Which Is The Best Pond to Fish In – Donald Smith

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Donald Smith is the CIO of Donald Smith & Co. He began his career as an analyst with Capital Research Company and subsequently worked at Capital Guardian Trust Co.

According to Whalewisdom.com, Donald Smith & Co. has $4.46 Billion in assets under management. Over 30 years since inception Donald Smith & Co’s compounded annualized return is 15.3%. Over the last 10 years its annualized return is 12.1% versus −0.4% for the S&P 500.

Smith is a deep value manager who uses a bottom up approach and someone who value investors should follow.

Back in 2010 Smith gave an interview to The Graham and Doddsville Newsletter where he outlined his successful investing strategy.

Following is an excerpt from that newsletter which you can read in full here.

Let’s see what he had to say…

Describe the history of your firm and how you got started?

DS: Donald Smith & Co. was founded in 1980 and now has $3.6 billion under management. Over 30 years since inception our compounded annualized return is 15.3%. Over the last 10 years our annualized return is 12.1% versus −0.4% for the S&P 500.

We have seven investment professionals and three of those went through the Value Investing program at Columbia. The program has been a wonderful hunting ground for us to find analysts who understand the value approach.

Our investment philosophy goes back to when I was going to UCLA Law School and Benjamin Graham was teaching in the UCLA Business School. In one of his lectures he discussed a Drexel Firestone study which analyzed the performance of a portfolio of the lowest P/E third of the Dow Jones (which was the beginning of ―Dogs of the Dow 30‖).

Graham wanted to update that study but he didn‘t have access to a database in those days, so he asked for volunteers to manually calculate the data. I was curious about this whole approach so I decided to volunteer. There was no question that this approach beat the market. However, doing the analysis, especially by hand, you could see some of the flaws in the P/E based approach.

Based on the system you would buy Chrysler every time the earnings boomed and it was selling at only a 5x P/E, but the next year or two they would go into a down cycle, the P/E would expand and you were forced to sell it.

So in effect, you were often buying high and selling low. So it dawned on me that P/E and earnings were too volatile to base an investment philosophy on. That‘s why I started playing with book value to develop a better investment approach based on a more stable metric. I then went to Harvard Business School and spent a lot of my time analyzing stocks.

Upon graduation I went to work as a securities analyst at Capital Research in Los Angeles. They had just bought an IBM mainframe and had a lot of excess computing capacity. They had a bright programmer and I asked him to set up different screens.

So we backtested many value strategies based on price to book, price to earnings, price to sales, price to dividends, growth rates, return on equity, etc. We found that a lot of the value approaches worked. I guess the moral of the story is that there is more than one way to skin a cat. But I still kept coming back to price to book.

Most of the backtests we did showed that price to book would come out the best or close to the best. I liked the simplicity of it. It made common sense to me that stocks should sell in some relationship to their underlying book value. At the time analysts used price to book for utilities, banks and insurance companies, but it wasn‘t emphasized outside of these industries as much as I thought it should be.

When I joined Capital I started applying price to book more broadly and I soon became known as the deep value portfolio manager.

G&D: Today it‘s a lot easier to screen than it probably was when you started out. Has that made the strategy more competitive?

DS: Screening for tangible book value has certainly gotten easier. However, we make a lot of adjustments that don‘t show up in the databases. For example, we adjust book value for dilution from options and convertible debt. We add back deferred tax asset valuation allowances if there is a likelihood that they will be used to offset taxes in the future.

We also adjust for ―phantom goodwill which can occur when a company does acquisitions and writes up the assets in the process so that the purchase premium does not show up in goodwill. That is something that most investors don‘t do.

G&D: The contrast to that might be when tangible book value understates the asset value. Do you tend to miss out on companies with hidden asset values?

DS: That can happen, but I think it happened more often years ago. Companies, in the quest for earnings, have sold many highly valued assets when they had the opportunity.

In our fundamental research we dig intensively into the liquidation value of companies to find instances where that value is significantly higher than tangible book value. In that case it‘s just frosting on the cake. However, we still like to focus on basic tangible book value because of the margin of safety it offers.

If we know the tangible book value is $10, the liquidation value is $20, and we can buy the stock for $7, that‘s ideal.

G&D: There aren‘t many investors that maintain such a strict focus on tangible book value, with many seeking out franchise businesses.

