Smead looks for ‘hated’ companies

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Investors should seek out ‘hated’ companies that are generating cashflow off addicted or sticky customer bases in order to maximise their chances of beating indices such as the S&P 500, according to the latest note on US equity from Smead Capital Management.

William Smead, CEO and CIO, writes that investors who bought the S&P 500 companies worst rated by analysts would have made twice the return since 2008 than either the index or actively picking out the top rated companies.

What that means is that investors could have turned an investment of $100,000 into $270,000 since 2008, against an S&P 500 tracker fund, which would have turned the investment into $170,000 – according to figures contained in a article quoted by Smead.

Finding hated companies also raises the question of sectors, given that some such as tobacco are more hated than others, implying a discount for all constituents. However, this can in turn increase the potential return over time, in mind of factors such as ongoing cashflow generation.

“The wages of sin is exorbitant profit,” Smead quotes a piece found in the Financial Times earlier this year.

“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,” that FT article added.

Smead himself added: “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.”

Applying this approach, Smead notes a number of US companies and the reasons for their being ‘hated’ by investors. These include Gannet (newspapers and TV stations), Comcast (US cable TV), Ebay, and Navient and SLM (student loan providers). All these areas of business face considerable pressures, including regulatory changes, as well as possibly being disliked by investors personally – Smead points to so called Millenials, young people with large student debts, who may actually feel personal antipathy towards student loan providers. However, this is also another example of the ‘sticky’ customer base which will enable companies to continue generating returns over a longer period.

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