The Smart Money Method

How to pick stocks like a hedge fund pro

Stephen Clapham

• Publisher: Harriman House
• Year: 2020
• ISBN:
  9780857197030
• Topic: Business
• Subtopic: Stocks
• Index: Business

In The Smart Money Method, the stock-picking techniques used by top industry professionals are laid bare for investors. This is the inside track on how top hedge funds pick stocks and build portfolios to make outsize returns.Stephen Clapham is a retired hedge fund partner who now trains stock analysts at some of the world's largest and most successful institutional investors. He explains step-by-step his research process for picking stocks and testing their market-beating potential.His methodology provides the tools and techniques to research new stock ideas, as well as maintain and eventually sell an investment.From testing your thesis and making investment decisions, to managing your portfolio and deciding when to buy and sell, The Smart Money Method covers everything you need to know to avoid common pitfalls and invest with confidence.Unique insight is presented in several specific areas, including how to:•Find stock ideas•Assess the quality of any business•Judge management's ability•Identify shady accounting and avoid dying companies•Value any business to find bargain shares•Navigate the consequences of COVID-19And throughout, there are real-life investing examples and war stories from a 25-year career in stock markets.The message is clear – you can beat the market. To do so, you need to learn and apply the insider secrets contained within this book.

Introduction

Picking winning stocks is a key objective of every investor. There must be thousands of newsletters claiming to do exactly that, sometimes run by failed hedge fund managers.

Myself, I am a former hedge fund equity analyst. The difference with this book is that I am not going to offer you stock tips. Instead, I offer a methodology which will help you develop your stock-picking skills and give you the tools and techniques to find great stocks which will beat the market.

Methodology and process are essential to successful investment. In this book, I explain the process I followed when I was a hedge fund analyst making huge investments in companies, with positions often well over $100m each.

When you are investing such significant sums, of course it’s necessary to do a huge amount of due diligence, beyond the capabilities of the average investor. The good news is that, as with most of such endeavours, the Pareto rule applies: 20% of the work will take you 80% of the way. And that’s enough for 99% of stock decisions. Even better, I shall show you some of the shortcuts the professionals employ in evaluating an investment.

You might well wonder what qualifies me to write a book like this. I was an analyst at various investment banks, top-ten rated in my sector by investors every year. I then moved to join one of my clients and I have been a partner and head of research at two multi-billion-pound hedge funds based in London. I have picked international equities and run portfolios for a £5bn asset wealth manager. And I now run a business training institutional analysts at some of the UK’s largest and most successful investors (and an online investor school).

For a few of my clients, I also do bespoke research. One called me in 2019 and asked me to review CK Hutchison, the Hong Kong quoted conglomerate, controlled by Li Ka-shing. It’s an incredibly complicated business. My client (which has a team of 40 analysts) did not have the time nor the forensic skills to do an in-depth analysis.

CK Hutchison looked cheap – it was trading on a P/E multiple of 7–8x, an extremely low valuation multiple. And it owns some fantastic assets: ports in Hong Kong and around the world; safe assets like Northumbrian Water, a regulated UK utility; and a string of renewable electricity generation assets. Other positive factors which attracted my client included:

• Li Ka-shing is a billionaire and one of the world’s most successful businesspeople.
• Many of the assets owned by the holding company would command multiples of twice or three times the parent, if separately quoted.
• The group had a spread of interests, both geographically and across sectors, which should make it highly resilient to a downturn, reducing investment risk.

At the time, CK Hutchison was quoted in Hong Kong, where local unrest was then a factor in undermining the valuation of the local stock market. My client was naturally intrigued – could they buy this high-quality portfolio of international assets at a discount? Perhaps the market disliked the stock because it was quoted in Hong Kong, although its business was not significantly exposed to the local unrest? I was asked to find out.

My normal modus operandi with a new complex company is to do an initial review to determine the scope of work and agree a framework with the client – this can take a couple of hours or a day in the case of a complex business like this one. In four hours, I emailed the client to suggest abandoning this project.

Why? How could I do this so quickly?

The reason is simple – I found a huge amount of debt (over $10bn!) in a structure which removed it from the group balance sheet, a consequence of CK Hutchison’s use of complex ownership structures. Its debt looked lower than the economic reality and its valuation more attractive than it really was.

I found this quickly because I have developed my research process over the last 25 years. That is the subject of this book. Sometimes, when a business is this complex, it’s a bit like detective work, but without the weapons. Most of the time, it’s straightforward.

In this book, I have distilled all these years of experience, thousands of hours reading thousands of company releases and annual reports, countless meetings with company managements and likely tens of thousands of research reports. For sure, I surpassed Malcolm Gladwell’s 10,000 hours to become an expert many years ago, and hopefully this book will save you having to make the same mistakes and spend as much time learning as I did. After reading it, you should be a better investor.

1: What Makes A Good Investment?

Introduction

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 sometim...