(Ep.94) The Acquirers Podcast: Stephen Clapham – Smart Money: How An Ex-Hedge Fund Analyst Uses Forensic Accounting To Pick Stocks

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In this episode of The Acquirers Podcast Tobias chats with Stephen Clapham, author of The Smart Money Method. During the interview Stephen provided some great insights into:

  • The Importance Of Pricing Power
  • Use Simple Charts To Measure Investor Sentiment
  • Evaluate The Company’s Industry, Capacity & Demand
  • Forget P/E And Focus On EV/Sales
  • Start With The Balance Sheet
  • Write A Short Thesis Before You Buy
  • Analysis The Shareholder Register
  • Dealing With The Man Overboard Moment
  • Don’t Fall In Love With Stocks You Hold
  • Finding Great Stock Ideas Like Peter Lynch
  • The Smart Money Method
  • Read The Accounting Policies

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is Stephen Clapham. He’s returning for his second go-around. He’s got a brand-new book. It’s called The Smart Money Method. He’ll give us the full title in a moment right after this.

Tobias: Good day Steve, how are you?

Stephen: I’m fine. And thank you so much for having me on. How are you doing?

Tobias: I’m very well. Thanks. Just hold up your book cover and tell everybody the title, so they can find it, if they’re hunting for it.

Stephen: The book is called The Smart Money Method: How to Pick Stocks Like a Hedge Fund Pro. I was laughing about this because I think it’s a very American marketing title. It’s just not me, but my guy, Joseph, who does the copywriting came up with the title, and the publisher loved it. The working title was called The Effective Equity Analyst, which was why–

Tobias: I can’t see you selling a lot of those ones.

Stephen: [crosstalk] –wouldn’t sell very many copies we decided.

Tobias: You are a hedge fund pro of the old school who likes to do some forensic accounting analysis. So, is that what folks are going to find in the book?

The Smart Money Method

Stephen: There’s a little bit of that. What I tried to do is I tried to make it pretty accessible. The trouble is that most investment books are either full of formulae, or they’re sort of anecdotal. What I tried to do with this was to create a book that people could read that they wouldn’t be turned off by, that would also help them improve their investment techniques. So, the book is really designed for the lay investor or people with a bit of experience, but to try and make their research process more professional.

Tobias: What’s the process that you recommend in the book? Is it the same one that you employ when you’re investing?

Finding Great Stock Ideas Like Peter Lynch

Stephen: Yeah, it’s exactly what we developed at the hedge funds. So, the process really starts with where do you find the stock idea? There’s lots of places to find stock ideas, so I go through all of them.

Tobias: Where do you find them? I may get to hear that. Where do you find good ones? [chuckles]

Stephen: Well, this is quite an interesting thing. I came up with about, I don’t know, 12 or 15 different places you could find stock ideas. What I say in the book is, it’s actually very important to try and trawl a wide range of places for your ideas because if you get all your ideas from your mate who’s a hedge fund manager down the pub, then when he starts to underperform, you start to underperform. So, even if you just get your ideas down in the pub, get them from a range of different people. But I go through, don’t take a tip in the press because one of my old colleagues used to say, “If it’s in the papers, it’s in the price.” You read something in Barron’s– I’ve got no idea Barron’s has got a good track record in tipping stocks or not, but the chances of you making outsized returns from following recommendations in a newspaper or magazine are quite low. I go through some alternative sources.

There’s all sorts of sources. I’m a great believer, like Peter Lynch, in the idea that you use your personal observation, and just lots of areas just looking around you that you find good ideas and products that you like can be incredibly effective source of ideas. My wife spends more money than I think anybody else in the UK with our online shopping supermarket, Ocado, and she loves it. When she says, “Oh, this is fantastic. You should buy shares in it.” I don’t always do as my wife says, but I do go and look at these things. I think just finding products that you think, “Man, that’s really good.” Stuff that’s related to your own life, stuff you know about, you’re far more likely may have a successful investment if you go into an area that you know. So, if you’re involved in a particular industry in a particular field, you have a pretty good idea of who’s effective.

I go through the different places to find an idea, and I start off with finding an idea and I go through the whole process, ending up with when do you sell? One of the things that both private and professional investors are really bad at is when to sell.

Don’t Fall In Love With Stocks You Hold

Tobias: Why is that? Why is it so hard to figure out when to sell?

Stephen: Because you fall in love with the stock. You’ve owned the stock, it’s been going up, it’s done really well for you, and you then fall in love with it. You get to know the management, you feel comfortable with them, you know everything there is to know about it. I was talking to Clare Levy, who runs Essentia Analytics because I’m doing a behavioral finance course. So, I’m just writing the content for it at the moment. One of the things she said is that some very successful investors, when they look at the data, they look at trade data, they look at big hedge funds, big long term investors, and they can see where people go wrong.

