Guest: Bill Smead is the founder of Smead Capital Management, where he oversees the firm. As Chief Investment Officer, he is the final decision-maker for investment and portfolio decisions as well as reviewing the implementation of those decisions in the firm’s separate accounts and mutual funds.
Date Recorded: 3/22/19 | Run-Time: 1:03:00
Summary: Bill begins with how he came to be a value investor, describing himself as someone who came from a family of educated gamblers, and as a boy, going to greyhound races, learning to put probabilities in his favor, and even developing a criteria system for selecting greyhounds.
Next, Bill talks about his beginnings in the investment business, starting out in an era of high interest rates, and reading about Buffett, Lynch, and some of investing’s great minds. He describes his 8 criteria for selecting investments: 1) Does it meet an economic need 2) Does it have a long history of profitability 3) Does it have a wide moat 4) Does it generate high and consistent cash flow 5) Can the company be purchased at a discount 6) Business must be shareholder friendly 7) The company must have a strong balance sheet 8) The company must have strong insider ownership.
Meb then asks Bill to elaborate on the investment landscape, and what he’s seeing in a specific pocket of the market. Bill discusses the parabolic move in e-commerce companies, and issues he sees in the strategies and valuations of companies like Amazon.
As the conversation winds down, Bill lays out the thesis that the Millennials are in position to drive the economy in the future.
Sponsor: Mountain Collective
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Links from the Episode:
- 0:50 – Sponsor: Mountain Collective
- 1:22 – Welcome to Bill Smead
- 2:05 – Bill’s interest in value investing
- 3:21 – Episode #39: Ed Thorp, “If You Bet Too Much, You’ll Almost Certainly Be Ruined”
- 3:26 – Bill’s early career path
- 6:04 – What led to him to opening Smead Capital Management
- 6:42 – How Bill thinks about finding opportunities
- 8:50 – Bill’s investment philosophy
- 8:55 – Thinking, Fast and Slow (Kahneman)
- 9:09 – Bill mentioned anesthesiologists examining x-rays, but meant radiologists
- 16:03 – Bill’s comments on Buffet’s recent letters
- 17:07 – Shareholder friendliness
- 22:59 – Sponsor: Mountain Collective
- 23:32 – The landscape today for stocks
- 24:19 – We See Dead Stocks (Smead)
- 31:52 – Separating a business from a stock
- 35:32 – Buffett’s Annual Letter: Forest for the Trees (Smead)
- 35:42 – Antitrust “Internet Style” (Smead)
- 36:00 – Anti-trust concerns in tech
- 36:07 – Life After Google: The Fall of Big Data and the Rise of the Blockchain Economy (Gilder)
- 42:15 – How demographic shifts and Millennials will impact the economy
- 53:01 – Episode #124: Howard Marks, “It’s Not What You Buy, It’s What You Pay for It That Determines Whether Something Is a Good Investment”
- 55:09 – Credit card companies and Millennials
- 1:00:52 – Most memorable investment
- 1:02:15 – Connecting with Bill – SmeadCap.com
Transcript of Episode 150:
Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast’s participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Welcome, podcast listeners. We’re in the middle of March madness. We have an awesome show for you today. He’s the founder, CIO of Seattle-based Smead Capital Management. Prior to founding Smead, he served roles at Drexel Burnham, a local L.A. shop, Oppenheimer, Smith Barney and Wachovia, going back to my Winston-Salem days before starting Smead. Welcome to the show, Bill Smead.
Bill: Thanks for having me.
Meb: Bill, so you’re in Seattle now. How’s things up in Seattle? It’s a beautiful day here in March, into March.
Bill: Yes. Season turned about a week ago. And I’m looking out the window at blue skies and a beautiful view of Elliott Bay.
Meb: Awesome. I love it up there. We spend as much time as I can get hopping up in the Pacific Northwest. All right, so we have a lot of we want to take about today, you’re an old-school value guy, take me back to the beginning, were you inoculated at birth like Warren Buffett or when did you catch the value bug?
Bill: Well, I grew up in a family of what you’d call educated gamblers. So, my dad grew up playing poker every Saturday night with his family, played poker every Wednesday night for 30 years with 10 or 12 of his best friends in a group called the jolly boys, started going to the greyhound races at the park in Gresham across the river in the Portland area at about 12 years old, and that was the beginnings of a life of trying to pip probabilities in your favour.
Meb: It’s so funny, we talked to so many investors that have those origins. I mean, for me, same thing, my father loved poker, my grandmother loved…I mean, she must have taught me how to play Blackjack. She called it 21. I mean I couldn’t have been older than five years old. Yeah, so I think that’s how I learned to count and add.
Bill: My grandmother was Yahtzee.
Meb: Yahtzee, I love the Yahtzee. And then, you know, the generation of my grandparents, I mean, I think my parents met playing Bridge. It’s not something the younger generation plays as much, but certainly some of the best investors have that history. I mean we had Ed Thorp on the podcast, one of kind of the pioneers of “Beat the Dealer” back in the day. Okay, so you just got to learn a little bit about that, was it something that you started applying in high school, university, or what eventually led you to Drexel and starting your own shop? What was the path?
Bill: So, in Greyhound handicapping, there came about five main criteria that you are looking for, and just like in common stocks selection Charlie Munger would argue that you need to be very patient and be extremely selective and the same is true, you know, play good cards in poker and wait very patiently for superior odds to set up in a greyhound race, and then bet heavily when the superior odds put themselves together, so I came up with a criteria system for selecting greyhounds.
And then I went to Whitman College at Walla Walla, Washington. I was an econ major. And my fraternity brothers and I would sit in the TV room a lot on Saturdays and Sundays watching games, and when I was a junior one of my best buddies looked at me and goes, “You know, you’re so opinionated, you ought to go in the investment business,” and that was a pretty good thing for that guy to say because his grandfather ran the most successful brokerage office in Seattle in the ’40s, and ’50s, and ’60s, and then secondly my best friend’s girlfriend, her dad was the manager of the Drexel office in Palo Alto. When I was a senior, I sent him a resume and a letter that his daughter helped write. He passed it forward to the Seattle manager and I got hired straight out of college. And we graduated on the 25th…Mount St. Helens blew up on the 18th of May, I graduated on the 25th of May, and I blew into Seattle and started working at Drexel Burnham.
