The Genesis of Our Stock Selection

We have gained a number of new investors and get regular vetting interest from investors who need to understand the roots of our stock-picking discipline. Our stock-picking discipline is built around our eight criteria for stock selection listed below:

Required over the entire holding period:

• Meets an economic need

• Strong competitive advantage (wide moats or barriers to entry)

• Long history of profitability and strong operating metrics

• Generates high levels of free cash flow

• Available at a low price in relation to intrinsic value

Favored, but not required:

• Management's history of shareholder friendliness

• Strong balance sheet

• Strong insider ownership (Preferably with recent purchases)

Before we unpack the eight criteria, let's look at the history of where it came from. To understand the origin of these criteria you must understand the psychology of a risk taker. When I was an assistant manager and training director from 1983 to 1989 at Drexel Burnham, we did a great number of job interviews for stockbroker positions. My favorite question was, What risks have you taken in the past that would indicate that you will thrive in a risk-taking environment? Remember, these were stock brokerage positions paid via commissions.

If I had five dollars for every person who told me they climbed Mount Ranier back then, I'd be rich. You see, we were looking for financial risk-taking like starting a business, making an investment, or using personal skills in gambling. My dad's family thrived by taking risks on their math and analytical skills in gambling as a hobby. They played poker, went to Nevada to play blackjack and the craps table and enjoyed handicapping greyhounds.

In my case, it was baseball card statistics, poker with my buddies and handicapping greyhounds at Multnomah Kennel Club in Gresham, Oregon. I adored baseball players like Willie Mays with years of fantastic success documented on the back of his Topps playing card. I played better poker hands, made better estimates of my competitors' hands and sought to control my risk in poker. But it was handicapping greyhounds where our eight criteria really got started.

Greyhounds were bred to run, and they could run 550 yards in 33 seconds. After a number of years of watching and speculating on who would win, we began to discover factors that could lead to better outcomes. First, like in any other sports contest, the dog that had beaten better dogs before was more likely to win than the other dogs.

Second, the dogs ran on an oval track and many dogs would bang into each other on the first corner and ruin their chances. Therefore, early speed was an important factor. Third, most of the dogs were bred for early speed, so dogs with late speed could take advantage of early speed dogs that burned each other out in the first 400 yards of the race.

Next came number four, post position. The greyhounds demonstrably preferred running around the inside of the track, but many liked to run around the outside. So, you wanted to bet on dogs that met our other criteria when their post position matched their past tendencies.

Our last criteria for dog selection was the Janet Jackson rule, How have you been running lately, OOH, OOH, OOH, OOH? Why is the Janet Jackson rule so important? In the summer after my freshman year in college, I worked mostly swing shift from 4pm to 12pm and had no social life. My primary entertainment was handicapping greyhounds at my cousin Gary Smead's house along with my other cousin, Jack Ross.

A dog named Pastel Peepers came into town after a fabulous winter campaign at the Palm Beach track, which was considered the strongest track in the country. We knew of the dog's success because we received track records from the other major tracks. Pastel had early and late speed and had great success in Palm Beach.

I lost more money on that dog than I had ever lost on a single dog in a year. By the middle of the summer, Pastel had dropped two levels from A class to C class, even as my dad and I had turned our $400 into $1400 by the end of the summer when I went back to school. In the last one-third of the year, Pastel Peepers won almost every race, including beating all the best class A dogs. In other words, if I had waited for the Janet Jackson rule to kick in, I would have made even more money that summer, because Pastel Peepers finally got comfortable running in the Pacific Northwest at Multnomah Kennel Club.

We discovered that on any given night of 11 races, there were likely only one or two races worth betting on. Hence, selectivity and patience were automatically included in the dog selection criteria.

Now, fast forward to 1985. I'd been a stockbroker for five years and had very little success in stock picking. I'd read Peter Lynch's book, "One Up on Wall Street," was watching Sir John Templeton on Wall Street Week and was beginning to learn about the work of Warren Buffett (Trades, Portfolio) and Charlie Munger at Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B). Then Drexel Burnham took a closed-end fund public to put $100 million dollars in the hands of a manager by the name of Barry Ziskin in a fund called the Z-Seven Fund. Ziskin had seven criteria and it reminded me of my greyhound handicapping.

This triggered me to think about developing my own criteria. So here is how we thought about each of our criteria:

• Meets an economic need. You have no idea how much trouble we have avoided by thinking about whether a company's product or service meets an actual need.

• Strong competitive advantage (wide moat and barriers to competition). Your moat wasn't a calculation and was more of an observation. We felt our life experiences put us in a better position to understand brands and products.

• Long history of success and strong operating metrics. I had no skills in identifying young up-and-coming companies and wanted to lean on courage and being a contrarian to buy when others were afraid.

• Generates high levels of free cash flow. We wanted to think about our common stock investments like you would if you owned the whole company.

• Available at a low price in relation to intrinsic value. We wanted a discounted stock price from the prior five to ten years.

• Management history of shareholder friendliness. We wanted companies that treated shareholders like partners.

• Strong balance sheet. Many times, the discount in price meant something needed to be turned around. Balance sheet strength is needed in turnarounds as well as free cash flow.

• Strong insider ownership (preferably with recent purchases). If we could only have one of these eight criteria, this one has proven to be a money-maker in academic studies.

By 1991, all I wanted to do was find people who would let us buy them a portfolio of stocks based on our eight criteria for common stock selection. Then, in 1992, Smith Barney invited me to be one of 100 brokers who would be allowed to run separate accounts on a percentage-fee basis. This put my compensation directly aligned with portfolio performance. As a father of five kids, getting paid on Saturday and Sunday was a Godsend.

By 1998, I was running portfolios based on our criteria totaling $150 million. After 14 years of running these separate accounts, we started Smead Capital Management in July of 2007.

Our eight criteria for stock selection and the patience associated with waiting for the fat pitches to come along explain much about what we do. Combine this with the willingness to hold winners to a fault and you get a pretty solid understanding of our discipline. Fear stock market failure!

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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This article first appeared on GuruFocus.