Trader tales: Stephen Clapham’s The Smart Money Method

Ever wanted the inside scoop on how top hedge funds pick stocks and build portfolios to make market-beating returns?

Stephen Clapham, founder of a research and consultancy firm called Behind The Balance Sheet, is a former hedge fund equity analyst who spent more than 20 years in the industry.

His extensive experience has made him a highly sought-after hedge-fund expert, and his recently published book, The Smart Money Method: How To Pick Stocks Like A Hedge Fund Pro, gives readers a guide to understanding how smart money invests.

“The book gives these people a framework to use to avoid picking losers and hopefully will help them find winning investments,” he tells Opto, adding that it explains the methodology he developed to look at stocks when working for multi-billion dollar hedge funds.

Clapham has adapted his institutional investing knowledge into a methodology that can be used by private investors. While there are many crucial elements to taking a smart money approach to investing, he believes a proper study of the balance sheet is unmissable.

By going through a company’s balance sheet, even without knowing the company’s name, he is able to distil the multiple dimensions of the business’ financial characteristics.

“Indeed, with the balance sheet and half a dozen ratios, you can identify quite a few companies, or at least their sectors. This weighting of the importance of the financial statements, starting with the balance sheet, is central to my process,” he adds.

The following excerpt is taken from the introduction of Chapter One of The Smart Money Method, published with permission.

What makes a good investment?

A good investment, in my view, is any stock which beats the market over a short or long period.

In my professional career as an equity analyst at hedge funds, I looked for stocks which I believed either:

• would appreciate by 50% or more over an 18–30 month period, or
• had 20% or more absolute downside in a prevailing bull market.

Of course, when you buy (or sell) the stock, you can only hope for the right outcome – my actual results fluctuated wildly. But there are a huge number of equities globally in which you can invest, and selection criteria such as this are a useful way of narrowing your field of endeavour.

Routes to price appreciation

For a stock to outperform (or do better than) the market – active managers are generally measured on their performance relative to a market benchmark, hedge fund managers are measured in absolute dollars – one of three things generally has to happen:

1. The stock has to be rerated, i.e., market participants are prepared to pay a higher multiple of earnings or cash flow.
2. The company has to generate high returns on capital and strong cash flows, and reinvest those cash flows at similarly high rates.
3. The company’s earnings have to increase, or consensus estimates of those earnings have to increase.

Anticipating a rerating is possible, but difficult to time. An example of the type of rerating opportunity I look for is an orphan stock on its own in a sub-sector, and a competitor with a stronger story coming to the market. This is likely to drag up the rating of the incumbent. A rerating sometimes happens because of a fashion or new trend, but such opportunities tend to be rare. Without such catalysts, it can take a considerable amount of time for the patient investor to be rewarded with a higher multiple, as you wait for the market to recognise the quality of an investment. I tend to avoid this approach, unless there is this type of catalyst.

High-quality cash compounders are, generally, fantastic long-term investments, but they are often highly valued. In recent years, the prevalence of ultra-low interest rates and low growth made such companies inherently more valuable. They have also become much more highly rated. They remain suited to a long-term investment portfolio, rather than my special situation strategy.

My focus has been the exploitation of overly conservative profit forecasts by ‘the Street’, looking for companies which can beat consensus expectations of earnings over a two- to three-year period. (The consensus is generated by taking an average of the sell-side brokers’ forecasts for the company.) Usually, when companies beat expectations they also enjoy a rerating, which makes such investing highly profitable. Conversely, for shorts, I look for stocks likely to miss forecasts.

If the stock with the forecast anomaly is a high-quality business, or is in an industry undergoing a rerating, or enjoys some other benefit, so much the better.

That’s what I am looking for in an investment. The next thing to think about is where to look?