Meb: I love it. And so you eventually started your own shop and with stints at Wachovia, which is a name that has a lot of fun memories for me, I grew up partially in North Carolina, in Winston-Salem, what led you to starting your own business? Is that “I’m ready to do this on my own?”
Bill: Yes. So I started out as a stock broker/financial advisor, and then in ’92, I was at Smith Barney when they started the program for running separate accounts, and they had us all go through getting an IRA shingle, taking a test and getting license to be an IRA, and I was one of the first people they invited into that program. So, at the beginning of ’93, I started the process of doing nothing but running separate accounts where I was picking stocks. That’s what I did from ’93 until the summer of ’07. And we were tracking how we were doing as compared to the mutual fund managers that I admired the most and found that our numbers were stacking up quite well.
And my wife and I had five children, and they were all good athletes. And so we entertained ourselves and never missed a practice, never missed a game, running that private client separate account business, and then the youngest daughter got to be 17 or 18 and she was an outstanding athlete, but she decided she was more interested in boys than she was in softball. And so that was the point at which it’s time to go out in the public domain and put your stock picking skills to the test against the other people that have gotten their neck stuck out there everyday.
Meb: Well, 2007 would have been certainly an interesting time to be doing that. I’m fairly familiar with your process, but you talked about…I’d love to talk about your framework, and then we’ll start to get into some themes and potentially some ideas, kind of the way the world looks, but lay the groundwork for us, I’ve seen you mentioned that there’s eight things you’re typically looking for as you think about investments. You wanna give us a broad overview of how you think about finding opportunities?
Bill: Yeah, let me take you back in time and hopefully I won’t make the listeners feel too much like I’m the guy in the song “I’ve got a king-sized bed and a PhD in the way things used to be.” So when I got in to the investment business in 1980 with an economics degree, I knew just enough to know that those high double-digit interest rates were likely a once in a lifetime opportunity. And so the first 10 years that I was in the investment business, 80% of the money I looked after was in fixed income at rates of return that you normally had to buy equities to get, and then you dabbled on the side in the stock market and you read. And so I was lucky enough in the ’80s to learn about Buffett and read everything there was there, read everything Peter Lynch wrote, read Phil Carret and Phil Fisher, and John Neff, and read Peter Lynch’s books and so forth, and then have some life experiences that cause you to get scars, and those great investors that preceded us led us to eight criteria for stock selection, which were things that we felt were demonstratable. Each one of them individually is not that important, but in totality the eight criteria are like a checklist for getting in the cockpit of an airplane and Boeing having the right software.
So that’s where our eight criteria for common stock selection came from, but remember it kind of matched up with the way we were selecting greyhound, which was by five key criteria in the greyhound race. And so once that came together, once that common stock selection criteria came together about 1990 or ’91, that was the beginnings of being able to run a concentrated, high-quality portfolio, first on separate accounts and then as a fund in separate accounts.
Meb: Would you mind kind of flushing out, you don’t have to go through all eight, you can if you want, but maybe you…
Bill: I’d be happy to. You know, the book about Danny Kahneman and the other brilliant guy that kind of created the behavioral finance thing, there’s a section in there, there’s a guy that wants to improve a medical system up in Toronto, and one of this he did is he took like 400 anesthesiologists and asked them what they were looking for at an x-ray to determine whether someone had cancer, and then they created a computer program out of that criteria that the 400 anesthesiologists gave them. And then they took 500 random x-rays, had those 400 anesthesiologists tell them whether they thought the x-ray had cancer or not, and then they ran those 500 random x-rays through the criteria that the 400 anesthesiologists had come up with, and the computer did a better job of getting it right than the people that came up with the criteria did.
So the first thing to understand is the criteria that we’re operating under is more important than any feelings, or eyesight checks, or anything. So first of all, I know this sounds ridiculous, but think of how much trouble it saved us in 1999 and think of how much trouble it would save you on all these money losing unicorns going public, and that is, first of all, does it meet an economic need? And I know that sounds simple, but it’s important.
The second thing is just have a long history of profitability. Mike Trout got signed to a $430 million contract. Why? Because for five, or six, or seven years he’s been clearly the superior baseball player in all of major league baseball and what that’s saying is that you’re not looking to invent the wheel. You were at the end of 10 years of growth stomping value consistently, for almost 10 years without any interruption whatsoever to a magnitude that equals the outperformance from ’95 to 2000. So it’s the same magnitude, it’s just built constantly for 10 years. In that kind of an environment people look…and they’re not afraid of risk. I think Howard Marks did a great job of covering that for you in your conversation with him. They’re not afraid of risks, the price of money is incredibly low, which means the opportunity cost is incredibly low, and so we are not here to invent the wheel, we are here to wait until a wonderful business that has been outperformer over the last 20 years compared to the S&P and a company that fits our other criteria and buy them at a point in time when they’re out of favour.
The third thing is they must have a wide moat, and wide moat is not something that people at Morningstar can create a mathematical formula for. Buffett and Munger talked all the time about the fact that you probably know all the math you need to know to be a great investor by the time you finished seventh grade, and every IQ point above 125 is probably detrimental to your ability as a stock picker because these things are not complex, they’re just hard to execute. So wide moat means a child is born in the United States regardless of socio-economic background and they’re immediately a customer of Disney Corporation. It’s a virtual guarantee that that child will go to Disneyland in the first 10 years of their life whether it be a relative sending them or the local charity sending them, someone is gonna fend them, they’re gonna be a Disney customer. We’re a nation of 60-year-old people that are starving for their first grandkid, the spoilage is gonna be legendary, and the parents and grandparents are just dying for them to get old enough for Disneyland to be useful to them. It’s just crazy, the moat at Disney is unbelievable, and then the fact that they take something that was made 90 years ago and resell it, oh they don’t have to draw Mickey again, they just keep selling Mickey, selling Mickey. I mean it’s just that incredible, incredibly profitable business.
