pay to have a four-year head start? What you do in a cleansing is expose fraud, expose bad investments, write off bad loans, recapitalize banks -- you get public companies to get their financial house in order, you get citizens and households to live within their means. All the kinds of things that have to happen to lay the groundwork for a solid economy in the future. It’s long past the time for anyone to bet that the cleansing isn’t going to work because it has.

Q: Why do you own Gannett?

A: A lot of people think the newspaper business is dying. Warren Buffett doesn’t and we don’t. Gannett trades at four times cash flow and they retired $3.3 billion of debt in the last five years, raised dividends 150 percent and are doing stock buybacks. Maybe Gannett doesn’t last 50 years but at the price we’re paying, it only needs to survive like, five for someone who owns the stock to get their money back. If it lasts longer  -- say 15 years -- it will be a great investment. Professional journalism is probably the most undervalued it’s been in my 54 years of life. We get a free bet on the newspapers with this stock, as Gannett also own 23 television stations and and other Internet-based properties. We’re paying about $15 a share and it’s worth at least $25.

Q: What sectors are you avoiding?

A: We've avoiding capital-intensive sectors that require lots of debt and equity to grow—utilities, telephone companies, industrials, basic materials and energy. They do well when interest rates are low and borrowing is cheap -- and do badly as rates rise and borrowing becomes expensive. As rates rise over the next 20 years, capital-intensive businesses will be valued dramatically lower. Another reason we’re avoiding energy, basic materials and heavy industrials is we believe China is having a hard landing that will severely damage companies in sectors doing business with it.

Q: Why do you think there will be a hard landing?

A: If you study economic history, the bigger the boom, the bigger the bust. The best historical analogy for China is the U.S. in the 19th century. The U.S. grew 9 percent compounded from 1800 to 1900. But during those 100 years, we had 18 recessions, three depressions and three all-out panics -- and by the way, we took time out in the middle to slaughter 500,000 people in the Civil War. Where China is now is comparable to the biggest and one of the worst four-year depressions the U.S. had in the 1800s, when we overbuilt railroad systems out West and there was nobody to ride them.

The bust comes because the things you built in the boom don’t pay the rent and whoever loaned money loses that money. In China, they built the Olympics bird’s nest stadium and high-speed railroads and there’s virtually no profit coming in from those investments, so whoever loaned money is not going to get paid back.

Q: Although you like high-quality stocks, you also own financial companies like Wells Fargo and Bank of America. Given the problems in the sector, what's the appeal?

A: I’m excited about the domestic economy, so financials relate to that. Wells Fargo is taking share from competitors weakened by the financial crisis. And because it bought Wachovia with a backstop from the government, it has an amazing number of foreclosed homes on its balance sheet, as do Bank of America and JPMorgan. All three own a lot of housing. That is a very good thing because there are 85 million baby boomer kids who are an average age of 28 that have been slow to marry, buy a house and have kids. They will get married, buy a house and have kids. Meanwhile BofA trades for less than its subsidiary Merrill Lynch would be worth trading as a public company on a stand-alone basis. So we get the largest bank deposit base in America and one million foreclosed homes for free.

(Lewis Braham is a freelancer based in Pittsburgh.)

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