Dear fellow investors,
With markets extremely difficult and volatile as we work through COVID-19, we thought it would be good to review important parts of our investment discipline. One way to do that is to consider stocks we found via our eight criteria for stock selection and did not keep long enough to get to their ultimate rewards.
The latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More
Buffett's Sins Of Omission
Warren Buffett is always asked what his biggest mistake has been in his stock picking discipline over the years. He points out that it was his “sins of omission” which hurt his results the most. In other words, stocks which he owned and did not stay with that ended up being huge winners. The poster child of this concept for Buffett was buying a 5% Disney (DIS) position in 1965 and selling it a year later for a 50% gain. Even though the stock is well off its high and part of today’s tribulation, the pain of selling is intense.
The math of the stock market explains why these omission sins matter so much. If you buy a five-percent position and it goes down 60%, you lose 3% of your portfolio. If you miss a ten-bagger/ten-fold price increase in a 5% position, it can make a 25% gain difference in the overall portfolio value even when the rest of the portfolio doubles. Disney has a market cap of around $196 billion, so Buffett’s position would be worth about $9.8 billion today. He bought his 5% position for $4 million. This means he passed on a 1,225-bagger since then (not counting dividends).
We will share three huge sins of omission which we have personally made, that have affected our long-term results over the years to help you frame this discussion. In early 2000, at the height of the dot-com bubble, we bought shares of Exxon (XOM) at around $35 per share with a juicy dividend yield. Oil prices were very depressed (like now). We held XOM for three years and sold it, because it was one of our poorest performing stocks in a stretch where we did extremely well relative to the stock market. When the dot-com bubble broke, our investments flourished. Eventually, Exxon went up to $100 per share as stocks got pummeled in 2007-2008, and Chinese economic growth drove oil prices to $145 per barrel. Owning XOM from 2003-2008 would have had a huge impact on our overall results the first six months our strategy existed in the public domain.
Costco's Stock Performance
Also, in 1999, I got sick of watching my wife and family rave about spending money at Costco (COST). One day in early 2000, my wife mentioned that she got a check from Costco as a 2% rebate for $260. My multiplication skills are excellent and when I did the math, I swore to myself that when given a chance to buy shares at a reasonable price, I would jump on it.
In the spring of 2000, Costco pre-announced that its earnings were going to be very disappointing and the stock dropped sharply from around $60 per share. Then when they did have the earnings report, it was worse than expected. The stock dropped from $41 to $28.50 per share in one day and I stepped in to buy.
Unfortunately, in the next three years, the earnings per share went nowhere even though sales were growing 10% per year. I thought something must be wrong, how do you sell 10% more each year and not make more money? I sold the stock around $35 per share in 2003. On June 26, 2020, Costco is trading around $298 per share. It turned out that Arnold Schwarzenegger getting elected Governor of California and fixing the worker’s compensation system helped Costco more than most companies because their largest number of stores were in that state.
In the summer of 2006, Microsoft (MSFT) announced a Dutch Auction to buy a huge chunk of their shares between $22.50-26.50 per share. We purchased a sizeable stake around $22.50 per share. The stock peaked on December 27, 1999 at $53.60 per share. We eventually bought a slug of it and built an 8% position by late 2008. It was our largest position toward the end of the 2007-2009 bear market. However, there was one big problem with MSFT. The CEO of Microsoft was better at wasting money than almost any executive we have witnessed in 40 years in the investment business.
He bought a series of companies at inflated prices, while refusing to allow employees to own or handle Apple products. Here is what he said about Apple:
“Three years ago, just before the original iPhone shipped, here’s what Steve Ballmer said in an interview with USA Today’s David Lieberman:
‘There’s no chance that the iPhone is going to get any significant market share. No chance. It’s a $500 subsidized item. They may make a lot of money. But if you actually take a look at the 1.3 billion phones that get sold, I’d prefer to have our software in 60 percent or 70 percent or 80 percent of them, than I would to have 2 percent or 3 percent, which is what Apple might get.’”
He emphasized Xbox and Zune, and chased an endless group of rabbit trails with shareholder money. In 2011, we gave up at $28 per share to buy bargains in shareholder-friendly companies (which made us a great deal of money since then). Microsoft trades at around $197 per share and has benefitted from terrific management beginning in 2014. We never got back in because we knew nothing about the new CEO and were naturally gun shy at that point! We wish we stayed with them, but five years was a long time to wait on a flat stock.
Disappointing In Price Performance
What stocks do we own today that have been disappointing in price performance, even though they fit our eight criteria?
- Discovery Communications (DISCA)
- Wells Fargo (WFC)
- Pfizer (PFE)
These companies are deeply out of favor and are usually highly respected. Discovery makes the most popular unscripted TV shows (Deadliest Catch, Fixer Upper, 90-day Fiancé, etc.) which come through cable, satellite or via streaming. The assumption is that streaming will kill their business. We believe that Amazon, Apple and Netflix covet their 19,000-hour library and hold on 25-44-year-old viewers. Advertising is down due to COVID-19 and non-streaming delivery is shrinking. Investors are afraid cable will die completely.
We got involved with Discovery (DISCA), because they bought our stake in Scripps Network at a 45% premium in 2017. Even though Scripps channels like HGTV, Food Network and Travel Channel have been hugely successful, the stock market only seems to love Netflix. Heavy insider buying occurred at prices ranging from $17 to $27 from big names like John Malone. Here we sit with coronavirus negatively impacting advertising for DISCA three years later. The stock has been dead money since we started buying at $17 per share in 2017.
Wells Fargo (WFC) has existed since the 1850s. They have superior mobile banking technology and have been punished for very poor decisions on sales incentives and previous management motivation in the mid-2010s. The punishment has scrubbed the company well the last three years. COVID-19 has brought interest rates very low and will temporarily affect current dividend payments. The stock is approaching financial crisis pricing to book value and normalized earnings. The question isn’t whether Wells will survive, it is whether they will prosper. We’ve owned it since 2009.
Pfizer (PFE) is a premier maker of medicines and treatments. They are spinning out their non-patented drugs into a company merged with generic drug company, Mylan Labs, to be called Upjohn. We expect the spin-off shares to be worth around $5 per PFE share. The remainder businesses will be the part of Pfizer with the brightest future, including everything their massive research and development budget is creating. The company produces immense free cash flow and pays substantial dividends. Investors hope this spin-off will reinvigorate the company. It has underperformed our portfolio in recent years.
In conclusion, we are patient in our buying, patient in our holding, and patient in our selling. We can add value by avoiding sins of omission, even though they are inevitable. Our hope is these three stocks take off in our favor so that they don’t have to be added to our list of “sins of omission.”
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, 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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