So wide moat, for example, we are buying and own the home builders. The moat in home building has exploded in the United States in the last 10 years. The market share of the publicly traded companies is growing immensely, and they have the best set up to deal with limited carpenters, limited plumbers, limited framers, all the tradespeople, if you’re a tradesperson and you can go to a place that Lennar is building 150 homes, you can go to work in the same place every day for a year, you’re thrilled. You don’t wanna go do a one-off or a two-off at some mom and pop builder and besides that the tax code now penalises a $2 or $3 million home and is all set up for a boom in $500,000 homes.
Next, does it generate high and consistently cash flow? We own NVR, they generated positive free cash flow in ’08, in ’09 as a homebuilder, and ’10, and ’11. In 2011, in the United States, we built 320,000 new single-family homes. We had about 315 or, you know, 320 million people in the United States that year, and in the ’60s and ’70s where we ranged from say 175 million people to say 200, the worst recession year and there was some nasty recessions, and there were some terrible things happening, the Vietnam War, and race riots, and all kinds of horrendeous stuff were going on in the United States, the worst year of building homes was 550,000. So 2011, we built 40% fewer than the worst recession when we had, you know, 40%, 45% less humans in the country. It’s just crazy.
So generating free cash flow through that misery was remarkable for NVR to do that. We need to be able to buy at a bargain price in relation to the prior 5 to 10 years when we initiate our position. We’re looking for a bargain, we’re looking for not only a great set up from an economic standpoint going forward 5 to 10 years, but we want something that at the time we buy it it’s very much out of favour or misunderstood in relation to what the future success of the business is gonna be. We’re trying to buy the most future success for the least amount of money. And then the other three are we want businesses that are shareholder friendly just to use NVR and Amgen as a couple of examples. Amgen has swallowed half their float in 15 years, and NVR has swallowed 75% of their float in 20 years.
Meb: That’s a phrase that Charlie Munger says looking for the cannibals or the companies that kind of eat themselves, some people call it shareholder yield, but certainly that reducing the float has historically been a monster factor for outperformance. Okay. Keep going, didn’t mean to interrupt.
Bill: Honestly, I am very frustrated and kind of unhappy with Buffett and Munger because that’s exactly what they should be doing with Berkshire Hathaway right now. If they owned a company that was in their situation, they’d be banging on their door everyday. What are they doing? You know, eat your own cooking.
Meb: Yeah. Let’s talk about that for a second, and we’ll hop back to the list of eight. Most of my conversations are like this. They bounce around all over. But I know you’re a frequent Buffett commentator. I saw some comments you made about the recent letter. Maybe elaborate on that point because it seemed to me like Buffett was laying the groundwork a little bit for saying, “Hey, we might be buying back some more stock aggressively in the future.” They used to have some sort of floor on price to book, but it seems they removed that. Talk a little bit more about that point, then we’ll get back to the eight criteria.
Bill: Yeah. I’ll answer this quickly. My answer to why they’re not doing that is Warren turns 89 this summer, and Charlie is a lot older, and I think they want that stock buyback done so full the day one of them dies that they can just start firing. I think that’s the reason. Now, why they don’t just tell us that? You know, they’d be mad at a company if they didn’t tell them that. It’s okay to do it, I understand why they would do that, but tell us, right? Okay, so back to shareholder friendliness is what we’re talking about. So we owned Amgen in the summer of ’11…and by the way, it’s like the media that follows the stock market just needs to call us and listen to us. I remember talking to a journalist of the major publications at that time, Amgen started their dividend in the summer of ’11. They paid 28 cents, their stock was at 52, 28 cents a quarter, and that annualised rate at that moment in time was higher than the 10-year treasury. Now, how many blue-chip companies that are in the S&P start a dividend at a yield higher than the index? And the answer is I think it’s the first time it’s ever happened. And who reported that? Nobody. You know, they’re paying $5.80 a share? We’re getting 11% return in cash from dividends after tax, after their taxes and stock buybacks and 16% spent on research and development on a pre-tax basis, we’re getting 11% from that purchase in the summer of ’11. And people wonder why I like hanging on to the stock.
Okay. So next, strong balance sheet. And boy, when the worm turns here and the price of money rises, the balance power in the common stock market is gonna shift from revenue growth stories to strong balance sheets and high and consistent free cash flow. In other words, as capital becomes more expensive, the companies that use their own capital internally and don’t require outside capital will trade at premium price-earnings multiples to the people that have to go to the capital markets to get money. I’ve been around 39 years. I know how tough it was to find capital in 1980 to ’85. I mean Milken was a genius because he unlocked the door to very large corporations with less than A ratings to get access to capital and that is, we’re at the absolute dead opposite of that spectrum. So the balance sheet’s very, very important. So I have two co-portfolio managers, and they’re both very strong. I mean literally it’s like the eight criteria and me are to the company as the criteria the anesthesiologists came up with are, you know, to determining whether people have cancer.
Tony Scherrer, our director of research, and Cole Smead, my oldest son, they’ve been here for the last 11 years on the fund which, by the way, started the second training day of ’08, and the first 14 months employing that strategy in a fund was the worst 14 months in 86 years if anybody out there is wondering if we’re good market timers or not, and the answer is we make no effort to market time because we can’t.
So, anyways, so back to the insider, so I’ve often said that if I only had one of our eight criteria, the one that I’d want is strong insider ownership preferably with recent purchases. And I could run you through the list. We own JPMorgan because the world trade hit JPMorgan in 2012 and Jaime Dimon bought $13 million worth of stock at $34.50, and we couldn’t follow him in there faster. I worked with him for 11 years at Smith Barney, admire him, and think he’s an outstanding manager of that business. We were buying Bank of America in early ’12. The insiders were loading up and the stock was depressed, and we figured out that we were paying about $20 million or $30 million for the largest deposit bank net of what Merrill Lynch was worth, which they bought at the height of the financial crisis.
And we see that over and over again. If the officers and directors of a company are calling up their broker to buy…you know, like Peter Lynch said, “There’s 50 reasons to sell, and there’s only one reason to buy.” Or how about this, last 12 months, Amgen which has now been trading, I’d say the last year between about 170 and 210, there was $5 million worth of insider sales in Amgen the last 12 months. It’s a $120 billion market cap company. It’s like there’s always somebody that needs a new house, or there’s always things that are going on, they must have dozens of insiders there, and their headquarter in Thousand Oaks, it’s not cheap to buy a house close to their headquarters.