She said, one of the most common things is that people own shares for three years, and they’ve done really, really well and then they should exit, but they don’t, because they feel super happy with the stock. They know it, they know the industry inside out. If they just sold it then, they really maximize their performance. But what often happens is it goes up for three years, and then it flatlines relative to the market. So, you’ve got this of unproductive capacity, sitting there in your portfolio that you feel very comfortable with, but it’s not working for you.

Tobias: It’s an interesting idea because there’s this idea at the moment, never sell. Have you heard of this?

Stephen: Oh, yeah.

Tobias: If you’ve been a seller for valuation reasons over probably the last say three, five years, you’ve basically left money on the table. So, who’s right and who’s wrong there? Are the never-sell guys wrong in holding on for that exceptionally long period of time?

Stephen: No, I’m not saying anybody’s wrong. This is factual data from a large group of professional investors. I think it’s a couple of hundred billion dollars of assets under management and they’ve got the trade data. This idea that all these people that we see on Twitter, Toby, that we don’t care about valuation, it’s a great company, we’re going to hold it forever, they’re doing really well right now, but when that stops working, it will stop working very badly. And there is no such thing as investment without worrying about valuation. Smarter people than me have sold Amazon before now, and they’re looking pretty stupid for now. We’ll see if they’re looking pretty stupid in 12 months’ time.

The fact is that the stock market has been a very unusual place for the last– well, several years, and valuation hasn’t been the forefront of people’s minds. Now, look, it’s perfectly possible that I’m completely wrong on this and that valuation won’t matter for the next 10 years. I mean, interest rates could be negative, and people may not care what they pay for equities. That is a plausible scenario. I work on the basis of mean reversion. Things don’t stay different for that much longer. Obviously, each cycle is different, and we’ve seen that in spades this time. But the death of valuation– the death of value, I could kind of understand that philosophy. Death of valuation, I don’t think so.

Using Simple Charts To Measure Investor Sentiment

Tobias: Well, let’s just go back a little bit to the process, because I’m sort of interested to know it. Once you get the hot tip from your mate at the pub or from your wife, what’s the next step after that? [crosstalk]

Stephen: Well, the big step after that– The thing is, what I used to do is, I used to always have a lot of things on the watchlist. The problem then is, you don’t want to go away and do an in-depth piece of research on an idea that may or may not be a good one. So, my system and the system I recommend in the book is, the first stage is what I call “Testing the hypothesis.” I’m looking at a stock, why am I looking at it? I’ve got some reasons, some hypothesis about it, some reason I think it’s going to go up or in the case of the hedge fund, it’s going to go down. But the case of the retail investor, for some reason you’re attracted to it, and you think that it’s going to go up. The first stage is to test that hypothesis, why do you think it’s going to go up?

Then, what I do as I go through the steps, and I reckon that it would take me between 30 minutes and two and a half hours to do this quick review, and I go through all the steps. Now, some of those steps aren’t feasible for a private investor because if you’re sitting in a big hedge fund, it’s very easy to print off half a dozen research notes. You can do that in five minutes on Bloomberg and you scan them, and that isn’t available to private investor, but there is research available. There is press cuttings, there’s a lot of information on the internet. So, I go through the various steps and one of the steps is looking at the charts. I get a lot of flak because people– fundamental investors say, “Well, how can you look at the charts?” I’m puzzled why people think this. In fact, one of my colleagues, I used to work with say, “I don’t know why you’re wasting your time with the charts.” But it’s not that I’m a great chartist and looking at candlestick patterns and reverse flags or anything like that.

Tobias: The bearish harami.

Stephen: I simply look at the chart as a data representation of market psychology. The share price is the most informative thing about a stock because it tells you what the market thinks of that stock. And it tells you when the market thought the stock was in favor and when the market thought the stock was out of favor. And by using that, you can then translate, why is the market viewed the stock in that way? Because our job isn’t just to figure out what’s the company really worth? Our job is to figure out what’s the company really worth, and why does the market not recognize that? Because you only make money if there’s a gap between perception and reality? And you’ve got to understand well, why is there that gap, and what might happen to close the gap?

Now, obviously, over time, if you’re right in the reality, the market’s perception will turn around, but there may be something fundamental about that stock, that means the market may take a long, long time to change its mind. And those are the stocks that you want to avoid because you might be right, the company might do very well. But if the market hates the management and thinks they’re crooks, until the managements change, people won’t warm to it. So, you’ve got to understand that gap between perception and reality.

