Richard Gill, CFA, reviews The Smart Money Method, where author Stephen Clapham provides investors with the insider stock picking techniques used by top hedge funds.
While 2020 was a terrible year in many respects, for some equity investors it was their best ever. Despite stock markets plunging in March, many indices around the world finished the year well ahead, with the NASDAQ up by 42%, the AIM All Share up by 20% and the S&P 500 rising by 15%. The UK’s major markets were the ones letting the side down, with the FTSE 100 down by 15% and the FTSE 250 ending 2020 7% lighter. More notably, it was an excellent year for stock pickers. On AIM alone seven companies delivered returns of over 1,000% and another 110 doubled or more in value. But just how can you pick the winners from the losers in order to make multi-bagging returns?
In The Smart Money Method, author Stephen Clapham answers this question by providing investors with the insider stock picking techniques used by top hedge funds. They use them to build portfolios which have the potential to deliver outsized returns. Clapham initially trained as an accountant then spent 20 years as an equity analyst at different investment banks, consistently rated in the top ten in his sector. He moved to the buy-side in 2005 and was a partner and head of research at two multi-billion-dollar hedge funds. Now, he runs Behind the Balance Sheet, a leading investment research and investor training consultancy.
The Smart Money Method is divided into 14 chapters which run investors sequentially through the journey of finding investment ideas, analysing them and then managing them in a portfolio. This echoes the author’s research process over the lifecycle of an investment.
A brief Chapter One kicks off with the simple question, “what makes a good investment?” In the author’s view it is one that beats the market over a short or long period. Over his career as an analyst, Clapham specifically looked for stocks which he thought could go up in value by 50% or more over 18 to 30 months. His favoured approach to finding these is to look for companies which have the potential to beat consensus market forecasts and thus rise in value.
After providing a range of sources for generating investment ideas in Chapter Two, Chapter Three provides information on how Clapham goes about filtering these by doing further research. As researching a stock fully can take many hours, his approach aims to prioritise the best ideas by subjecting them to some brief initial checks. These include looking at how liquid a stock is, its recent share price performance, a valuation screen and earnings estimates. Once a stock passes these initial hurdles, the real in-depth analysis begins.
Chapters 4 to 8 go on to explain Clapham’s research process in detail, providing useful checklists along the way to make sure all of the key points are covered. The first part of the analysis focusses on a company’s wider industry, looking at competitors, customers, suppliers and demand/supply trends, to determine revenue and margin trends.
No stock investment book would be complete without a nod to Warren Buffett, and Chapter 5 looks at determining the quality of a business and its “economic moat”. In other words, if and how it can maintain a competitive advantage for the benefit of long-term profits, a factor much favoured by the Sage of Omaha. Chapter 6 also considers quality factors, looking at aspects such as the structure of the business, its history and shareholder base.
For small cap investors in particular, company management is a key factor, and Chapter 8 provides some key questions you should ask of the directors and a company’s corporate governance before committing to an investment. There is also an interesting section on how you can make money by investing in companies run by convicted criminals, the reasoning being that the stock market prices such companies at a discount which can reduce over time as profits and cash flow are delivered.
The past few sections have mainly focussed on a company’s qualitative factors, but Chapter 9 brings in the analysis of a company’s accounts. While being publically available, the author believes that financial accounts can in fact provide an information edge as, in his experience, very few investors actually read them in full. As well as analysing the numbers, Clapham believes that the detailed, and often long and boring, notes to the accounts can provide insightful information. Chapter 9 then goes on to the crucial valuation part of the analysis, providing a range of methods on how you can make a judgement on the value of a stock.
Appropriate as we enter into the new year, the final chapter contains the author’s thoughts on how the pandemic may change his investment approach in the coming months and years, and how equities will be affected. Written in April last year, Clapham had the foresight to suggest that predictions of higher earnings in 2021 compared to 2019 would be fanciful. At the macro level, he expects governments around the world will be keen to maintain inflation above interest rates in order to deal with their huge debt burdens, perhaps for decades, thus favouring demand for growth stocks. Growth stocks may be boosted further due to their rarity, as Clapham also expects companies to become more risk averse, shunning debt as they rebuild their balance sheets.
A sterling system
The Smart Money Method provides just what you want from a stock picking investment book. The core text provides a clear framework for finding your own investment ideas, interspersed by stories of Clapham’s time working in the investment industry which provide further insights into how professional money managers go about their business. The book is easy to read, jargon free, with any theoretical concepts simply explained, and written by an expert who claims to have surpassed 10,000 hours of experience many years ago
This book is for anyone interested in investing. Beginners will find it accessible, while those who have some trading experience will find it adds a range of techniques to their arsenal. I also think it would be an ideal guide for anyone looking to enter the finance industry as an analyst, with one specific chapter dedicated to how you can communicate an investment idea via an eye catching research note.