Meb: I was a biotech engineer in a former life, and one of my first interviews out of college was at Amgen in Thousand Oaks. And I spent an entire day there, didn’t go work there, but certainly I have some memories from hanging out in Thousand Oaks, and it’s funny because I actually asked a lot of the young people that were there, I was in my early ’20s at that time, I said, “Where do you live?” and half of them said they lived in Los Angeles and commuted an hour a day each way. I said, “Oh my God. I can’t do that. I will go crazy after about a week.” Funny, it bring backs some memories.
Bill: Well, no, that’s right. And so the lack of insider selling at a company that size almost works the same as an insider buys to on smaller companies. John Malone bought $32 million worth of Discovery, most of it at 23.50. The stock’s trading today at 26.50 or something. Does John Malone buy something a year ago to make 10% or 15%? It’s just crazy. It’s just crazy. Twenty-five year old women that use cable television, the two most popular things for them to watch, which by the way it’s a pretty good chance it’s gonna be part of Discovery because they are 50% of the viewership on cable TV, the number one is “HDTV” and the number two is “90 Day Fiancé.”
Meb: Oh, that’s funny.
Bill: Now, if you don’t think that’s a ticket to the American dream, you 25 to 35-year-old males out there, you’re on the wrong dating site.
Meb: That’s funny.
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Meb: All right. So the process, if I was to distill it, is a very thoughtful one. It sounds like a value approach, with quality, with insider ownership, and a strong balance sheet, and a history of shareholder friendliness. I mean that is a pretty robust screening criteria. As we talk about implementation and cycles, you made a thoughtful comment, starting the company in the global financial crisis, but following since, you know, I think a lot of traditional value factor strategies whether it’s quantitative, or whether it’s Buffett, or a lot of people, this past cycle seems to have been really characterised by a lot of growth in those sort of investments. You had an interesting recent piece where I’m gonna read a quote, and then we can kind of use that as a jumping off piece called “We See Dead Stocks,” where you said, “Financial euphoria episodes are a common occurrence in investment markets and the U.S. stock market. When a new one comes along, market participants accelerate their enthusiasm toward the end, which makes the shares of companies involved dead to us. The new mania becomes comparable to prior episodes and prepares to destroy the capital of those who extrapolate the existing trends and enthusiasm.” Maybe elaborate a little bit about the landscape today, kind of what you’re seeing, are you seeing a ton of opportunity for investments, are you seeing a little more challenges in finding stocks, and then go off into any number of tangents from there.
Bill: You’re inviting me into about four or five of my favorite subjects at once, so let me handle them one at a time. First, we have a chart that goes back 45 years that shows that the e-commerce parabolic move is the third biggest parabolic move over the last 45 years, only behind the .com bubble and not very far behind it, and only behind the ridiculously stupid ’03, ’04, ’05 residential housing stupidity. Okay.
So, anybody that thinks that’s owning these things, that doesn’t realise that at best we’re in the late stages of a parabolic move is kidding themselves. Now, we have so many charts right now that show the similarities through now and ’99 that we’re starting to get depressed just looking at them. For example, just one example, by the end of September of last year, the year 2018 had broken the record for money-losing companies going public, over ’99. Everybody says, “Oh, no this is not nearly as bad as ’99 because Facebook and Google have earnings yadda, yadda, yadda,” and now, if you can trust what they’re showing in their numbers, Amazon is showing free cash flowing profits, if you can trust their numbers. Their offices are 10 blocks from here. We get to see them up close and personal. So they say it’s not as egregious, but you know what, the appreciation of the common stocks involved in a lot of cases breaks the Cisco, Intel, Microsoft, Sun Microsystem, Lucent Technology record.
When you see a bankrupt company named Levi Strauss go public and jump 30% the first day, when you see Pinterest read the tea leaves and their investment bankers read the tea leaves and go, “We’d better hustle,” Lyft, we’d better hustle, $2 billion revenue, $991 million dollar loss, better hustle, that the chief capital is gonna go away soon, you’ve got to get there. You got to hit the bid. Uber, every one of those…I mean, I personally think they’re all fools for not already going public. But what’s that’s gonna do is massively dilute where the growth people are gonna go with their money.
Cole made a great comment this morning, we were talking. He said, “What percentage of the advertising that’s done on Google right now is from businesses that are actually making a profit running the ad?” Every GrubHub, Drop Dead, whatever, you name them, all these delivery companies are losing their rear. By the way, the definition of insanity is doing the same thing over and over again expecting a different result. Give me the list of everyone that’s made a profit delivering groceries.
Meb: Webvan, right? Come on.
Bill: Webvan. By the way, that is to this day the worst corporate executive career move in the history of the United States of America when George Shaheen left Andersen Consulting about four years before they went public to be the CEO at Webvan which two or three years later was completely gone, his Accenture shares would have made him a multi, multi, multi, multimillionaire. It’s the worst trade in history.
So we’re here in Seattle. There’s like four of five main arterials in the downtown, the one from the north goes up to a neighborhood called Ballard and it crosses the Ballard Bridge, and on the other side of the Ballard Bridge, as you head from Downtown North was a great Chinese restaurant, Larry Louie’s Restaurant, and they had the best coconut shrimp, but the Louie’s gave up and closed it down about five or six years ago.
So sure enough that is the AmazonFresh location. It’s a very busy street. I mean during commuting times, thousands and thousands of cars go by there in both directions, in the morning, in the evening and all day long. So I kept going by there because I’ve got grandkids that live north, so I keep driving by there all the time, and during the first six months of the beta test on the thing, we noticed…I mean if there’s two cars there it seems like a miracle. One car is probably 40% of the time and no cars is 50% of the time during the first six months. And now we’re like a year, a year and a half into it, so partway into that beta test six months into it, Amazon announced that they’re buying Whole Foods.
