Popularity is fickle, brand loyalty is not. Businesses may have their ups and downs, but a good memory for an exceptional brand that the public will always gravitate towards is how value investor Bill Smead stays ahead – that and patience.
As the founder of his own boutique, Smead Capital, the Citywire AA-rated manager knows what it takes to create a successful business, and this knowledge has been shaping his approach to stock selection since he started in the industry over three decades ago.
Patience definitely played a role in picking one of his longest-held stocks, eBay, for his flagship $1.1 billion Smead US Value fund. Sitting at the top of his 29-holdings-strong portfolio, the e-commerce giant had been on Smead’s wishlist for over 20 years before he finally made a move.
He watched it go from ‘dotcom darling’ in the 1990s to trash when the tech bubble burst in 2003. He snatched it up when he launched the US Value fund in January 2008 because it was cheap, had no debt, had huge cash holdings and a number of profitable offshoots such as PayPal, StubHub and a host of classified advertising businesses.
‘[eBay] are one of the best-known brand names without advertising’, says Smead, who looks for brands that resonate with consumers, such as Starbucks, Aflac, Nordstrom and Disney – all of which he currently holds.
Lead manager of the $29.4 million Pareturn Smead US Value fund – the Ucits version of US mutual fund Smead Value, which he runs alongside Cole Smead and Tony Scherrer – Smead has returned 21.15% with this strategy since it launched in November 2013 compared with the 17.50% rise of the S&P 500.
Looking at his long-term track record, the Smead US Value fund has returned 159.4% over the past five years to the end of July while the S&P 500 rose 112.3%. A good portion of those returns have been derived from his allocations to consumer discretionary, his biggest sector at 36.7%, followed by financials (31.5%) and healthcare (19%).
Picking the right cast
Being a big name isn’t enough to get on Smead’s stock roster, comparing his stock-picking style to that of a movie casting agent who tests an actor in a variety of small roles until he feels they are ready for the big time.
‘We are like the producer of a play or someone who produces movies. We are constantly auditioning actors and actresses, and when we put them under contract what we are hoping is that the cream will rise. The ones who pack in the big audiences, they are the ones who gravitate to the top.’
He wants the equivalent of Oscar-winner Meryl Streep, who came onto the scene strong, had a bit of lull in the late-1980s as she faced disputes over pay, but has since steadily proved herself as a true Hollywood heavyweight.
Independent biopharmaceutical company Amgen started auditioning with Smead in 2011. The healthcare sector was basically abandoned in early 2010, he says, when US president Barack Obama signed the Affordable Health Care for America Act and a number of pharmaceutical companies were hit by huge lawsuits.
‘The legal and regulatory environment were just as negative as you’ll ever see it. The Food and Drug Administration was the slowest it’s been in decades to approve drugs, and in the election cycles the drug companies were demonized constantly,’ says Smead.
Amgen’s most successful products have been medicines for treating osteoporosis and cancer, but when Smead took on the stock it had not yet received approval on what are now its two most successful cancer drugs. It now sits within the fund’s top five holdings, making up 5.3% of the portfolio.
‘[We had to have] some faith in the idea that Amgen, a company that had consistently found medicines in the past, would produce wonderful medicines in the future,’ Smead says.
Smead’s large cap company picks must meet eight criteria, including having had at least 10 years in the black and a bargain-basement stock price. Shareholder friendliness and strong insider ownership are also a plus.
He developed this checklist in 1990 while at Smith Barney, but its roots can be traced back to his summers spent analyzing greyhound races at the Multnomah Kennel Club in Portland, Oregon.
‘From about age 12 to 22, I spent a lot of time handicapping greyhounds in the summer and playing dime-nickel [small-stake] poker with my buddies in high school and college.
‘By 1990 I had come up with eight criteria for stock selection in the same way I came up with five or six things I looked for in handicapping greyhounds.’
