«Investors Act Like a Herd of Sheep»

Bill Smead Chief Investment Officer of Smead Capital Management warns of a 1987 like stock market crash and explains where he nevertheless spots attractive opportunities for long term investors.

Bargain hunters have a hard time in today’s financial markets. That’s especially true in the United States where equity valuations – even after the recent correction – remain at elevated levels and the enormous popularity of stocks like Amazon (AMZN 3106.27 -0.18%) and Netflix (NFLX 499.52 0.18%) has caused the market to narrow significantly. «Right now, we have the highest concentration of technology in the S&P 500 (SP500 3294.62 0.72%) since the end of 1999», observes Bill Smead. The renowned value investor from Seattle warns that this will end ugly and lead to a 1987 like market crash. Nonetheless, the founder of Smead Capital Management sees no reason to panic for astute investors. He argues that the American economy is on solid ground and will accelerate in the coming years when the millennials are going to fuel consumption. As a field-tested contrarian, he spots buying opportunities in sectors like old media, retail and biotech.

Mr. Smead, the stock market has lost steam. Four months into 2018, the S&P 500 is basically trading at the same level as at the beginning of the year. How concerning is this slump?
Historically, the S&P 500 spends about 80% of its time doing a pretty good job of representing the overall market. But 20% of its time it represents over popularity of just a few sectors. That’s because investors often act like a herd of sheep which are notorious creatures of habit. They will go to a pasture and it starts out being green pasture. But then they will graze until there is nothing green left and they will start digging in into the roots and stuff until it’s unhealthy.

And what’s the analogy regarding the stock market?
Investors act like sheep by continuing to walk through the same ruts to feed at the same trough. And that’s what happens to the S&P 500. It has no ability to transfer money away because it’s a capitalization weighted index. And right now, it is a glorified growth stock index. In the prior four years until early 2018, around 60% of the gain of the index came from seven of the 500 companies. That is unbelievably narrow. So the old rule is that narrow markets end badly. The crash of 1929 would proof this, as well as 1972 and 1999. So whatever the darling of that narrowness is needs to be avoided.

Then again, so far in this bull market bets on growth stocks like Amazon and Netflix have turned out to be pretty clever investments. Why should that change now?
You should not confuse brains with a bull market, meaning when stocks go way up for an extend time everybody looks like they’ve got a lot of brains. It’s like sitting on a boat and the high tide comes in: your boat is going to float just as high as the other ones. Today, a large segment of the stock market capitalization is tied up in the euphoria surrounding the pioneering efforts of companies like Amazon, Netflix, Tesla (TSLA 1512.9484 1.88%), Facebook (FB 251.04 -0.37%) and Google. Right now, we have the highest concentration in the S&P 500 of technology since the end of 1999. And the market, once a great deal of success happens, wants to extrapolate and attempts to predict the future by what has been going on in the recent past. So I’m reminded of a quote by the American businessman Shelby Cullom Davis. He figured out that «the thing that makes you rich the prior twenty years is usually the thing that makes you poor the following ten.»

But isn’t there also lot of potential in new technologies like artificial intelligence and autonomous cars?
That’s what I call a «well known fact». A well-known fact is a body of economic information that is known by pretty much everyone in the marketplace and has been acted upon by pretty much everyone with access to capital. In effect, when the taxi driver is giving you stock tips, whatever his theory is, it’s more than likely a well-known fact. For instance, looking back at the last twelve months, it’s a well-known fact that whatever business Amazon goes into, they are likely to ruin it for the people that are already in it.

But isn’t that the case? Just look at the wave of bankruptcies in the US retail industry.
That’s not my point. For example, at the end of 1999 the well-known fact was that the internet was going to change our lives. And it did but people lost 80 to 90% of their money with dotcom stocks. In 1929, the well-known fact was that radio was going to dominate entertainment for the next fifty years. And it did, but that didn’t stop RCA from going from $500 a share in 1929 to $5 in 1932. At the end of 1972, the well-known fact was that there were fifty growth companies, called the «Nifty Fifty». They seemed to be oblivious to what happens to the economy and all you had to do was to buy these fifty stocks. They even were called «one decision stocks» because all you had to do was buy them. But what happened to you on these stocks, even with the companies which succeeded like Disney (DIS 116.065 -0.24%), McDonald’s (MCD 194.74 0.17%) and Coca-Cola (KO 46.52 0.48%), you lost most of your money in the next two years and you really didn’t start getting it back until 1982.

Now what does this all mean for investors in the spring of 2018?
One of the most important factors in the investment markets right now is that the rate of interest that you use to discount future cash flows is extremely low relative to history. So in theory, the net present value of the future income streams of businesses is very high. And since interest rates have been going down since 1981 in the United States people tend to not include something else happening in their mechanism for discounting. In other words: the rate on the ten year treasury is around 3% right now and people kind of worry what would it be like at 3,25 or 3,5%. But they don’t spend a lot of time to try to figure out what it would be like at 4 to 5%.