DS: True. The problem is that franchise value is in the eye of the beholder. Sometimes it is real, but many times it disappears. One of the great franchises of all time was supposed to be the distribution system and trademark of General Motors. No one could ever penetrate Chevrolet distribution.

People paid a lot of money for that ― franchise‖ and then it disappeared. Eastman Kodak was one of the greatest trademarks in the whole world, and then the value of that trademark disappeared.

There are some exceptions – Coca Cola has managed to keep its franchise intact. In general though, franchise value can disappear on you very easily and that‘s how you get hurt. Often when we‘re buying stocks below book, there is some franchise value there that isn‘t on the books: customer relationships, intellectual property, etc.

We‘ll take it as a freebie, but to pay for it, that‘s something else.

G&D: There are plenty of studies suggesting that the lowest price to book stocks outperform. However, only 1/10 of 1% of all money managers focus on the lowest decile of price to book stocks. Why do you think that‘s so, and how do people ignore all of this evidence?

DS: They haven‘t totally ignored it. There are periods of time when quant funds, in particular, use this strategy. However a lot of the purely quant funds buying low price to book stocks have blown up, as was the case in the summer of 2007.

Now not as many funds are using the approach. Low price to book stocks tend to be out-of-favor companies. Often their earnings are really depressed, and when earnings are going down and stock prices are going down, it‘s a tough sell. Analysts don‘t like to cover them and they don‘t have an easy time pitching them to portfolio managers.

The companies are often difficult to understand and have many moving parts. Institutional investors don‘t want to have to explain to clients that their stocks have gone down 50%, that same store sales are negative, that market share is decreasing. In general people like glamour, growth, clean and simple stories.

It‘s also tough to ride out our strategy during hard times. Every ten years or so the low price to book strategy has a down period. From a psychological standpoint, it can be a difficult approach to stick with.

(Source: Graham & Doddsville Newsletter, 2010)

(Source: Graham & Doddsville Newsletter, 2010)

G&D: How much importance do you put on a company‘s management team?

DS: Quite a bit, in the sense that we want a management team that will do no harm. We don‘t expect a stock selling at 70% of book to have Einstein running it. We spend a lot of time questioning the management. Do you plan to do acquisitions (we‘re generally anti acquisition)? Do you like your own business? If the stock is selling at 70% of book, why aren‘t you buying it back? Ben Graham said that the opinion people have of management is correlated with the stock price.

I have seen dumb managers whose stocks are selling at $10, suddenly become geniuses when their stock goes to $40. One of the attractive things about owning a stock with a low price to book ratio is that it often attracts good management.

A good manager at GE for example would rather become the CEO of a company with a stock that‘s at 80% of book than one in the same industry selling at 1.8x book. We‘ve had companies with average management teams that end up with terrific management, and those companies have become some of our biggest winners.

G&D: Would you mind talking about how the composition of that bottom decile has changed over time? Is it typically composed of firms in particular out of favor industries or companies dealing with specific issues unique to them?

DS: The bulk is companies with specific issues unique to them, but often there is a sector theme. Back in the early 1980‘s small stocks were all the rage and big slow-growing companies were very depressed. At that time we loaded up on a lot of these large companies. Then the KKR‘s of the world started buying them because of their stable cash flow and the stocks went up. About six years ago, a lot of the energy-related stocks were very cheap.

We owned oil shipping, oil services and coal companies trading below book and liquidation value. When oil went up they became the darlings of Wall Street. Over the years we have consistently owned electric utilities because there always seem to be stocks that are temporarily depressed because of a bad rate decision by the public service commission.

Also, cyclicals have been a staple for us over the years because, by definition, they go up and down a lot which gives us buying opportunities. We‘ve been in and out of the hotel group, homebuilders, airlines, and tech stocks.

G&D: Speaking of cyclicals, you mentioned your understanding of the macro picture. How do you overlay your macro views on top of your bottom-up perspective?

DS: A lot of times our macro view is generated by our bottom-up process. For example, we have followed homebuilders, banks and the mortgage GSEs for years.

When we did a bottom-up review four years ago, we saw that these companies were extremely overleveraged and that housing prices were unsustainable relative to income levels. At the same time, down-payments were going from 20% to 10% to 5% and then 0%.

We sent a client letter out in 2007 saying that housing prices should go down 40% just to get back to normal valuations. That was very valuable, and primarily precipitated by bottom-up analysis. It helped us to avoid some huge value traps. Sometimes it‘s not what you own but what you don‘t own that makes you successful.

