Bill Smead is chief investment officer at Smead Capital Management
) -- Oppenheimer's chief market strategist, Brian Belski, put out a great piece of research last week -- "U.S. Strategy Weekly: Shifting Focus to Value Over Growth" -- on the composition of the companies that make up the value half of the market capitalization of the
The index is divided into growth and value partitions by the factors listed in the following table. High ratios in the growth factors show investors expect a bright or growing future. High yields in the value factors infer low future expectations on the part of investors.
The two accompanying charts appear to "paint a thousand words." The first chart shows the number of companies in the value side of the index has grown immensely in the last 15 years. We believe it is not unusual for this to happen in the aftermath of a major market decline.
The second chart shows which sectors of the S&P 500 Value index are the most overrepresented and underrepresented today as compared with the average of the index over the last 15 years.
We have only begun to decipher the "thousand words," but here are a few translations. First, what would have caused the growth half of the index to require far fewer companies than before to equal 50% of the S&P 500's market capitalization?
When the growth factors improved in the energy industry, investors moved massive amounts of capital into the sector. Energy is the most underrepresented in the value side of the index (4.7%) compared with normal (12.6%). These energy companies tie up a massive amount of capital because of their capital-intensive nature, taking money away from other sectors. (Energy companies that are listed on the S&P 500 include
Many other cyclical stocks hold above-average growth factors as the lemmings have overcrowded the BRIC (Brazil, Russia, India and China) trade, giving market premiums to capital and labor intensive companies.
We have admired the stock-picking of folks like FPA's Robert Rodriguez and the sector analysis of Jimmy Rogers for 20 years, but they both need to consider that owning energy and living in Singapore is not lonely contrarianism today.
If this were the course of action to take, we should move Smead Capital Management to the New York/New Jersey metropolitan area to be closer to the drug companies to show our bold contrarian spirit.
Second, what is overrepresented in the value half of the index compared with normal? It's consumer staples and health care, by a whopping margin! Consumer staples, which include such companies as
, represent 14.9% today vs. the normal 4.4% in the value index, while health care is 13.6% today vs. its normal 4.5% weighting.
Many of these companies have beautiful balance sheets, strong international brands, generate massive free cash flow and earn high returns on capital. We haven't done the research yet, but we believe we will find that consumer staples and health care, companies such as
, are normally as underrepresented in the S&P 500 Value Index at this point in the cycle as energy is this time.
I heard Warren Buffett tell a story about raising money for his early partnership. We believe it does a great job of illustrating why we at Smead don't want to own BRIC-trade cyclical companies.
Buffett went to see the owner of the largest farm-equipment dealer in Omaha, Neb., when he was raising money for his partnership in the 1950s. He asked the owner how he had done this year. The owner told him he had done great. Buffett asked what he did with the profits. The owner went over to the office window and pulled open the drape. He told him that it was all sitting on the lot as he showed Buffett the inventory for the coming year.
In many cases, a great year in a capital-intensive business leads to more capital expenditures and little free cash flow for investors. Consumer staple and health care companies have a history of producing consistent free cash flow, which the owners or management of the company can use any way they see fit to enhance shareholder value.
-- Written by Bill Smead in Seattle
Bill Smead is the chief investment officer of Smead Capital Management (SCM) in Seattle. Bill started at Drexel Burnham Lambert in 1980. He then spent 11 years at Smith Barney, beginning in 1990. While at Smith Barney, Smead started managing money in the same program that spawned the careers of Bruce Berkowitz and Robert Olstein. Bill founded SCM in July 2007, after managing money under Wachovia Securities from 2001 to 2007. A fan of Warren Buffett, Smead's writings (Smeadblog.com) and his Roadshow talks are all focused to remind investors that owning a few great companies can create wealth. He is the lead portfolio manager of the Smead Value Fund (SMVLX).