So what would it be like?
If the US economy improves dramatically in the next twelve months and we move from the 2% level on real GDP growth to, let’s say, 4 or 5% a year over the next two years, interest rates are going to rise a lot higher and they are going to go up fast. That means this will probably result in a bear market. It would be a bear market which has to do with overvaluation, not a bear market which has to do with earnings. And that’s what happened in 1987: The stock market went from 800 to 2700 from 1982 to 1987 and in the spring of 1987 the ten year treasury interest rate went from 7% to 10%. And when those two things collided, the market fell 40% in 78 days.

On October 19, 1987, a day that became known as «Black Monday,» the Dow Jones (Dow Jones 26673.51 0.03%) plunged 22.6%, its largest single-day percentage drop. Nevertheless, the economy didn’t fall into a recession. What would happen today after a stock market crash like 1987?
Another argument that’s kind of a well-known fact is that we are late in the economic cycle in the United States. So as mentioned, you can lose a lot of money betting on a well-known fact. But you can make even more money betting that a well-known fact ends up being wrong. For contrarian investors like me nothing is better than that!

Nevertheless, the last recession in the US happened around ten years ago. So we’re already looking back at one of the longest economic expansions since World War II.
But we also had the most anemic economic recovery coming off a deep recession that we just about ever had. Today, the stock market is built around the idea that the economics that exist right now will be the same ten years from now. But in the coming years the millennials are beginning to dominate the economy of the United States. This means that the largest demographic group, which has been late to be impactful on the overall economy with home and auto buying, is just getting started. So how could the United States be late in the economic cycle when its largest adult population group is just getting started?

But aren’t millennials quite different from prior generations when it comes to spending and their lifestyle in general?
What we know is that the number of 35 to 44-year-old Americans wills growth as explosively in the next twelve years as it did when the baby boomers turned 35 to 44 years old. And when the number of 35 to 44 year olds is high you have the most people in society making really good money and they have to spend it all to make their life work. So for example, the today’s number of homes is way below what is going to be needed to meet the demand of people who have waited into their 30s to have children. Also (ALSN 236.5 -2.27%), the market thinks it knows that when the millennials are 35 to 44 years old that their choices of how they access products and services will be heavily influenced by the convenience of the internet. But no one has proposed what they are going to do with all the time they have because they aren’t doing a lot of the things their parents did.

What are the implications of this demographic shift from an investor’s perspective?
Companies that are threatened by e-commerce are trading very, very cheaply. And that’s where we spot our best opportunities. Because if these companies have any kind of decent economics in the coming years the financial opportunity for investors is dramatically greater than when you invest in the success of companies which you have to pay a very high price to get involved in.

So in which sectors are you putting your money?
For example, in the entertainment world. The market assumes that the distribution methods are going to be more important than the content. So Disney trades at 14 times earnings and Netflix trades right now probably at 250 because the market thinks that the distribution channel is going to be more valuable and that those distribution channels are preeminent to the actual creation of content. That’s why companies like Disney and Discovery Communications (DISCK 19.2 0.37%) are on sale on a relative basis right now. And that creates opportunities. In the case of Discovery, we know that one of their channels called HGTV has the best audience and the best advertising experience for an advertiser with respect to women in the age of 30 to 50. So it really doesn’t make any difference whether you are going to watch HGTV’s shows on Netflix, on replay or live being streamed by Hulu or on cable.

Where else do you see value?
A great question to ask someone who runs a portfolio is how happy they would be owning shares in the next bear market. We went through the worst bear market in 80 years in 2008-2009 and the quality of the companies identified by our eight criteria is one of the things which got us through that torturous decline. Most of these criteria are quite simple like meeting an economic need, high and consistent profitability, long history of a constantly high cash flows, immense balance sheet strength, strong insider ownership, shareholder friendliness and of course: Is the stock a bargain compared to the last five to ten years? Right now, our portfolio trades at 13 times what the companies are expected to make in earnings this year. At the start of 2012, it was trading at 12 times earnings. So basically, our portfolio offers the same kind of value it did six years ago. On the other hand, a growth manager at the start of 2012 properly had a portfolio trading at about 16 or 18 times earnings and that portfolio now trades at 25 times earnings. In other words: the spread between these two investment styles is as high as it ever gets.

So what are other key positions in your portfolio?
Stocks like Lennar, Amgen (AMGN 245.228 -0.86%), Walgreens (WBA 40.73 -0.85%) and Target look really interesting to us. And again: All that interest is very closely tied to the fact that these companies fit our criteria for common stock selection and we know that the general market psychology is extremely negative associated with investing in them.