G&D: It‘s interesting, you‘ve heard very few people saying positive things about the airline industry. Warren Buffett says that each time he thinks about this space, he has a 1-800 number he calls to prevent him from making an investment in the industry.

What is it that you guys see differently; is it more a matter of understanding the cycles that the industry goes through?

DS: People are overly negative on the industry because they have been burned in the past and because ― conventional wisdom now states that you should never buy an airline stock. Yet, we think there are a lot of new things going on. Consolidation has reduced competition and not as many airplanes are being ordered.

Companies are being run by CFOs that became CEOs so they are more focused on the bottom line rather than empire building. Historically overcapacity was due in part to easy access to off balance sheet lease financing. It would be a real positive if airlines had to put all their leases on balance sheet, of which there‘s some talk.

The moral of the story is that no matter how bad the industry is, at the right price and especially when the fundamentals are turning, you can make a lot of money. The steel industry was terrible for years, but when the fundamentals finally turned, we made a lot of money on AK Steel and US Steel.

(Source: Graham & Doddsville Newsletter 2010)

(Source: Graham & Doddsville Newsletter 2010)

G&D: This is probably a good segue to talk about timing and your average holding period, which is under one year for most funds. But for a lot of these theses to play out, obviously you‘ll be waiting much longer than that. What is your typical holding period?

DS: We usually hold stocks for three-to-four years and when we do our earnings estimates, it‘s based on normalized earnings looking out two-to-four years. We find that it generally takes that long for a business to fundamentally turn around, and that even after it turns around, it takes a while for the Street to pick up on it, and even longer to attract the momentum investors.

Some academic studies suggest that long holding periods for low price to book stocks are better than short holding periods. Often our holding period gets cut short because we have a lot of takeovers. This year we have had 8 takeovers out of about 60 stocks, and the premiums have been very attractive.

G&D: You have a few tech stocks in the portfolio, which we were surprised to find.

DS: Many small and medium-size tech companies have been in a bear market since the 2000 tech bubble, so over the last couple of years we have purchased a lot of tech stocks at well below book value. We think all the new gadgets, like smart phones and iPads, and the corporate replacement cycle for technology provides good growth prospects for this industry over the next couple of years.

The stocks have sold off recently because of the fear of a double -dip recession. There may be a slowdown in consumer spending, but the typical smart phone uses 7x the semiconductor content of a traditional cell phone.

Thus, we think revenue growth is going to be strong for the enablers of these trends. We think there will be a lot of takeovers in this space. Many tech companies have a lot of cash, and have stocks trading at big multiples of book value, so it makes all the sense in the world for them to buy our tech stocks at book value for cash or stock, even paying a premium. Some of these companies also have valuable intellectual property that we are getting for free.

G&D: You‘ve been in this industry for over 30 years, which is much longer than many people last. Over 30 years of investing, what is the most difficult part about a deep value strategy to stay disciplined about?

DS: About every 10 years this strategy has a bad period, but those clients that stick with us are usually highly rewarded. After these tough periods, our stocks have massively outperformed the S&P. Older clients that have experienced these rebounds are very loyal to us. But with newer clients, it can be a tough sell.

The 2008 down period lasted about 18 months, which is good. If it lasts more than two years, patience wears out. Our worst stretch was 1998 and 1999. During times of underperformance there‘s a lot of pressure to change your stripes, and that‘s what happens at many value firms. I‘m convinced that one of the main reasons for our superior results is that we take a long-term focus and are willing to tough it out during rough periods.

G&D: Any parting words of wisdom?

DS: The universe of investment opportunities is very large and there is a lot of analytical noise in the system. When I started at Capital I realized there were a lot of smart people out there working 12 hours a day analyzing every opportunity – how could I possibly beat them?

So I said, let‘s just eliminate 90% of the universe and focus on the lowest price to book decile. To begin with this is a much better pond to fish in. It also gives me a 10 to 1 focus advantage over the competition. We learn much more about these companies than they can learn about the whole universe.

Most importantly, when push comes to shove and stock prices are falling, we have an anchor of solid tangible value supporting our stocks, so we can confidently buy at the lows. So I would just say that you need to have a differentiated investment philosophy.

After transaction costs, it is a negative-sum game, so not too many people can substantially beat the market over time. You need to have an approach that is unique.

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