Donald Smith & Co., Inc. is a deep-value manager employing a strict bottom-up approach. We generally invest in stocks of out-of-favor companies that are valued in the bottom decile of price-to-tangible book value ratios. Studies have shown, and our superior record has confirmed, that this universe of stocks substantially outperforms the broader market over extended cycles. A study that we conducted with Compustat data showed that from 1951 to 2009 stocks in the lowest price-to-tangible book value decile had the highest long-term returns, delivering a 15.4% return versus 10.7% for the S&P 500.
Our process begins with quantitative screening to identify low price-to-tangible book value investment opportunities. Within this universe we conduct intensive fundamental research to identify which stocks have the greatest potential for outperformance. This process involves analyzing the quality of book value and identifying hidden assets and liabilities. In addition, we seek to identify companies with significant underappreciated earnings potential over the next 2 to 4 years. We initially screen approximately 10,000 stocks. Those that meet our strict valuation criteria are added to our proprietary watch list for further analysis. From this list of approximately 300 low price-to-tangible book value stocks we choose the most attractive 30 to 50 based on in-depth fundamental research. Because we concentrate our research resources on a limited universe of stocks, we believe we can achieve an analytical edge over our less focused competitors. We invest with a long-term perspective and have an average investment holding period of approximately three years. We sell our holdings if they appreciate and valuations become unattractive, if better investment opportunities are available, or if fundamentals deteriorate. We do not have an explicit stop-loss policy - if a stock declines in price without a material change in fundamentals, we regard it as a better value and are inclined to buy more. We focus on minimizing absolute risk, which we define as the risk of a permanent loss of principal. We believe that the most effective way to mitigate such risk is to buy stocks with a large margin of safety. We believe that our intensive balance sheet analysis, focus on asset quality and strategy of buying stocks trading at deep discounts to tangible book value, effectively limits downside risk.