I go through some of the basic quick valuation tests that you can do very quickly to decide, is this stock worth pursuing? So, in my case, as a hedge fund doing special situations, so, very deep work on a small number of ideas, this would just be the prelude to actually going and doing very much detailed work, but for a private investor, this might be, “Oh, you do?”

Tobias: So, just to go back to the chart, what are you looking for when you’re looking at the– that’s a nice mug you’ve got there. I like that. Is that your book cover on the mug?

Stephen: Yeah, that’s a book cover in the mug. Yeah, I copied your idea.

Tobias: That’s great. I love it.

Stephen: I saw you had The Acquirer’s Multiple on your mug. So, I thought, “That’s a very clever idea. I’m going to do that.”

Tobias: [chuckles] I love it. What are you looking for on the chat? Are you looking for something that’s fallen? Are you looking for momentum? How are you viewing it?

Stephen: I’m not looking for anything in particular. I’m just looking to see– it’s not that I would buy a stock because it was below or above its moving average or anything like that. I’m simply looking at the chart as a representation of how the market feels about that stock today. I might well buy a stock that’s falling. Remember, I was working at big hedge funds, and we were taking big positions. Once the things turned, you can’t really buy it, you’ve got to buy the falling knife–

Tobias: You need the liquidity.

Stephen: –to make real money. But that’s not the case for every position, every place I’ve been working or every position that I was taking. Often you might take a small position in something that was actually going up because you thought, “Well, now the sentiment’s turning.” The book is basically, I’ve taken the book and it’s the same format and same layout as my online course. In the online course, we go through this how to test hypotheses. I just use the example of Procter & Gamble. It’s obviously a big well-known company, and an easy thing to look at. When I did that, the chart actually had turned around. P&G, then at that point was quite interesting because the share price had gone above where it had been in the last five years. The analysts were still very lukewarm about it. One of the things I say is, look at how many buys and how many cells and how many holds there are, and at the time that I did this, P&G had four buys, 16 holds, and one sell.

Now, sells are very unusual, but that that profile of 16 holds, tells you that the South Side has fallen out of love with the company, but 16 holds is a very, very low rating by US standards. The fact that the shares have turned around in the last six, nine months, and they’ve actually been very strong, told you that the market was changing his mind about P&G. It had been dull, for the last five years. It’s created sideways. And here, people were starting to get interested in again. That piques my interest. If had carried on falling, I would still have been interested in it, because obviously, it would have been cheaper, but it’s just using the chart to tell you about how the market feels. I think that’s very overlooked and very important.

Analysis The Shareholder Register

The other thing I do in that initial check, is I check who the shareholders are. And understanding who the shareholders are is a really important thing for a private investor. It’s less relevant if you’re at a big hedge fund because you’ve got to be early. So, you want to be there before your competition, but if you’re a private investor, you don’t have to be clever. You just have to ensure that the people that own the shares are people that you respect and like and want to be alongside.

Tobias: Do you advocate some sort of like a 13F or the UK version of the 13F to see who’s buying? Or you just go to the shareholder registry and you see, are these smart fundamental value investors who are on this shareholder register? Or did they’re just not there, which might be some sort of indication in and of itself?

Stephen: Well, I mean, the US system is fantastic. Now, I really don’t understand why they want to change the thresholds for funds reporting their holdings, that’s really–[crosstalk]

Tobias: Get rid of all the free riders.

Stephen: Well, look, it’s the same for everybody. Even if you’re sitting in the UK, you could have filed with SEC, and there’s some very interesting UK investors that probably are off the radar in the United States are really worth following.

Tobias: Give us their names. Let me write down a few names. [chuckles]

Stephen: You know the names.

Tobias: Terry Smith.

Stephen: Terry Smith, Chris Holn, Nick Train, I mean, there’s lots of very successful guys and ladies in the UK, but either using the 13F or following a few people that you like and respect. So, in the UK, you don’t have to disclose until you’re about 3%. So, a lot of holdings are opaque. But if you read the fund letters, or the presentations or whatever, then you can see that people are buying particular stocks, and then you can ask yourself, “Okay, why do they own these things?” But looking at the shareholder register at the start, I mean, obviously, if you’ve got access to Bloomberg, that data is all available at the press of a button. But it’s not even that difficult for the retail investor, even outside the United States. There’s plenty of data sources now.

Tobias: One of my favorite type of situations to find and I haven’t seen one for a long time because the markets been so strong, but in 2013 to 2015 period, there were a lot of companies that had got very expensive in the late 1990s and had gone nowhere for more than a decade and had got cheaper and cheaper over that period of time because the underlying business had remained very, very strong. It’s just that there was so expensive in 2000 that it took them that long to work off the overvaluation.

