“Stocks in the lowest price-to-tangible-book decile delivered the highest returns over the long term.” --Donald Smith
Donald Smith (Trades, Portfolio) brings a relatively unique perspective to value investing, dealing only with stocks in the bottom 10% based on price-to-tangible book values.
He and his firm serve only institutional clients, so we do not have a lot of details about his performance. A couple of clues lead us to believe he has done well for those clients, however.
Who is Smith?
According to Inside Philanthropy, Smith earned a Bachelor of Science in finance and accounting at the University of Illinois, an MBA from Harvard and a law degree from the UCLA Law School.
His career as an analyst began at Capital Research Company, where he went on to become a director, vice president and portfolio manager. That was followed by a stint as chief investment officer of Home Insurance Company and the president of Home Portfolio Advisors.
Smith bought the latter firm in 1983 and changed its name to Donald Smith & Co. Inc.
GuruFocus reports Smith volunteered for Benjamin Graham while at UCLA, and with him conducted a study on a low price-earnings (P/E) strategy.
With three degrees, we can safely assume Smith brings at least intelligence and curiosity to his work. Having connected with Graham helps us understand how he became interested in value investing, and particularly in deep-value investing.
What is his company?
The original company was formed in 1975, and bought by Smith in 1983. It is a registered, independent investment advisor specializing in value equity accounts for big institutions.
The firm has four owners, of whom Smith is the principal owner. Richard Greenberg, the senior portfolio manager and director of research, has worked alongside Smith since 1981.
The firm operates through six funds, none of which is available to individual investors:
- All Cap Value Equity.
- Large Cap Concentrated Value Equity.
- Midcap Value Equity.
- Small Cap Value Equity.
- Micro Cap Value Equity.
- Global Value Equity.
For the funds, they invest in equity products listed on national exchanges. That includes domestic equities, American depository receipts of foreign companies and dually-listed companies. The Global Value Equity Fund adds common stock of foreign companies. They do not use derivatives or fixed-income securities.
In the Form ADV filed April 11, the company reported having $4.426 billion of assets under management (AUM).
Smith and his firm operate through six funds, which cover four different market caps, one all-cap and one global fund. With these funds, they have built the firm into a sizeable player based on AUM.
Investment strategy
On the Investment Strategy page of their website, Smith and his colleagues say they look for out-of-favor companies that are valued in the bottom decile of price-to-tangible book value ratios.
Unpacking that statement, start with “out-of-favor” companies, which leads to Graham, and to buying the cheapest of the cheap stocks. Something like Warren Buffett (Trades, Portfolio)’s “cigar butts.”
And they mean seriously cheap, the bottom 10% (or decile) means bottom-fishing at its most serious. It also means, no doubt, that good companies at those prices will be relatively hard to find.
The universe is narrowed again by focusing on price-to-tangible book value ratios. That ratio spells out a relationship between the share price and the tangible book value, which is to say for how much the real estate, bricks and mortar, physical equipment, saleable inventory and so on could be sold. Smith would likely expect the sale of these tangible assets to cover the cost of the shares.
GuruFocus provides this ratio for the stocks it covers; it can be found in the right column of the Summary page. It looks like this for Deere & Co. (DE):
Clicking on the name/link leads to more detail about the ratio when applied to the company. This chart shows how Deere’s tangible book value has bounced above and below the averaged share prices:
According to the firm's website, “Studies have shown, and our long record of outperformance has confirmed, that this universe of stocks substantially outperforms the broader market over extended cycles.”
Of course, that strategy has a critical second half: Figuring out which of the bottom price-to-tangible book value stocks will recover or regain the market’s favor. On the InvestmentU.com website, Smith is quoted as saying, "We stress test. That's the first of the value traps, buying something that ends up going bankrupt on you. The second trap is buying a cheap asset that stays cheap forever."
That stress testing is described on the Investment Process page of the firm's website. It starts with quantitative screening, which identifies stocks in the lowest decile of the market—on their key ratio: price-to-tangible book value.
Companies that have “significant underappreciated earnings potential over the next 2-4 years” are the target of this research. Typically, that provides them with a proprietary watch list of 200 to 300 stocks.
Once that set of names is created, Smith does fundamental research to find the candidates with the best potential for outperformance. Getting more specific, it means going deeper on two key criteria:
- Book value.
- Hidden assets and liabilities (research plus company interviews).
Using tangible book value for the initial screening should provide a list of companies that have tangible (saleable) assets that add up to more than the stock price, thus eliminating initial downside risk. Underappreciated earnings power over the next two to four years provides the second half of the formula; if earnings power grows on a stock that cost less than its assets, then a positive return is almost assured.
Holdings
The following GuruFocus chart shows the sectors that make up Smith’s holdings:
It also lists his top 10 holdings as:
- AeroCap Holdings N.V. (AER, Financial): 10.0%
- Micron Technology Inc. (MU, Financial): 9.7%
- Kinross Gold Corp. (KGC, Financial): 6.3%
- Air France - KLM SA (AFLYY, Financial): 6.2%
- Iamgold Corp. (IAG, Financial): 5.6%
- Unum Group (UNM, Financial): 4.0%
- KB Home (KBH, Financial): 3.9%
- Yamana Gold Inc. (AUY, Financial): 3.8%
- JetBlue Airways Corp. (JBLU, Financial): 3.4%
- American National Insurance Co. (ANAT, Financial): 2.9%
What is striking in this top 10 list are the weightings on gold and airlines. The latter is not surprising; the airline industry had struggled with overcapacity and fuel prices for several years. It seems unlikely gold is being held to protect against inflation, although Smith may be anticipating an end to the Federal Reserve’s iron grip on interest rates. Other uses of gold, including hedging, may also explain the holdings.
Performance
Smith & Co. only serves institutional investors, so there is limited public knowledge of his performance. However, a picture of sorts can be developed from bits and pieces of information.
A 2011Â Investment UÂ article said Smith’s firm generated compounded average annual returns of 15.3% over the 30 years since inception. It added the firm had generated average annual returns over the previous 10 years of 12.1%, while the S&P 500 was basically flat. Given Smith & Co. was founded in 1983, making the company less than 30 years old in 2011, the reference may include Smith’s work with Home Portfolio Advisors.
Add to that the generally upward slope of equity assets under management, as shown in this GuruFocus chart:
Based on this chart, and assuming investor inflows and outflows generally follow the returns received by client investors, it appears Smith had poor years in 2007, 2008 and 2014, but otherwise did well. That is somewhat speculative, but probably the best we can surmise of Smith’s returns over time.
Whatever the returns, they appear to have been strong enough to keep bringing in new business while keeping existing clients. As noted, Smith deals solely with institutional investors, so we would expect their continued patronage to be based on real gains rather than good advertising.
Conclusion
Smith has done well for his clients, providing them with reasonable returns, although we do not know the details of those returns.
The guru is a value investor, but has stayed closer to “cigar butt” investing than other guru. Working with only the bottom 10% of companies brings in only cheap stocks, and by emphasizing price-to-tangible book value, along with underappreciated earnings going forward, he significantly reduces the chances of buying companies that are likely to go under or underperform for years to come.
Both strategy and execution have survived and delivered well for almost 35 years now.
Disclosure: I do not own shares of any of the companies listed, nor do I expect to buy any in the next 72 hours.
