The Internet is Brutally Efficient and Totally Agnostic

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Dear Fellow Investors,

On my way home from work recently my progress was impinged by a group of protesters headed up 4th Avenue in downtown Seattle to the headquarters of the Gates Foundation. Bill and Melinda Gates are spending millions trying to figure out how to make the U.S. education system more efficient and successful. Some of their recommendations are thought to damage efforts by the most powerful teachers’ unions to protect the interests of teachers. The Gates Foundation wants to bring efficiency and seems to understand that they need to be agnostic in their approach.

At Smead Capital Management, we believe investors in common stocks are like this group of teachers protesting the Gates Foundation. Just as some teachers balk at the Gates Foundation’s recommendations, many investors balk at the brutally efficient and agnostic approach the Internet fosters in everything from retailing, technology, communication and labor. We contend that investors' should remove their emotion when thinking of the Internet.

The Internet allows for new and great inventions every year that drive down prices for consumers. In effect, it is massively deflationary. The trick for business owners is being in toll-bridge businesses which require low levels of ongoing innovation, but can defend or (to our glee) raise their prices. Therefore, these toll-bridge business owners don’t need to march on the Gates Foundation headquarters.

Amazon (AMZN), eBay (EBAY) and others have brought efficiency to online commerce and a great deal of competition to brick and mortar retailing. As the 86 million echo-boomers age during the next 15 years, we see them driving online commerce to 15 percent of total commerce, up from the current 6.2 percent level. PayPal appears to be a big winner in an environment where secure, online payments could flourish. It will become more and more important for retailers to compete against online commerce by being effective online themselves and by providing significant value to what we call an addicted-customer base. We own eBay (EBAY), Nordstrom (JWN) and Cabela’s (CAB) under this premise. If you don’t have a cult of fans, you don’t have a toll bridge. Competing on price alone could kill many retail businesses—just ask former employees of companies like Sears and K-Mart.

The pass-through nature of the Internet is putting a great deal of pressure on designers and manufacturers of technological equipment. The commoditization of personal computers, cell phones and tablet devices appears to us to be another “Battle Royal.” For those who weren’t addicted to local professional wrestling, a “Battle Royal” was a situation where 12 wrestlers were put into the ring and threw each other over the ropes until one was left standing. Only the winner made money. It was quite entertaining for the fans, but a terrible business model for wrestlers. From our vantage point, technology manufacturing, automobile manufacturing and oil/gas production appear to be in a similar battle-royal situation. To avoid them, we prefer to own a company like Accenture (ACN), which is technology agnostic and is not threatened by the Internet. Accenture helps bring the brutal efficiency of the Internet to the largest organizations in the world to give them better systems and processes.

We compare the Internet’s efficiency to playing golf on a very good, but difficult course. When you play a tough course, the flaws in your golf game get exposed. Everyone is aware that the Internet is very democratic and well-written thoughts generally travel fast and gain great traction. The negative side of this is that massive amounts of relatively unworthy writing and business promotion can easily dilute the attention of readers. It seems then that content is king. To that end, we own Comcast (CMCSK), Disney (DIS) and Gannett (GCI) because they have proven they can provide well-written and well-created content. Any company that can gain multimillion person audiences with their content can be a toll bridge to advertisers in the agnostic environment.

Lastly, the Internet presents its brutal efficiency and agnosticism in the U.S. labor market. If I were a young man or woman, I would ask the following question: is the brutal efficiency of the Internet going to be my friend or my enemy? Can I compete better by fighting in the very competitive labor battle by being a participant in unleashing the Internet, along with millions of other super-smart software engineers? Or would I be better off to get out of the way of the Internet, learn trades and form businesses which meet economic needs on the ground. People need to eat, be clothed, be sheltered and have the physical aspects of their life be regularly maintained. We own NVR (NVR) in the home-building space, Pfizer (PFE) in the pharmaceutical industry and JP Morgan (JPM) in banking. These are examples of businesses which are primarily helped by the brutal efficiency of the Internet and employ laborers who are not threatened by a “Battle Royal.”

Warm Regards,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

© Smead Capital Management

© Smead Capital Management

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