So, when you find them in a decade or so later, and the stock price has gone nowhere, there’s no volatility in the stock either. So, the options become very cheap too. The very big companies, very good companies, very stable companies, very cheap sort of call options in there. I don’t use it necessarily. It’s not a screen that I use, but I think it’s like the situation when I find enough, found quite a few that way. But nothing for a very long time using that method, it’s– [crosstalk]

Stephen: That was Microsoft, right? Microsoft is perfect example of that.

Tobias: Walmart was another one.

Stephen: The market is better today at reading opportunities than it was even 10 years ago. The sophistication, and particularly the influence of the machines. The algorithms are so prevalent today that anything that’s quantitative is actually very difficult to exploit. Or you got to pay up.

Evaluate The Company’s Industry, Capacity & Demand

Tobias: You’ve done your preliminary research, and you’re satisfied that this is something you want to go forward with, what’s the next stage in the process?

Stephen: Well, the next stage, I mean, what I do, so I very often come to a situation where it’s in unfamiliar territory. So, it’s an industry that I haven’t looked at, or a geography that I haven’t looked at before. So, what I’d like to do first is to understand the industry. And it saves you quite a lot of time because you’re also one to understand the company, but understanding the company in the context of the industry, I think, is extremely important. One of the things I’m particularly pay attention to is the relationship of capacity to demand. Now, you’ll be very familiar with this, I’m sure because there’s the group here, Marathon Asset Management, not the US Marathon, but the London firm.

They’ve written a couple of books, Capital Returns is the one that’s in print now. This was a philosophy that they’ve espoused for many years. But it’s something that because of my background, one of the industries that I was worked with on the South Side was the transport sector. In the transport sector, if you’re looking at airlines or shipping, there’s actually quite a lot of data around and what capacity is doing.

The thing I find quite funny is that everybody gets obsessed about demand, so everybody’s obsessed with total addressable market and what demand growth is going to be? Well, demand growth is quite difficult to forecast, and you have quite a large range of error. Capacity growth is usually very easy to forecast because there’s all sorts of data, there’s all sorts of lead time operate in many, many industries. So, I spend quite a long time starting off looking at new situation. Looking at, “Well, what’s capacity doing? What’s it been doing? And what’s it going to do?” And if you find a situation in which capacity growth has stopped, and you’re fairly confident demand growth is going to continue, that is usually a very attractive situation. I mean, often the best situations are ones where people have started to close capacity. So, you’ve got an industry in which demand profile looks terrible, everybody hates it, and management are starting to get the message and they’re starting to close down production. Those situations can be very, very powerful.

Tobias: You find that particularly in transport. You know the sort of ships that are coming online, you know how many planes are going to be in the air, and so you can forecast roughly what that’s going to look like, and so that’s how you sort of lay in your bed.

Stephen: Yeah. When I used to do the airlines, I mean, many times made very, very good returns. I mean, it just short-term, three to six months start type of trades but looking at the amount of capacity in the market, when there’s too much capacity coming on, then the price collapses. It doesn’t take a huge amount of change in the price of the seat to make a massive dent in the airline profitability. When companies miss earnings, there is no prisoners taken, they then go down. We made lots of money on the airlines just doing that. It’s not complicated. I mean, people are more sophisticated now looking at that, but you can apply it to lots and lots of industries.

One of the industries that I used to use this for was cement. It takes quite a long time to build a cement plant. In order to build one, you’ve got to have various planning and there’s all sorts of lead time and there’s all sorts of evidence that you’re building one, so you can see what’s going to happen. One of those classic industries is very expensive to transport. So, you get areas like Florida, where there’s imported cement as competition, but for many areas inland, how much capacity there is. You can see if the new plants being built, and if there isn’t, you can feel much more confident about the demand, looking about the pricing outlook.

Tobias: It’s very interesting. So, you get comfortable with the capacity in the industry and then what’s the next stage after that?

Stephen: I just try and build a picture of the industry. I try and build a picture. I start with capacity. Of course, I look at demand, and then what’s the past demand growth? What demand drivers? Is that are those drivers weakening or strengthening? And then I look at the industry structure. Where is this company? Where is it in the industry? Who are its competitors? What I like to do is I say, “Okay, so who are the winners in this industry? And why have they been winners?” When I get on to looking at the company itself, I start to drill down and say, “Okay, so this company has been a winner in this industry. Why is that? Is it geography?” Looking at history is incredibly helpful, incredibly informative, because where you’ve come from and forms where you’re going. I like to look at that.