Now, my problem is I’ve been around way too long, and I know that John Mackey was the guy that went in chatrooms in 1999 on AOL, which by the way was the most popular stock of that particular era, and was in control of everything associated with the internet in 1999 when the movie “You’ve Got Mail” came out, and went into chatrooms to smear Wild Oats and other publicly traded organic grocery store companies so that he could acquire the company cheaper, and got caught by the SCC. But basically, he was the Elon Musk of back then. So that’s what they bought because the AmazonFresh beta test wasn’t going well, and then told people that…they gave him a completely different reason for why they bought it, and we were sitting right here and knew exactly why they bought it because that was gonna be DOA because the definition of insanity is doing the same thing over and over again expecting a different result.
So the point of all this is there is a mania in e-commerce, it’s been a massive parabolic move, we have no idea when it ends, we do not have that kind of ability, all we know is that every single incident like this 10 years later has been nothing but heartache, nothing but heartache. Coca-Cola and Disney were the Amazon, and Netflix, and Google, and Facebook of 1972, 80 times earnings on Disney, 80 times earnings on Coca-Cola. Coca-Cola owned Columbia Pictures in the late ’70s because they thought it was a good idea to go into the movie business, does that ring any bells for everybody listening out there? And were trading at six times earning paying a 5% dividend when I got my brokerage license at the end of October of 1980. It’s the first stock I pitched. I’d pitched it about 100 times in the next 30, 40 days after I got my license. My dad and my cousin were the only two people that bought it. I thought, “You’re gonna starve if you’re gonna try to open accounts with this stock,” and went on to another project. Buffett paid six times that price in ’89.
So it was from 80 times earnings to 6 times earnings. And Disney went from 80 times earnings to 10 times earnings, even though nothing got interrupted about the attractiveness of the Disney Corporation. So I love people fanning all over these stocks because they’re going into Hollywood.
Meb: Just real quick, it’s a great example, I think a lot of investors have a hard time separating a business or a company from the stock. And so you could have a great company like Disney where it’s sometimes it’s priced attractively and sometimes it’s not. If you go back even further, there’s a great research white paper by Professor Shiller that looks at sector valuations around history, and he talks about how utility is the most boring possible sector on the planet as the sector hit a P/E ratio of like 60 in the roaring ’20s. And so the names changed, and the stories changed, and the sectors changed whether it’s electronics, or plastics, or .com, or today a lot of the e-commerce stocks you’re talking about, but I think we all know, maybe not my millennial listeners, but the older, gray hair, no hairs listening certainly know that paying P/Es of 50, 80, 100 plus historically has not been a good bet.
Bill: It’s a death ticket for your capital. So, Buffett, in his most recent letter…you know, I love this. It’s like, “Why don’t they just let me come on and ask the questions when they have them on TV?” So Warren wrote in his most recent letter exactly what you just explained. He said, “A very good company that’s going to succeed as an underlying business for decades can trade at a price that either caused permanent damage to your capital, or at a minimum so much damage for so long that you will never stay with it.” He put that in there, and no one asked him about it, not a word, no one. No one asked him what he was talking about. And you got Charlie Munger out there going…he sat on the board of Costco for a long time and so thinks that everything is gonna be another Costco, and he says, “Gosh, all I can say is Amazon is a force of nature.” Are you kidding me? If the chairman and CEO of one of the companies that we owned did what the chairman and CEO of Amazon did, our stock would get pummeled. I mean pummeled. Pummeled.
And it’s like, “What has happened out there?” I mean, you know, the Bible says that there will come a time when right and wrong and wrong is right. And then I saw a guy that I respect a great deal that I won’t name wrote a piece recently that price range ratio doesn’t matter and maybe all these things that are cheap…so, here’s the breakdown, you’ve probably seen it in some of our writing, we have a set up for breaking the S&P down into the five P/E quintiles like David Dreman’s book when he wrote it, I don’t know, 30 years ago or whatever. Anyway, so right now the cheapest 100 stocks in the S&P trade for about eight times earnings and the next cheapest 100 trade at about 12 or 13, and then the middle ones trade at just a little over the market multiple like 18, and then the next one up is like, I don’t know, I’m not looking at it right now but say 30, and then the 1 in the 100 most expensive trade at 94.8 times earnings.
The only time, the only time, I’m not talking about all the rest of recorded history, the only time in the Ibbotson that you can find that would have been the last six months or maybe the first few months of 2000, the last six months of ’99. It’s the biggest bifurcation. And since it’s taken so much longer to develop so now you’ve got really well thought of excellent stock picker portfolio managers and their will is being bent to the circumstances.
Meb: We’ll definitely have to link to your piece in the show notes, listeners, mebfaber.com/podcast, and some of these writings. That’s a very sobering statistic certainly. I mean you’ve also even written a little bit about some of these tech companies and possibility, we’ve seen quite a bit with rumblings from the politicians starting to talk a little bit about antitrust and other concerns, not that he mentioned lot of the mood shifting about data, and privacy, and those sort of ideas, but feel free to keep going down the path I interrupted you on, or you can chat about that article too.
Bill: George Gilder got a really good book out called “Life After Google.” Let me explain these two different directions. First of all, the primary mechanism for balancing supply and demand in a democratic capitalist society is the price of the good. So we have what we call the three identical strangers, which if you haven’t seen that documentary it’s fantastic, the three identical strangers are Facebook, Google, and Amazon because they both give the main thing they do away for free, free social media, free search, and free delivery.
Now, that is guaranteed to distort the democratic capitalist system because it virtually puts anyone that could possibly wanna compete with them at a complete and total disadvantage. So now let me shift gears to explain to your listeners what is wrong with the system at the moment. When I moved to Seattle, I played one year of division three college basketball. I had a blast, made great friends, I’m 5’8″ and a left-handed point guard, and the physical challenges stopped me from continuing on, but I love basketball. So when I came to Seattle, I was a single guy, in Saturday morning I’d go down to Green Lake, and there were some of the best pick-up basketball games in town down at the playground at Green Lake. So I’d go over there for about five or six weeks in a row on Saturday and I’d play, and then about the sixth time I’d played, when you play pickup basketball there’s no referees and the players themselves are the ones that call the fouls. And it’s a virtual guarantee if you play for two or three hours that there’s gonna be a fight when somebody calls a foul that the guy that fouled didn’t like.
