A Market of Extremes

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A number of factors in the U.S. stock market are at historical extremes. We at Smead Capital Management like to look for what we call "well known facts" in the marketplace, also thought of as areas of extreme optimism and pessimism. In this way, we can avoid euphoric situations and/or buy into abnormal bargains on solid long-duration companies which fit our eight criteria for common stock selection.

A "well known fact" is a body of economic information which is not only known to almost every market participant, but appears to have been acted upon with almost every dollar at their disposal. It is, in effect, a very crowded trade—usually capped with borrowed money and derivative leverage attached. The following are “well known facts” we believe exist in the current U.S. stock market:

1. Technology is the best place to invest.

In late 2010, I was on CNBC's "Squawk on the Street" with Erin Burnett and Mark Haines. It was the public offering day of Dangdang and Youku, two Chinese internet darlings. We wrote back then that the soaring first day prices of these glamorous Chinese companies would be looked back on with humor. “Dang, I paid too much for these stocks” is what we expected and ultimately heard. Dangdang trades at a fraction of its first day average trading price!

Snap could be the perfect compliment in the U.S. to Dangdang in today's market. The thing which will snap the hot streak of technology stocks is over-valuation and over-ownership. Snap hit a $35 billion market cap during its first trading session with $500 million in sales and red ink everywhere.

The "well known fact" is that as capital spending goes up, technology only gets better and technology stocks only go up. In my 37 years in the investment business, the only time tech stocks were a higher percentage of the S&P 500 Index than they are today was in 1998-1999. Tech stock ownership in the S&P 500 Index bottomed in 1990 at 7% of the index, even though Microsoft (MSFT) had been public for four years and was going to be spectacularly profitable. My guess is that most of today's darlings won't ever become highly profitable and those who bet on them in the face of the index overweight will end up unhappy (while muttering ‘dang’)!

2. Oil going to $80 per barrel.

We covered this in our missive two weeks ago. Hedge funds and non-economic oil market participants had more leveraged derivative and futures contract long bets last month than anytime since the oil peak in 2008.

We believe investors should follow the advice of Kevin O'Leary, Canadian businessman and Shark Tank's Mr. Wonderful, on oil stocks. He said, "Don't buy until you see grown men cry."

3. Amazon and Netflix will crush brick and mortar retail, as well as the TV and cable companies.

John Templeton said, "If you wait until you can see the light at the end of the tunnel, you are buying too late!" We are culling through retailers looking for surviving future success stories among companies which fit our eight criteria. We especially like looking at those which could see the distress in the industry improve their moat. We believe content providers are undervalued in the wake of the pioneering love affair with all things new.

4. Lower drug prices are the heart of healthcare affordability and Trump will clobber pharmacy benefit management companies, drug distributors and drug makers.

There is never any guarantee on companies which fit our eight criteria, but Express Scripts (ESRX) appears to fit our model to a tee. Everyone hates them. Anthem (ANTM) is their largest customer at 15% of revenue. They hate them because Anthem foolishly put a compensation system in their long-term contract with Express Scripts which worked out better for ESRX than it did for ANTM. Watching Anthem fight with Cigna now helps us realize that Express Scripts might actually be the good guy in that disagreement.

Now that Trump is out doing his thing, the healthcare cost dumpster for those fears is in the common shares of ESRX. When it comes to "well known facts”, this kind of hatred attached to fantastically high free cash flow gets our contrarian juices running.

5. Very high professional investor sentiment.

The Investor's Intelligence survey of newsletter writers hit a 20-year high lately at 63% bullish versus 17% bearish. Since the majority of the new money which has come into U.S. stocks in recent years has come in via the buying of passive indexes and ETF vehicles, a very crowded trade has developed. Two kinds of declines have followed numbers like these since 1980. In 1987 and 2007, the extreme optimism for stocks among professionals led to a selloff in virtually everything. In 2000, it set the stage for all things in tech and telecom shares to get crushed. However, money was made in that bear market in non-tech stocks. As long-duration investors, we like how much less expensive our average company is to the average company in the S&P 500 Index. We also like the low level of overlap we have (high active share) with its holdings.

Individual investors have not yet jumped on this bandwagon, with their latest reading at the American Association of Individual Investors (AAII.com) of 46% bearish and 30% bullish being much closer to the other extreme. If the individual investor sentiment matches professional enthusiasm, long-duration investors should make sure they can sit through the inevitable future bear market with all their cash needs met. Remember, bear markets happen once every five to seven years and trim about 30% off of the indexes on average. We relish those declines because they "make us lie down in green pastures" over the long haul.

In summary, we like what we own via our eight criteria for stock selection. Our portfolio dwells among the disliked and despised financials, healthcare and consumer discretionary companies which have created wealth historically. Our lack of overlap with today's possibly misplaced enthusiasms and our overweighting of hated/meritorious companies gives us optimism for our long-duration investors.

Warm Regards,
William Smead

The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. 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. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

© 2016 Smead Capital Management, Inc. All rights reserved.

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