The other thing I like to look at, is I like to just try and understand the quality of the business. I prefer to invest in quality situations. Unfortunately, when you’re a special-situations investor, where you’ve got a very high return threshold that you need to exceed, you usually end up buying low-quality situations, you buy rubbish, because it’s cheap, and you have a reason for thinking that’s a catalyst that it’s going to stop being cheap. But understanding the quality is absolutely essential if you’re a private investor, because you don’t want to own low-quality companies because low-quality companies require a much greater attention and focus. So, you’re much better off owning higher-quality companies.

There’s a whole chapter in the book about how do you assess the quality of a business, and then I go on to talk about how to assess management and how do you think about that. One of the key things I talked about is looking at the management incentives. Are there incentivized on earnings per share, or are they incentivized on ROIC?

Companies that are incentivized on return on capital, tend to perform a lot better than companies or not. I mean, there’s all sorts of academic evidence of this. I go into some of the other things like, if you’re looking at a mining company, is the CEO, is he incentivized on the number of accidents, on the number of deaths? And if they aren’t, you’ve got to ask yourself, “Well, why not?” This whole issue of– I mean, I call that sustainability, because that’s to me is, if you’re not looking after your employees, it’s not sustainable business. If you’re in a high-risk industry, you’ve got to pay very close attention to safety because that at the end of the day means, the company that is a safe company, is a company that will persevere.

BP is a classic example of a company which got safety wrong, and paid a huge $65 billion price for it. I think it’s important to pay attention to those sorts of things. And then, once I’ve done all that, I then go in the book, I go through, how’d you look at the accounts[?]?

The Importance Of Pricing Power

Tobias: Just before we move on to that, let’s talk a little bit about quality. What’s your definition of business quality?

Stephen: There isn’t a definition. If there’s a definition, it makes a return invested capital above X. But the problem with the quantitative measures, as I was saying before the algos have worked all this up. There’s a great piece by Rob Barnett, so you’re the Rob Barnett man, so you probably know better than me. But they did a great piece and a very kindly let me reproduce chart in the book. It was incredibly complicated chart, but one of the things that they looked at was the Novy-Marx paper in 2013 and gross profitability. Right. And they did this paper that said that gross profit abilities really worked.

But it’s actually 90% of performance has come because the stocks have been rerated. What that tells you is that people have worked out. So, it was a very effective paper when it came out, but people have read the paper and said, “Hey, this works. Let’s put this into our algo.” And so the opportunity for these things to continue to outperform and give you excess performance, I think it’s highly unlikely that you could find a quantitative measure, which will consistently perform that because they’ve all attracted so much money that you’ve got to pay up in order to buy that.

So, I think, yes, you want to make sure that you’ve got companies that got good quality, high ROIC. But you then got to start thinking about qualitative measures. If people want to think about one thing they should look at, its pricing power because if you have pricing power, you’re safe. So, obviously, that will manifest itself in a good ROIC in high gross profitability. But there may be situations in which the ROI see today isn’t all it might be but the company’s acquired pricing power. And that’s really what you want to look at. Company that’s going through a fundamental change, where it’s not got a fancy valuation today, but not only will the profits improve, because it’s suddenly found its pricing power, but in three years’ time, people are going to go, “Oh, man, look at the ROIC. We better buy some of that,” and the rating goes up. And that’s really what I look for. Companies that aren’t necessarily in favor today, but could be in favor tomorrow. Obviously, it doesn’t always pan out the way you think, but you got a portfolio full of those things, and you’ve done your homework, then enough of them will pay off that you’ll have really outsized returns. And that’s what I try and show in the book.

Tobias: How are you assessing pricing power?

Stephen: Well, it’s very subjective thing, isn’t it? I mean, pricing power to me is, when you go into the shop and you buy the product, you’d wince, but you don’t think about buying something else. No, you’re laughing, but I remember–

Tobias: No, I agree. I’m just laughing at it.

Stephen: I took the family to Florida for a holiday because the kids wanted to go to Disney. I remember going to the agency to buy tickets for Disney and all the other things for the week. When the guy told me the bill, I thought you’d made a mistake. Honestly. [crosstalk] I thought you’d read it wrong, I thought you had an extra zero. And, of course, Disney, guess what? They figured this out. They figured out that it really takes a lot of money before you’ll say no to your kids. It’s going to be really, really expensive.

So, whether it’s 100 bucks a ticket, or 105 bucks a ticket or 110 bucks, it doesn’t really matter. So, that’s this kind of thing to look for. Obviously, it’s well recognized in Disney, but there are other products where you can see the businesses are gradually inching the price up. And it’s quite interesting. I mean, this isn’t very scientific, because you saw with the iPhone. They kept putting the price up. But when it got to $1,000, there was a pushback, wasn’t there? And they then started pushing– Well, I’m not an expert in Apple, but this is my take on it, was that they started producing a range of products at different pricing points because they didn’t have the same take-up from their customer base that they thought they would be, because they thought they could just keep putting prices off forever.

