Dear Fellow Investors,
As we overhear the chatter of major stock market media outlets and read the best writing on publicly-traded companies, we realize how incredibly popular and exciting most of the companies are which dominate investment news. We like to think of it as a love affair between investors and certain “popular” companies. There are numerous contrarians floating around in the media world as well and they caught our attention recently. The good folks at Marketwatch.com and at the Financial Times provided some very good reasons to avoid the love affair and adjust your mind to a more sustainable discipline for acquiring and holding common stocks.
In his January 30, 2015 article, “Easy way to get rich: Buy the most hated stocks,” columnist Brett Arends points out how well you would have done in the last seven years if you had purchased the 10 most-hated stocks based on Wall Street analyst opinions. Here is how he measured this:
Go back seven years, to the start of 2008. Imagine at that time you had invested $100,000 in an S&P 500 index fund, reinvesting all dividends, using a tax-sheltered account. Today you’d have about $170,000. Not bad.
If, instead, you had invested that money at the start of each year in the 10 stocks that analysts rated most highly, cashing out on Dec. 31 and then buying the top 10 most loved stocks for the following year, today, seven years later, you’d be slightly better off — you’d have nearly $180,000, according to my analysis using FactSet data.
But now imagine you had done the exact opposite, and each year had invested your money in the 10 stocks that analysts rated the worst. How would you have done?
Hmmm.
Today you’d have $270,000. No, really. You’d have earned more than twice as much as investing in a simple index fund.
By
B
Columnist
In about the time it took to absorb and appreciate the wisdom in the Marketwatch.com piece, we then were engaging the writing of James Mackintosh and John Authers at the Financial Times on February 10th of 2015. Their article titled, “Sin stocks pay as alcohol and cigarette stocks beat sober rivals,” gave the kind of long-duration historical view which we at Smead Capital Management love.
The wages of sin is exorbitant profit. New research into the best equity market performers over the very long term shows that nothing beats tobacco and alcohol stocks. One dollar invested in US tobacco companies in 1900, with dividends soberly reinvested, would have turned into $6.28m, according to a work of financial archaeology by Elroy Dimson, Paul Marsh and Mike Staunton of London Business School. The study, produced for Credit Suisse, similarly shows that brewers and distillers were the best performing British shares of the past 115 years, turning £1 into £243,152, including dividends.
Sober, solid industries fared far worse. The engineering companies that helped build Britain’s global dominance during the industrial revolution of the 19th century were the UK’s worst performers over the following 115 years, turning £1 into just £2,280. The shipbuilders who helped define “the American century”, meanwhile, only managed to turn $1 into $1,225 since 1900. The US textile and steel industries were not far behind, while the food sector — now attracting ethical investors’ ire as a sin sector itself — turned $1 into $384,027.
There are numerous important points in both articles which need to be unpacked. First, the psychological swings of investors create stock market anomolies. People usually pay a premium for popular companies and deeply discount out of favor shares. Every academic study we have seen shows that the cheapest stocks in the S&P 500 Index, based on price-to-earnings ratios or price-to-book value ratios, outperform the index average and all the more popular quintiles in both the following year and for years to come. The popularity differential causes alpha for contrarians in as short a time period as one year and a larger differential by seven years.
Second, if there is something about a company which causes both tremendous corporate success while maintaining a great deal of hatred among investors, they are in a position to create wealth in a massive way over long-duration time periods. The best customers of so-called sin stocks such as alcohol and cigarette companies despise the company even while they are addicted to the product. Think how negatively friends and relatives of addicted drinkers and smokers view the companies involved.
Lastly, consider how easy it is for ethical investors to avoid owning these shares, leaving a large pool of natural common stock owners abstaining from ownership regardless of how well they fit quantitative and qualitative screens.
As we see it, Peter Lynch, the former manager of the Fidelity Magellan Fund, had one of the best stock-picking track records of all time and used these facts in portfolio management. He craved owning wonderful businesses which were hated for one reason or another no matter how well the business did. Two of his most successful investments were Phillip Morris (tobacco) and Fannie Mae (a GSE which facilitated the mortgage market). Most investors stayed away from the stocks for reasons of natural disdain despite the hugely successful earnings and dividends produced by the two corporate juggernauts.
