Value investing is very similar to farming. A farmer needs fertile ground, well-planted seeds, unshakable patience, loads of sunshine, watering and weeding, as well as a great deal of courage and faith to succeed in the long run. Today, we believe that investors need to reexamine the benefits of a value investing approach toward the end of an era which has rewarded growth stock investing.
For a farmer, fertile ground means property which is high in nutrients. Fertile ground also means being smart where you farm. Florida is great for citrus fruit orchards because you have year-round sunshine. Wheat is grown where winter provides snow and summer provides hot sun. Similarly, as large-cap value investors, we search for companies which meet our eight criteria for common stock ownership. They must have a long history of profitability, produce high returns on equity, generate high and consistent levels of free-cash flow and have balance sheets which give management the ability to recover from business cycles.
Well Planted Seeds
A farmer seeks out the finest seeds to plant. Charlie Munger is our authority on which companies we believe investors should plant their money in:
“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.”1
Some seeds take months to sprout and many winning stocks take as long as three years to blossom. We sat for years with Aflac (AFL), Amgen (AMGN) and others before they began to outperform the stock market. The major banks were a swear word for politicians and investors from the financial crisis in 2008 until this year’s capital releases. To get multi-decade winners you must show a farmer’s patience by standing firm in good seasons and bad ones.
Loads of Sunshine
The farmer doesn't need loads of sunshine all the time (unless they farm citrus fruit or bananas), just during the part of the year when the seeds break through the ground and plants and vines ripen. In value investing, we buy when there is no sunshine and most of the experts and market participants wonder whether the sun will ever shine again. For this reason, John Templeton, the dean of all common stock pickers, coined the term the "point of maximum pessimism." The great economist and investor, John Maynard Keynes, explains common stock investing in another way:
“It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.”
Can farmers succeed if every farmer in America plants the same crop? Even if you get loads of sunshine, the prices you'll get for your crop will ruin your efforts. In the same way, the popularity of the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks could ruin returns going forward because there are no investors left to participate.
Watering and Weeding
When the sunshine warms the fields of a farmer, they must provide additional water and do regular weeding, as weeds suck nutrients out of the fertile ground. My job as a ten-year old kid was to weed the area around the cucumber and tomato plants in our garden. I hated weeding, but it was essential to the success of the garden. I was shocked when the chefs in California started putting the weeds I pulled as a child into my salads.
The stock-picking portfolio manager must regularly identify the companies in their portfolio which can grow to be many times your original investment and water the holding period. We must also determine the ones which we believe will never become the kind of stocks Munger was referencing. You must pull weeds!
The math of investing is in your favor. The worst thing a stock can do is go to zero, so weeding protects your capital to the downside. Watering winners gets you to your best performers and multi-decade winners cover a multitude of duds.
Courage and Faith
The best farmers get hit by droughts, natural disasters and other problems outside their control. It takes courage to believe the long run will treat them well. You must have faith in the process and the cycles in growing, harvesting and pricing. Large-cap value managers must do the same with bear markets, severe declines in existing multi-year holdings and temporary setbacks.
Where is the Fertile Ground in the U.S. Stock Market?
Any industry which is being threatened by the FAANG companies has the kind of negative psychology we crave. We will focus on retail by looking at the following chart:2
Let us unpack this chart for you. In late 2008 and early 2009, the stock market was pricing in the possibility that we were entering another Great Depression. Discretionary spending had fallen off a cliff. Short sellers had enormous confidence that they would succeed on their negative bet. Therefore, investors are pricing retail companies today as if the FAANG companies will negatively impact their business like a huge depression in overall discretionary spending.
What Company Sticks Out Among Retailers?
In a recent article at MarketWatch.com, all the so-called "Dividend Aristocrats" (25 consecutive years of dividend increases) which have fallen in price this year were singled out. What sticks out the most is how high the free cash flow and dividend coverage Target (TGT) has as compared to other formerly highly thought of peers.3
Much like a farmer, we never know ahead of time which of our crops will do the best and how long a drought for an industry like retail will last. What we do know is Target is a bargain as compared to the bottom of the worst bear market of the last 70 years and has financial characteristics which qualify them under our eight criteria for stock selection. We will provide the courage and faith in the idea that 25-30 companies like Target could provide a bumper crop of long-duration gains and wealth creation.
2Source: BESPOKE (https://www.bespokepremium.com/think-big-blog/page/2/)
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.
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