I can afford $1,000 as £1000 pounds for an iPhone, but I can afford it, but I don’t like spending it. I think “Oh, well, you know what? I’ll just keep the phone for another six months, or I’ll just replace the battery. I’ll replace it next year.” Trying to understand where the level is, and there’s no science to any of this. I know nothing about Apple, so I hope you don’t get loads of complaints that I’m talking rubbish because I may well be, I don’t know anything about Apple, but I only have my own personal observation. But when you start to research a stock and look at it closely, then you get a feeling for, is that the right pricing point? And how close is it to the ceiling? And how much room do they have to increase it further? And obviously, if you’re getting in early, then you’ve got a much better opportunity. If you’re getting in late, then you’ve obviously, A, you’ll be paying up and you’ll be paying up in a multiple of the higher price.

So, there are very few companies which have got no price resistance amongst the customer base, and such a moat that nobody can come in and compete with them because of the matter of trying, as a matter of trying to understand. I try and give some examples in the book, the sorts of things that you should look for.

Tobias: Yeah, Apple has a diabolical approach to pricing. They have an iPad out at the moment for $329, but when he actually ended up buying it, it costs you $758 is very, very clever pricing, very clever marketing for that particular object.

Start With The Balance Sheet

Tobias: The way that I think about you, you’re the forensic accounting guy, who really does like to tear into the accounts. That’s where we lift the process, so let’s go back to that. We’re approaching the accounts, what’s your approach when you start looking at them?

Stephen: Well, most people start off with a P&L. Now, obviously, by the time, I come through open the report in accounts, not in detail, but I already had my first crunch looked at the business. When I first looked at it, obviously, I’ve looked at their earnings numbers and the revenue growth. When I open the account, I start with the balance sheet because a balance sheet is the most important financial statement. It’s completely overlooked.

It’s completely underrepresented in people’s efforts. If you think that there’s something wrong, you usually find it in the balance sheet. I have a very simple procedure, I start off at the top, and I work my way down the balance sheet. And I go, I read every line, and I read every note. I ask, “Well, does that make sense?”

It’s amazing to me that, just by doing that. I do this in the course when I do the how to read a balance sheet course physically with people. I go through, and I say– I use a company that nobody’s heard of, nobody knows, and I just explain. From this, you can tell lots and lots about the company, you can tell how capital intensive the asset base is, you can tell how much inventory there is.

One of the companies that I use, has got a large amount of raw material, a large amount of finished products, and a very, very small amount of work in progress. I’ve never been in one of these factories, but obviously, it’s a very short cycle. So, they produce their product in less than a day because that’s how much is in work in progress. And it’s just that, looking at the numbers tells you what’s really going on, you don’t need to listen to the calls or read the management stuff at the front of the book, all of the glossy pages. You get the 10K, so you’re not allowed glossy pages.

In Europe and in Asia, the accounts are full of wonderful pictures telling you about the product. I read that to the end. I look at the numbers because I don’t want to get distracted or colored by what the management are telling me about the business and how great it is. I want to look at the facts. And just by reading the balance sheet, you can tell a huge amount. The audit report is another one. You, in the United States, had a weird thing where we’d all under IFRS, the auditors has had to flag off issues where they’ve had disagreements with management.

And that’s one of the first places I look because the audit report can tell you, it’s not shining a spotlight on where the problems are. It’s only December 19 year ends that that started to be the case in the United States, but it seems to be the auditors just only do one thing. “Oh, well. Netflix. Yeah, there’s a bit of an issue about the content accounting, a bit of an issue.” But then, there’s a lot of tricks to look at in the company accounts. I could write a whole book about going through the accounts and if this book sells, well, maybe I’ll write another book about it. [chuckles] It’s not something I’m rushing to do. I don’t know how you managed to write four books. I mean, I found it a very difficult and painful and lengthy process.

Tobias: Extensive brain damage. You’ve got to forget about it rapidly after you finish it. That wasn’t so bad. I think it’s like my wife describing to me giving birth. She forgot about the pain pretty quickly afterwards, and then you got a kid running around.

Stephen: Yeah. But the thing with having a child is that you’ve got this lovely little bundle of joy afterwards until they grow up and raid your wallet. With a book, I hadn’t– The author copies came from the publisher in a big box, and I filmed myself opening the box. I was very excited to see the cover and everything. But I haven’t wanted to look inside because when I start looking inside, I’m going to find mistakes.

Tobias: That’s it. That’s exactly I was about to say.

Stephen: I don’t think I’ll ever read it.

Tobias: The only time you that you’ll find every single typo, the very next time you read through it, now that it’s already been published.