And I realised about the sixth time I played that I was the only guy playing that had a job. This was the summer of 1981, unemployment was 10.5% and the prime interest rate was 20%. And I said, “You know, Bill, you probably shouldn’t play in this game because you’re the only one here with a job.” Now, that is where we are with Facebook, Google, and Amazon. They are being allowed to officiate their own games, and then spending millions and millions of dollars to control the body politic in a way that will allow them to continue to be the referee.
So here is the problem. The problem is that under antitrust laws that were written between 1900 and 1920 to protect consumers, it does nothing to address what is going on there because a thing called the internet, which Katie Couric didn’t understand when it came along, had not yet been invented. And there is the ability to aggregate power in business on the internet in a way that no one back when those laws were written could vaguely have imagined.
So the first thing we need to do is to rewrite the laws. That’s the first thing. The second thing we need to do is apply the laws, and here is how it works. Let’s just use Google as an example. So my wife and I own a condo two miles from the office overseeing Elliot Bay about five blocks from what used to be the Amgen headquarters and next fall will become Expedia’s headquarters. So I thought, “I’m gonna keep track of Expedia not because I’m interested in paying that kind of multiple for the stock, but because if I ever go to sell this condo I’m probably gonna sell it to an executive of Expedia that no longer likes commuting from Redmond, Washington, to downtown,” which is a nightmare during rush hour, both directions.
So I get their annual report, this is maybe a year and a half, two years ago, and it says they did $9 billion in travel commissions, and then I go over to their expense list and the number one expense of that corporation is paying Google for advertising. And then I went over to Google’s annual report and Google did $12 billion in travel commissions. Now it is ridiculous that the people that know everything about everybody by giving away free search and know everything about the interactions between Expedia and the clicks should be doing business head to head with their customer, you know. I think if you looked that up in the dictionary you’ll find it under schmuck.
Okay. Now that’s just one example. How about this, how about more than likely the single most profitable thing that AWS does is web host the porn industry, and what if you could lose money delivering all this stuff because you’re being subsidised by that? What if the two largest customers of Amazon are the porn industry and Amazon e-commerce? And they’re losing the money on the one side so they can build up the money they’re making on the other side. What if you’re Facebook, and you’re giving away social media, and people aren’t like Bill Smead who wakes up a year and three months ago and says, “Wait a second, why am I working as an unpaid actor or actress for these guys? They’re not giving me a very good return.” So I looked, I said, “I don’t wanna be Bruce Almighty. I don’t wanna get six million per request, and number two, I don’t want somebody tracking me everywhere I go, and number three, I don’t wanna intensely dislike friends that I have because of opinions they put there that are just so…” I just think regardless where do you come down to from a political standpoint, you’ve got to express yourself in a way that’s conducive to ongoing civility. So, anyway, needless to say, that’s just some of the…you know, the privacy and all that, there’s no officiating because there’s no rules. They’re letting the prisoners run the prison. It’s as simple as that.
Meb: So, we’ve touched on a few things, and there’s a couple of other themes I wanna hit on. We’ve certainly talked about where we are on the cycle and some of the challenges and the things to avoid, largely expensive companies, as well as some of the tech and e-commerce. You mentioned at the very beginning, and I would love to kind of come full circle and actually touch on a few of the ideas or themes that you think are worth allocating our hard earned dollars to, and one of the things that you briefly mentioned and I would love to hear you expand a little bit more on is this concept of demographics and millennials, their kind of growing role in the economy. Thoughts there?
Bill: The group in front of the baby boomers at its peak number of population was 44 million people. So you can pretty much track the United States economy this way. When the boomers moved into the 30 to 45-year-old age bracket, which is the borrowing age in the United States, that’s when you take out the biggest mortgages in your life and the biggest car payments and all that kind of stuff, when 79 million boomers replaced 44 million silent generation people and between them and their parents, just think about it, what happened to the price of money when you had 35 million more borrowers than the prior era? Skyrocketed. That’s what made the 20% prime and the 15% treasuries. So then, after that got over, the baby boomers replaced those 44 million people in the saver age from 45 to 60, so we had 35 million more savers and the group behind them was 65 million, so we had about 17% fewer borrowers and 75% more savers, what’s happened to the price of money? And the answer is now we got 2.4 something 10-year treasuries. But what’s gonna happen next is the group behind the gen Xers is already 89 million strong and will be 95 million at the peak because their age group is who gets to work for businesses.
And so we, over the next 10 to 15 years, are going to add the equivalent of all the 30 to 45-year-olds in Canada, England, Ireland, Wales and Scotland on top of the 65 million gen Xers that we already had into the highest multiplier of that part of the United States economy. This is the antithesis of the last 10 years. So let me just stop and address that last 10 years. The last 10 years was about millions of 20 to 30-year-old well-educated people making above average income if they had a college degree, which a lot more of them do than prior generations, living in expensive coastal cities, drinking craft beer, eating fast food, and buying iPods, iPads, and iPhones, and paying rent.
Now if you dig into the economics behind those activities, you will find there was zero multiplier effect. The iPads and the iPhones were assembled in another country, and nobody that wraps chipotle burritos, or Shake Shack burgers can afford to buy anything else other than a bus fare, and the bartender at the craft beer place in these expensive cities, all they can afford is to pay their rent. So there was no multiplier effect, and Seth Rogen played 26 to 27-year-old characters who were drunk and stoned, sometimes living in their parent’s home, and we laughed our guts out because we were gonna cry if we didn’t . Okay. That’s what the last 10 years is about, therefore, you wanted to own the companies that benefited the most from 26-year-old single people, and that’s what did the best. Amazon, Netflix, you know, they’re young and poor, and maybe they do wanna spend the rest of their life doing nothing but watching “The Office” which NBC never should have sold to Netflix in the first place. By the way, the guy that runs The New York Times came out to the area yesterday and said, “Hey, we’re not gonna put our newspaper in Amazon’s newsfeed. Wall Street Journal is agreeing to, to split 50/50. You gotta control your content.”
Okay. So start following 35 to 40-year-old parents of two or more kids around for 5 or 6 weeks and track where their money goes because over the course of the next 10 years that’s gonna be what it’s all about, and Mark Wahlberg is on the cutting edge of it, he made a movie called “Instant Family.” And even Seth Rogen is married now and living next door to a fraternity or sorority. Now, he doesn’t know enough not to say terrible things around children, but he hasn’t quite got there. Okay.
