Dear Fellow Investors:

In our business, we like to say that insider transactions never lie. For this reason, one of our eight criteria for selecting common stocks is strong insider ownership, preferably with recent purchases. Additionally, as contrarians, we want to make our original purchases in a business at a time when most investors are scared to buy for one reason or another. When we see officers, directors and substantial existing shareholders of a business buying at prices which are temporarily depressed, we raise our confidence in the long-term future of a business.

What triggered the urge to discuss insider ownership at home and abroad came from a recent Time magazine article titled, “Found: Offshore Wealth Stashed by Families of China’s Leaders.” Since so many people, including investors, money managers, and media seem to fawn over the long-term prospects in China, we believe it is valuable to look at what the insiders in China are doing with their own money in the same way that we look to officers and directors of the public companies. Here is an excerpt from the article.

On Jan. 23, anyone with an interest in the intersection of power and money in the People’s Republic will receive an early Chinese New Year gift: the names of nearly 22,000 mainland Chinese and Hong Kong citizens with funds in offshore tax havens in places like the Caribbean and the South Pacific.

The trove of leaked documents originates from two firms that help clients move their money offshore. After gaining access to these secret records, the International Consortium of Investigative Journalists (ICIJ) gathered more than 50 reporters around the world, who spent months combing through the files before they are released to the public. ICIJ has uncovered what it believes to be piles of wealth stashed overseas by “red nobility,” as relatives of China’s communist leaders are known…

Chinese economic growth has slowed from an average above 10% to a current pace around 7.5% on GDP. While China is reporting GDP numbers amazingly close to projections, the internal Chinese stock market, the Shanghai Composite, has been miserable the last six years with a total return of -55%.

To us, it’s not surprising that private money is leaving. What does surprise us, however, are three aspects of China and its economy which we are expected to accept: 1) A planned economy can always hit its targets, 2) The central planners can properly address what we view as major misallocations of capital in their society, and 3) China’s economy won’t suffer a recession or depression because the government will step-in to inject capital.

Time’s story reveals that the same Chinese Nationals who have become incredibly wealthy over prior decades from business success in China are placing their money outside China. Simultaneously, they continue to affirm publicly their faith in centralized planning and what we’ve come to know as “Red Capitalism.”

Here is what Time magazine found regarding insider activity in China:

The nation’s capital flight, which ICIJ says involves “every corner of China’s economy, from oil to green energy and from mining to arms trading,” should worry its leaders; particularly as the nation’s economic growth slows to its most sluggish in years. After all, what does it say about confidence levels when the very people who profited most from China’s great economic expansion are parking their cash abroad? Wang Huiyao, head of the Center for China and Globalization in Beijing, which on Jan. 22 released a report on China’s international migration patterns, cites research that found that Chinese with around $1 million in assets had transferred $465 billion overseas in 2011.

Perhaps this is the reason why the Chinese wealthy are not writing letters to major Chinese and International publications like Warren Buffett did on October 17th of 2008. When the US stock market suffered its own peak-to-trough decline of 53% from 2007 to 2009 in the S&P 500 Index, Buffett wrote a New York Times op-ed called “Buy American, I am.” He argued that despite the US stock market meltdown in the prior year, he was buying aggressively even if prices continued to fall. In retrospect, we now know just how brilliant that advice was. It was a God-send to those of us who found value in knowing what wealthy and powerful leaders did in one of the most difficult economic and stock market circumstances since the Great Depression.

As we have stated many times over the last four years, the situation in China doesn’t pass our smell test. The latest reports show that 64% of Chinese Nationals with greater than one-million dollars of net worth have set up life—or at least investments—in another country. It is bad enough that they are not investing in what we are told are undervalued companies in a country with a supposedly bright future, but they are also buying assets all over the world—just ask the residential real estate agents in London or the West End of Vancouver, British Columbia. While those who are the most knowledgeable to the inner-workings of China continue to invest abroad, we find a large group of apologists running around the rest of the world begging investors to bet on China and a successful transition to a more consumer-oriented society.

Numerous studies have shown the merit of following the purchases of insider buyers. The latest one showed that buying stocks with strong insider buying added significantly to returns over the following 12 months as compared to the S&P 500 index. Here is how Barron’s reported these statistics on December 24th of 2013:

[David] Miller's strategy can be traced to his schooling under University of Michigan professor Nejat Seyhun, an expert on insider activity as an indicator of stock performance. One hallmark of Seyhun's research is to focus on executives who are truly privy to insider information. Large shareholders, though classified as insiders, may not fit that bill.

Miller and a colleague discovered that if at least three key executives bought a minimum of 10,000 shares, companies outperformed the market by an average of 11.5% in the following year. Firms with the most insiders selling, on the other hand, underperformed the market by 4% in the year following their sales.

At this stage in the evolution of the Chinese economy and stock market we are asking a simple question. Why are smart money and wealthy individuals in China pulling their money out of their country rather than investing in the common stock of companies which could benefit the most from the supposed bright future advertised by China enthusiasts? We at Smead Capital Management answer this question by avoiding US companies and S&P 500 sectors which have the most to lose from the insiders being right in getting their money out of China.

Warm Regards,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

© Smead Capital Management

www.smeadcap.com

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