Stephen: There was a guy that I used to work with when I was on the South Side. Whenever I published a note, before the morning meeting, he would rush over and point out the typos. I thought, you’re brilliant at spotting typos, I’m going to give you a draft before it goes out. He never found another mistake.


Read The Accounting Policies

Tobias: Yeah, that’s not very helpful. So, balance sheet, what do you advocate then? Your cash flow, P&L, where do you go next?

Stephen: I start with the audit report, balance sheet, P&L, cash flow, and do the ratios. The most time-consuming part of all this is going through the balance sheet and going through all the notes. And then, people don’t normally read the accounting policies, and I’m a big believer in reading them because I’m just on the lookout, is there anything funny here? Is anything out of the ordinary? Why are they saying particular things? People won’t want to do that, but I do tell my professional investor clients that, “Okay, you don’t have an awful lot of time, you don’t want to read the whole accounting policies, but at least read that accounting policy on revenue recognition.” There’s less subjectivity now because there’s IFRS 15, and the SEC 606, which are much stricter on how you can recognize revenue. But you still do need to understand, does the company do anything funny?

It’s amazing I was looking at a very successful stock, which has trebled or quadrupled. I read the revenue recognition note, and I can understand it. One of my clients has got a big position, like over a 100-million-dollar position in this stock. I emailed my contact there who runs their US fund and I said, “Have you read this?” They said, “Mmm, get back to you.” And they get back to me and said, “It doesn’t make sense, does it?” No. It’s one of those stocks that nobody cares how much money it makes, nobody cares– Of course, it doesn’t a profit, of course, it makes a loss. It’s quadrupled. But they said, “Oh, okay, so we’ve got–” When you see that, you know you’ve got a problem.

To me, when you’ve got an issue like that, it doesn’t mean to say that you shouldn’t buy the shares, but you’ve got to be much more aware of the risk you’re undertaking, you’ve got to believe that the gain will be much higher because you know there’s a lot of risk and you know that you want to be looking for the exit. When you get into that sort of situation, it’s not a hold forever, it can’t be a hold forever because you know it’s not 100% clean.

Forget P/E And Focus On EV/Sales

Tobias: Once you’re finished looking at the accounts, what’s the next stage? Can we buy it?

Stephen: Almost, we’re almost there. The next stage is obviously to look at the valuation and say, “Is the valuation sensible?” I go through some of the ratios that I look at. One of my favorites is enterprise value to sales. People get very fixated in P/E. Some people use P/E alone, I’ve never understood how they can do that. You must use at least one enterprise value base measure because otherwise, you get distortions from capital structure, get distortion from tax, which can be very, very dangerous and can really come back to bite you. You’ve always got to use at least one equity base and one enterprise value-based measure.

And I really like enterprise value to sales because you’re comparing the enterprise value, which is a bigger number, with the sales, which is a bigger number, so it’s a much less volatile range. The South Side analysts always talk about this stock’s been in a P/E of 15 to 17 for the last seven years, and therefore, we’re going to value on 16 times the earnings. They never look at what the business does or whether it’s changed. They’re using such a volatile number, you’re much better off using the enterprise value to sales. Because the sales don’t move that much, the sales are much less likely to be alive than their earnings number. I mean, it’s hard to find the US company with an earnings number that isn’t a lie, Berkshire aside. So, using enterprise value to sales is a very, very powerful tool.

Once I’ve decided that the valuation is sensible– I mean, I wouldn’t necessarily abandon something because it’s got a high valuation. I’m quite happy to pay up for the right stock. But often, what we would do is you say, “Well, actually, our target price for this stock is X. So, we want to buy it at X minus 30%, or 40%, depending on the risks.” We’d say we think it could be worth this, let’s try and buy it at this so we’ve got enough of an opportunity. And then, we just put it on the watchlist. When it hit that price, we’d say, “Okay, is anything changed?” And if it hasn’t changed, then we press the button to buy it.

Write A Short Thesis Before You Buy

Stephen: Then, once you’ve said, “Okay, now is the time to buy it,” the next thing is to communicate that idea. And very controversially, I advocate writing a note.