“So that is where the puck is going to be,” Wayne Gretzky would tell you. And the way investors operate is they actually wanna be perfect at their time in getting involved in that, but I can tell you it’s a tsunami. The United States economy is highly likely to be the strongest in next 10 years it’s been since the baby boomers went to the 30 to 45-year age rates. The household Debt Service is the lowest it’s been in 40 years, the savings rate is the highest it’s been in 40 years, all the preconditions of that levering up are in place, and then as if the millennials are not spoiled enough, not entitled enough, and not coddled enough, we just had the Federal Reserve take the mortgage rates back to 4.3% just to make sure that they’ve got the best borrowing rate that any generation has ever had to buy their houses, and the people on TV think I’ve lost my marbles for thinking this.
In some ways, if we were all 25-year-old, young men and women, I mean you’d just wanna start a homebuilder and go to Albuquerque, or Omaha, or Kansas City, or Laramie, or Indianapolis, or Detroit where all these people are gonna uiltimately move because money goes where it gets treated the best. And people are making the assumption that this massive number of software engineers and computer science and coder people that are living the high life at 28 or 30 and making 100 grand that they’re gonna wake up in 10 years and they’re all gonna have done a startup or they’re all gonna be in management. And you know what, in 10 years they’ll be lucky if they’re still making $80,000 or $100,000, and they’re gonna be begging their company to move them to a place in the country where that money goes twice as far so they can take care of their family.
Meb: Having traveled around the country, you’re seeing that trend really accelerate. I mean, having spent time in places like San Antonio, where I said, “My God, the crane indicator of this town is booming,” and they said, “Look, you know, Austin is spilling over. There’s too many young people moving to Austin,” and they’re all having to move to San Antonio, and you’re seeing it in a lot of places kind of around the country. And it might actually be fuel to that fire, and it remains to be seen because it’s still getting drafted. But a lot of the legislation around opportunity zones, and funds, and investing could actually spur that development even more. It will be fun to watch.
Bill: One of the investments that I was too young to understand, to hold on to in the ’80s that I owned and sold it way too soon was public storage. If you could close your eyes in ’85 and know one of the most popular cable shows was gonna be “Hoarders,” you’d have realised…and “Storage Wars,” that people just get more junk all the time and they never throw it away. It’s very difficult for people to purge, and it’s really easy for them to add more junk. Well, Wayne Hughes is the guy that started that company, and he’s now got a new company called American Homes For Rent, and he owns about 52,000 homes, many of them brand new when he buys them and he’s renting them to people because that can be kind of a transition. You know, if you’ve been living in an apartment, you get married, and you’re not really sure that you want a home, you might rent a home for a while to see if it fits your family the way you want it to. Of course, as soon as you do that after about a year you realise, “Hey, I’d rather…”
You know, the homebuilders, and the banks, and these other people are doing a terrible job of reminding people that for the average family, the average 35-year-old couple with a two and a four-year-old, for most people the largest accumulation of net worth in their life other than maybe their 401K plan will be the for savings plan called a home and then all the utility that you get from it, and then all the studies show that the kids do better growing up in their own…it’s just crazy. So yes, it is absolutely crazy. So we like the homebuilders…Home Depot, it’s like, “Are you kidding me? Why is there a 10 P/E spread between Costco and Home Depot?” Why is that? It’s not like people are gonna spend more, I mean they will spend more at Costco, but on the margin the honeydew is just gonna explode, just explode.
And so we saw a big jump today in existing home sales, 11.8%. Diana Olick was shocked on TV today because she’s been leading the campaign on slowdown in housing and she says it’s because of affordability. Let me give your listeners a quick lesson on what affordability means in housing. So houses in the last 60 years were the most affordable in 2010, 2011. We built the fewest homes in 2011 in 60 years. So what’s the correlation between affordability and homebuilding? The answer is nobody builds a home when no one wants one. Now, other than the ridiculous ’05, ’06 peak, you have to go back to the mid to late ’70s where there were two peaks, one in the early to mid and one in the late ’70s and then the early to mid ’80s where the three big home single-family home building peaks where it was the baby boomers that were in the key demographic age group, when we had 200 million people instead of 330 million.
So once these tech companies get done with their arrogance and building their ridiculous buildings that they’re building that is definitely topping the cycle out just like the Empire State Building did in 1929, ’30, Devon Energy’s building, they finished in 2008, did the oil and gas, and I could go through the list, kind of thing Howard Marks would have talked a lot about on your podcast. Once they get done with that and they find out, “Hey, let’s take 10,000 of our employees and move them to Indianapolis. It’s got a great airport and homes trade for 40% of what they do in these expensive cities, live happily ever after.”
Meb: You know, this is certainly hitting pretty close to home. I live in Los Angeles, in Manhattan Beach, where I can’t even fathom the average home price here. It’s just bananas. And so you’re speaking to exact demographic where as a parent to a two-year-old and a partner to a wife who is very incentivised to become a homeowner, I look towards greener pastures like my family in Denver and other places and say, shake my head at the craziness here. So this is all very close to home.
Bill: What is the most likely TV show for a 35-year-old woman to watch on cable? “Fixer Upper.” Okay. Who advertises on “Fixer Upper?” Target and Home Depot. Let’s talk about Target. The idea that everyone is gonna have all their stuff delivered to their house has never met the mother of a two and a four-year-old or a stay-at-home dad with a two and a four-year-old who have a choice to being stuck at home constantly during the work week, or they can take a two-and-a-half hour break by putting the kids in the car, talking to another adult while they’re sleeping in the car, go to Target for the three things they need and the three things they don’t, go into Starbucks after checking out, taking the kids over to the fast-food place, probably McDonald’s, putting them on the playground, buying them a Happy Meal, and two and a half hours getting back and completely cause insanity that a cardboard box being delivered by a USPS person who the government and the taxpayers are losing money on delivering it to the door, and I don’t even wanna go into that because that just makes me mad.
