Dear fellow shareholders:
While we are pleased with a 15.79% absolute return for the quarter, the Smead International Value Fund (SVXLX) did underperform on a relative basis by 1.55% to the MSCI EAFE Index which gained 17.34%. Our holdings in Frontline (OSL:FRO, Financial), Interfor (TSX:IFP, Financial) and Porsche Auto Holdings (XTER:PAH3, Financial) were the largest detractors in the quarter. As many of you may know, at Smead Capital Management we view quarter-to-quarter volatility as the price we pay to compound wealth over the long term. As people that pack our own parachutes, we are investors alongside our shareholders. We will continue to focus on great companies that meet our criteria and offer a large margin of safety. On the positive side, our biggest contributors to performance for the quarter were Cenovus Energy (TSX:CVE, Financial), Meg Energy (TSX:MEG, Financial) and Unicredit (MIL:UCG, Financial).
For the full year 2022, the Smead International Value Fund returned a respectable 2.54% vs. the MSCI EAFE Index which was down 14.45% for the same period. The outperformance for the year was primarily attributable to our exposure in the energy sector and specifically to Occidental Petroleum (OXY, Financial), Cenovus Energy and Meg Energy as they were our biggest contributors. Our holdings in Interfor, Porsche Auto Holdings and West Fraser Timber (TSX:WFG, Financial) were the largest detractors for the year. The year 2022 stands as a great example of the benefits of our philosophy for three reasons. First, how it affords us the ability to think independently. Second, how we can take advantage of opportunities that misperceptions create. Lastly, the importance of demanding a high margin of safety in our investments. We are extremely grateful to our investors who are on this journey with us.
The Law of Comparative Advantage
In 1817, David Ricardo developed his theory of comparative advantage to explain why countries engage in trade together, even when one country has an absolute advantage. The law of comparative advantage holds true today, but comparative advantages for particular goods change. A country’s advantage ebbs and flows with currency value, labor availability, labor prices, tariffs and other factors when it comes to goods. The law of comparative advantage is always shifting on the map of the globe.
The last 10 years have been led by the dominance or advantage of products made in Asia, but profited from in the USA. The USA’s advantage has been primarily its lead in its entrepreneurial culture, company building, technology and the ability to raise money for businesses that benefit from these factors. The product that makes us think of this process of building in Asia, but profiting in the USA, is the iPhone produced by Apple (AAPL, Financial). The product wasn’t in existence 20 years ago, so it gives us a particular view of the flow of money for goods globally from a 20-year perspective. It was the most purchased product by revenue during that era.
Below is a breakout of the portion of the iPhone’s revenues that go to suppliers versus Apple itself:
This chart shows where the money has gone. The orange portion is the production costs, which have primarily flowed to Asia. The blue portion is what is going to Apple in the USA. This requires billions of people to purchase these products, ultimately in US dollars, and causes a huge demand-pull for the US dollar as a currency. The pandemic caused many people to go out and buy new iPhones. We had never been more completely dependent on technology in our lives at that point. Consumers aren’t buying iPhones now that they are free from their homes. They are off traveling and visiting the world. The flow of dollars from consumers has slowed to this product. This is our view of the current account of the USA in a classic economic sense.
Our view of the capital account in economics is what has taken place in the stock and bond returns. Below are the returns of US stocks and bonds over the last 10 years:
The USA went from producing gorgeous returns for foreign investors to producing losses in treasuries, corporate bonds and stocks. The old saying is that dogs chase cars and humans chase stocks. As investors, we know they chase anything that goes up and run from anything that goes down. The problem for the US dollar is that if they run from the asset they were just chasing, it could take a while for the capital account situation to get back to the strength it has had.
The last decade has been an unprecedented move to American technology products and US assets going one way together. This has been the USA’s comparative advantage and has helped the US dollar largely. Below is a chart of the trade-weighted dollar index over the last 10 years:
It peaked at a gain of close to 42%, coming off the fears of Ukraine and higher rates in the US. It has since fallen to a 30% gain over the prior decade. We expect the comparative advantage of US technology products and the US investment assets to be the problem of the US dollar.
Does this spell a nightmare for the US? No, what is in the rear-view mirror won’t tell us the future. We are going to watch the west shift their supply chains to their allies and closer to home. Thus, away from Asia, a departure from the recent past. If you read Shannon O’Neil’s recently published book The Globalization Myth, you could see a world where we are much friendlier to our neighboring countries, Canada and Mexico, again a departure of the last ten years. What else could be a complete departure from the last 10 years? Poor US stock returns, poor US bond returns and a weak US dollar. For the investors in the Smead International Value Fund, we should relish these problems. The frustration of other investors and the strength of non-US dollar assets we believe will be our comparative advantage.
Fear stock market failure.
The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