Like I say, I’ve tested this book because I’ve done this effectively as a course for private investors in London. When I suggested that people wrote down their idea, they were aghast. I have to say these people were not the best investors you’ve ever met, but they were pretty aghast. I said, “Look, just do me a favor. You’ve paid to come in this course. Why don’t you just try it? Just try it once.” About the next couple of months, they all started emailing me saying, “You know what? That’s a really good idea. I’m really surprised.” And this idea of writing it down is mission-critical because when you write it down, you’re forced to think through. I say, look, you don’t need to write a 30-page research. No. Just think about two things to start off with. The first is what does the company do? Don’t say the company’s in the software business. Say the company provides this type of software, which is critical to its customers. It’s on a subscription basis, paid quarterly in advance with a 2% churn. And then you understand–

Tobias: That sounds right, actually. [chuckles]

Stephen: Yeah. When I say that, you want to buy it immediately, don’t you? Because you know immediately, that’s a high-quality business. Write a business description, which translates the quality of the business that you’re buying. The other thing to do is write the hypothesis. Why do you want to own this stock? That hypothesis should be dead simple. Your 12-year-old kids should understand it. Anthony Bolton used to say this, a great Fidelity investor, if you can’t explain why you want to own the share in very, very simple language, the chances are, it’s not a good idea because the best investment ideas are that simple.

Tobias: Yeah, I love it. What are the objections to writing something down?

Stephen: I don’t know. I mean, I think people just have the idea–

Tobias: It’s time to buy.

Stephen: [crosstalk] John’s got a lot of this in his portfolio, and he’s really rich. It’s too much of a discipline, and people don’t want to be disciplined. But the more disciplined you are, the fewer mistakes you make and the less money you lose. And by writing it down– what I say is write down what’s going to go wrong. Write down why you’re buying it and write down what you think might go wrong. And then, when it goes wrong, because I can guarantee you that one of the things you buy will go wrong, you know whether it’s a planned error, a planned mistake, a planned thing gone wrong, or something that you didn’t foresee.

The thing you really want to worry about isn’t the thing that you knew this could happen because that’s part of your plan, and you know what to do then. “Yeah, this has happened. I knew this was going to happen. It’s going to be temporary. I’m going to have an opportunity to buy some more.” This looks like bad news, but the share price has going down, it’s actually good news for me because I anticipated it and I now have the opportunity to buy some more at an even cheaper price.

The thing you want to worry about, the share’s gone down because something you didn’t anticipate has happened. Then, you’ve got to panic and think, “What do I do now?” Well, you shouldn’t panic, but you’ve then got to pay attention, you’ve then got to work hard. You may need to change your strategy.

Dealing With The Man Overboard Moment

Tobias: You got to man overboard moment, as they call it. You don’t want to be working out what you’re doing in the man overboard moment. You want to know what you’re doing in the man overboard moment.

Stephen: Well, the thing is, sometimes something comes from left field that you hadn’t expected. And you then have to work out what the implications are going to be. So, you’ve got to go and do some work. You can always form a judgment. You can always form a judgment as to the new risk-reward profile at this new price in this new environment. If it’s something that you anticipated, you already know what the risks are, you don’t need to do any more work.

So, those two things are very different. And after I communicated the idea, I just talk about how do you maintain the portfolio? I talk about how do you look at the macro? How’d you think about disruption? I put in a final chapter, which I wish I hadn’t done that because I did it in May about what might happen with COVID-19. And it hasn’t– I haven’t read it again, but I suspect it wouldn’t have aged as well as the rest of the book. The rest of the book’s got a very long shelf life. That chapter I think probably, it sounded like a good idea. The publisher thought it was a good idea because they thought, “Oh, people will want a book that’s got something about COVID in it.” But actually, we didn’t know that by the time the book was published, there’ll be a vaccine and we’re looking at a different regime.

Tobias: Well, I hope that’s the case. The other possibility is that it’s timely for a long time, that wouldn’t be great.

Tobias: Steve, just as we’re coming up on time here, is there anything else you want to mention? Or you want to let folks know where they can get the book and so on?

Stephen: Well, the book is available–

Tobias: Amazon, all good bookstores?

Stephen: [crosstalk] –bookshops, I’m speaking– I’m in London, and no good bookshops are open. So, you have to go to Amazon, or Harriman House, my publisher, I’ve got a discounted offer on the book. And you can find me, my website is behindthebalancesheet.com. There will be a competition on there to win some signed copies and stuff. I’m on Twitter, @SteveClapham. But the book, confusingly, my name is Stephen with a PH. When I was deciding what should be in the cover, I thought I better put my real name because my parents who sadly have both died, but they would have loved to have seen the book, but they’d been very offended if I put Steve Clapham. And it’s such a stupid mistake because when you search the platform, you can’t find the book on Amazon. So, you need to put in Stephen with a PH, but everywhere else, I’m Steve and I’m going to have to change my name or something.

Tobias: Well, just hold up the cover one more time and then we’ll let folks see. There we go. The Smart Money Method: How to Pick Stocks Like a Hedge Fund Pro by Stephen, P-H, Clapham.

Stephen: The Smart Money Method.

Tobias: The Smart Money Method. Thanks very much, Steve. That’s absolutely fantastic. Look forward to catching up with you again sometime soon.

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