The aforementioned articles help crystalize what we do and how we select common stocks at Smead Capital Management. We have a series of qualitative characteristics among our eight criteria for stock selection, but seek to initiate our positions when a company is hated for one reason or another, much like the companies which Mr. Arends focused on in his article. Whether it is a one-time circumstance like Walgreens (WBA) walking away from Express Scripts in a negotiation over ongoing contracts in 2011, or industry disfavor (think large banks since 2011), we choose to love that which is meritorious and temporarily hated by analysts.
We like to own businesses with what we like to call an “addicted-customer” base. However, we don’t prefer to own companies which naturally damage the life of their best customers. Warren Buffett was interviewed by the Financial Crisis Inquiry Commission back in 2010. He was asked to boil his methods down to one thing. He said the most important thing associated with the maintenance of high levels of profitability for a company was the “stickiness” of the customer. Fortunately for us, there are many wonderful companies with “sticky” customer bases which don’t force us to profit from someone else’s misery.
We favor companies with long histories of profitability, earnings stability and free-cash flow. To have this kind of long-term record we think there must be significant barriers to competition (a wide moat). There must be forces that make the high and consistent profitability of the business stop potential competitors. The damage done to the life of the best customers of alcohol and tobacco companies serves as a perfect barrier to entry. There are millions of bright young people all over the world who want to start the next great tech company. The list of those who dream of conquering the alcohol or tobacco industries remains tiny in comparison.
What do we own today that is hated by analysts/investors in general, trades cheaply to the average stock and has an extremely defensible moat? Gannett (GCI) owns network-affiliate television stations, community newspapers, Cars.com, Careerbuilder.com, and broadband cellular spectrum. It is currently in the process of splitting into two companies. We don’t think we’ve ever seen an industry more despised by analysts and industry participants than newspapers. A close second is the TV business.
Comcast (CMCSK) might be the closest thing today to what Phillip Morris and Fannie Mae were in the 1980’s. They provide cable service, high-speed internet access and phone service to about 35% of the U.S. population. Past service problems and the resulting bad reputation that go with it are as pervasive as any hated company in America. On top of that, the current presidential administration and the FCC are just dying to regulate high-speed internet access in a way that seeks to ruin a great deal of the financial reward for risking billions of dollars to create and maintain the systems involved. We thank them for scaring people away from competing with Comcast.
Comcast also owns NBC Universal, a powerhouse in entertainment content. Many investors and analysts think that technology from companies like Netflix will ruin Comcast’s hold on eyeballs and advertising dollars. Investors even hate them because they think that Millenials will never buy a house and watch conventional television on cable! In the face of this hatred and a series of obstacles, the customers of Comcast have been incredibly “sticky” and absorbed price increases every year, resulting in large free-cash flow growth.
EBay (EBAY) might be the most hated tech stock of my time in the investment business. We have never seen more vitriolic hatred associated with a company which meets an economic need and generated $4.4 billion in free-cash flow in the year 2014. Every analyst asks why they aren’t growing like Amazon. It seems like each person who has had anything go wrong on their marketplace spends the rest of their life criticizing eBay scathingly online. Never has something so unimportant been so polarizing.
Lastly, we own Navient (NAVI) and SLM (SLM). Navient is the largest servicer of all kinds of loans (student, government agencies, etc.) and SLM is the largest originator of private student loans in the U.S. Considering the media are likely to have attended the nation’s best universities and graduate schools, they are also likely to have accumulated more student debt (or watched their peers do so) and would be familiar with the downside of borrowing large amounts of money. Therefore, it is unsurprising to see student debt for Millenials so widely and often negatively covered when it’s an issue that hits close to home. As for moat, only two major financial institutions (Wells Fargo and Discover) compete heavily with SLM on private student loan origination and Navient on servicing private loans.
It seems temporary disgust and more permanent hatred have proven to be available and useful for seeking success in the selection of common stocks. Jason Zwieg summarized the attractiveness of hated companies, in particular sin stocks, in his his February 13, 2015 Intelligent Investor column.
Still, there is an investing lesson in these results of sin-vesting. For excess return to persist, the typical investor has to hate something about the companies that produce it; otherwise, they would never be cheap enough to offer lasting value.
We agree. Addicted customer bases or extremely “sticky” ones contribute greatly to the long histories of business success and long-duration wealth creation. We believe the ultimate combination for long-term investment success is sticky-customers and ongoing disdain for a business.
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.