Meb: You know, it’s interesting to see this common theme definitely is a thread throughout your portfolio not just in the homebuilders but you mentioned in Target…
Bill: Let me keep going, I’m on a roll. The credit card spend on American Express is four times that of Visa and Mastercard. Forty percent of millennials say American Express is their number one card. What’s the biggest difference between a 30-year-old that’s got an American Express card, that makes $80,000 or $100,000 a year and a Visa or Mastercard? What’s the credit limit on the American Express? Way higher.
So a guy gets married at 30 or 31 to a 28 or 29-year-old woman, that’s pretty standard in the United States right now, and they get married and they buy a house, and the guy thinks, “Hey, I’ve done what this woman wants,” and she takes one look at him and says, “Honey, we just did the first half of this project. Now we need mattresses, couches, lawn furniture, a fence, landscaping, yadda, yadda.” You see, because the guy that’s been single to at least 30 or 31, he’s been a minimalist. He’s either been living with his friends in a house, and they might have had one piece of furniture, and boxes of mac and cheese and cereal in the cupboard, with milk in the fridge, and butter because you need that to make the Kraft Mac and Cheese. So they’ve been minimalist. They don’t even know what life is about. And they’re gonna get civilised by this woman.
So here we go. Half of American Express is identical to Visa and Mastercard, and what do they trade at? Twenty-five times, let’s just 26 times earnings, that’s probably low right now, but let’s call it 26. So half of American Express is a credit card processor, and their take is higher on credit card processing than it is at Visa and Mastercard. The other half of American Express is a bank, so let’s say they’re similar to JPMorgan, and let’s say JPMorgan closed today after getting bashed in the head at say 11 times earnings. So if half of your company is a 26 multiple, that’s 13 multiple points, the other half of the company is 5.5, that means that par on American Express is 18.5 times earnings in a market that trades at 17. Oh, but wait, it trades at 13, or 14, and Buffett brags about it in his letter, and he bragged about it at the annual meeting.
These guys could…they could own the world in 10 years, and they’ve got the highest credit-worthiness people, 40% of people with incomes over $100,000 in the United States are American Express cardholders, and the economy is likely to be better than people think, and the Federal Reserve Board guy, when we’re talking about kicks into gear the next three or four years, they’re gonna be pointing fingers at him like they did with Greenspan on the tech bubble and say, “Why didn’t you get in front of this thing?”
See, they started getting in front of it just last year, and then they lost their courage because they got spooked about the economy, and maybe for a good reason, I don’t know. But let’s just say, if you look at our portfolio, up and down our portfolio, the only thing that we’ve got that doesn’t really play right into the 30 to 45-year-old demographic is we’re in healthcare through Amgen, Merck, Pfizer, Johnson & Johnson, and Walgreens, and that’s because the second largest population group is the Bill Smeads, and that’s the baby boomers, and we wanna be kept alive and in good health for a good 20 or 40 years. And regardless of what the politicians say, that’s gonna be a great business.
By the way, one comment, I already mentioned Amgen, Merck and Pfizer, Amgen, all these companies expense the most important long-term capital investment they make. They are the opposite of the tech companies. The tech companies don’t count equity compensation as an expense. In the case of the pharmaceutical and biotech companies, they expense their biggest long-term investment upfront in the income statement. They have the most conservative income statements of any company in the entire market, one of the reasons they’ve always traded their P/E above the market because they’re clearly superior companies with clearly better economics, and they do great things for people, and they need to hire a better PR firm. They make medicine and treatment. They don’t make drugs. That’s something that Mrs. Reagan railed about. Just say no to drugs. You don’t wanna have people say you make drugs. They need to get a new PR firm. They make medicine. And by the way, is there a better reason for being the richest nation on the planet besides extending a life?
The only meaningful way to do damage to what we spend on healthcare is to shorten people’s life through euthanasia, which of course I don’t believe in for a minute, and I don’t think most of everybody else does. You spend 80% of what’s spent on you in your lifetime on healthcare in the last five years of your life. So this idea that you’re gonna cut drug cost, medicine cost, which is 12% of healthcare spending and do any significant damage to the cost of healthcare is typical hyperbole, and this idea that Buffett, and Bezos, and Jaime Dimon are gonna get together and figure out through technology some magic wand, the problem isn’t how to deal with people 30 to 50. That isn’t the problem. That isn’t where the money is. Willie Sutton robbed banks. Why? Because that’s where the money is. The money is in the last five years of life at the hospital.
Meb: I love it. Well, Bill, that is a great overview of a very thoughtful approach and portfolio. You have me a little melancholy that I’m a quant because listening to your ideas makes me wanna go out and buy all these tomorrow. As we wind down, we’ve already kept you for long enough, our favorite question to ask the guest is always, looking back over your career at all sorts of places, Smead and Drexel, what’s been your most memorable investment? It could be something wonderful, it could be something terrible. Anything come to mind?
Bill: The biggest mistake was, since I just mentioned healthcare, I bought a bunch of Humana at $7 back in ’99, and it went down to $5 and I stopped myself out, and it’s now $250, 20 years, $7 to $250. Buffett says all his biggest mistakes were sins of omission. You know, I think the funnest thing was having my own clientele scratch their head in ’07 and ’08 as we loaded up on Starbucks because no one was gonna wanna buy a cup of coffee in the deepest recession since the depression. That was the finest one. That was our best performing stock ’09, ’10, ’11, and ’12.
Meb: It’s fun to look back on those.
Bill: Yeah. You wouldn’t be talking to us if we hadn’t done that.
Meb: You mentioned Buffett and it’s funny about the sins of omission because another one of your portfolio holdings, Disney was one that Buffett often laments a little bit. Bill, this has been a blast. Where can people find you if they want to learn more about you, and your firm, and what you’re up to?
Bill: smeadcap.com, and all they have to do is add their e-mail address and just a tiny bit of information, and we write about 40 times a year, and they can read our best thinking when they have the time.
Meb: Bill, thanks so much for joining us today.
Bill: Thank you.
Meb: Listeners, we’ll add the show notes and links to some of the Bill’s reports, things we were talking about at mebfaber.com/podcast. You can always find the archives. Send us firstname.lastname@example.org. We promise to read it. Leave a review on iTunes, we promise we read all of them. Thanks for listening, friends, and good investing.