This checklist has led him to currently favor the financial sector, with banking giants JP Morgan Chase, Bank of America and Wells Fargo among his top picks. Smead believes these banks will be hit with a ‘waterfall of profits’ as interest rates pick up and the so-called Millennials – consumers aged 25 to 35 years old – start to settle down and have babies.
One thing people don’t understand about banks, says Smead, is that they trained two generations to deposit money with them without being compensated for it.
‘How many people have money sitting in the bank and they get diddly squat from it? As interest rates rise banks are going to be incredibly slow raising deposit rates.
‘If their rates are high enough they’ll keep 95% of their clients in place, and if they’re too low they’ll lose 10% of them. The interest rates spreads will get better and better.’
Even a 1% in spread is a massive opportunity for banks, says Smead, who believes banks are in the healthiest position they have been in for the past 35 years. He also says banks will benefit from the ‘velocity of money’, or how fast the same money changes hands.
‘If the economy moves from growing at 2% to growing at 3% or 4% for two to four years, the velocity of money would go up, as well as the price of money, because more borrowed money will be demanded,’ says Smead.
‘In that environment the banks get more transactions, and they get a tiny bit out of them. They will also be able to do more loans at more favorable rates. Those stocks can do incredibly well.’
Of course, even a strategy that’s not sensitive to business cycles cannot secure 100% outperformance.
According to investment firm Tweedy Browne’s white paper ‘10 Ways to Beat an Index’, even the most successful stock pickers such as Warren Buffet, John Neff and Walter Schloss underperformed the index 35% to 40% of the time over long-term investment records.
‘It’s a virtual guarantee that there are going to be years when the market does not agree with our long-term vision and the set of common stocks you own,’ says Smead.
‘For us that was in 2008 and 2010, so far. In the first six years that our fund existed we underperformed 33% of the time, which is what you expect.’
When the price of oil hit highs in the beginning of 2008, the only way a manager could keep up with the market was to keep a disproportionately large percentage of their investments in oil, basic materials and industrial companies that were enjoying China’s huge growth rates, says Smead.
Meanwhile, in the second half of 2008, any financial companies held ‘annihilated’ a portfolio. ‘So what hurt us in the first half of 2008 was what we didn’t own, and in the second half it was what we did own,’ he says.
A rebound in oil, basic materials and industrial shares hurt Smead’s fund once again in 2010.
‘When we look stupid we can look really stupid because we don’t make any effort to catch up to what’s going on. We need to operate our stock selection process without envy.’
The portfolio managers at Smead Capital come up with two to three good stock ideas each year.
‘We don’t know who the big stars are going to be. That’s why we own 29 stocks,’ says Smead. ‘If we knew, we’d own six. Six of those 29 stocks are going to make the lion’s share of our gains over a 10- to 20-year period and that’s the way our play runs,’ says Smead.
These are some of the stocks being tried out at the moment:
Gilead Sciences: 3.43% of portfolio
Biotech firm Gilead makes two pills capable of curing hepatitis C, at the price of $1,000 a pill. The only downfall in providing this very lucrative prescription is that the number of patients who need it will eventually dwindle to nothing unless they come up with additional products. ‘There is a risk they won’t be able to find additional products,’ says Smead. ‘We’re auditioning Gilead in the same way we were auditioning Amgen in 2011’.
American Express: 1.98% of portfolio
American Express has long been the credit card of choice among the wealthy, the well-traveled and the corporate contingent. However, the break-up of a 15-year relationship with large retail chain Costco has dented its standing. Smead stepped into purchase the $100/share stock for less than $80/share as he expects it to recover within the next two years.‘What we’ve learned over the years is if a company falls out of favor because they decided not to sign a contract with a company, because of the deal’s terms, and the stock then drops, that’s when we come in and buy.’
News Corp: 1.76% of portfolio
Media and information services company News Corp owns brands including the Wall Street Journal, Barron’s and the New York Post, and is a ‘treasure trove’ of assets, according to Smead. The company has a solid financial position, an interesting conglomeration of assets and almost no liability, Smead says.
This article was originally published in the September issue of Citywire Americas. To sign up to receive our free magazine, follow this link.