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The Smart Money Method: How to pick stocks like a hedge fund pro
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-19
And 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.
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-19
And 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.
288 pages, Paperback
Published November 24, 2020
168 people are currently reading
450 people want to read
About the author
Stephen Clapham
3 books4 followersStephen (Steve) Clapham is the founder of Behind the Balance Sheet (https://behindthebalancesheet.com/), an investment research and training consultancy, which produces bespoke research and runs training courses for a select group of institutional clients. Steve’s Forensic Accounting Training Programme launched in June 2018, and in its first two years some 300 professional investment analysts and portfolio managers at some of the biggest funds in the UK took the course, which has been enthusiastically received. The course is unusual in that it looks at the issue of financial manipulation from a practitioner’s perspective, and has over 150 real life examples of accounting chicanery from around the world.
Steve spent some 20 years as an equity analyst at different investment banks, covering various sectors, and was consistently rated in the top 10 in his sector in Extel, II and Reuters surveys. He moved to the buy-side in 2005 and was a partner and head of research at two multi-billion dollar hedge funds; he specialised in using a deep dive research approach to identify special situation opportunities.
Steve trained as an accountant and lives in London; he enjoys reading, yoga, and skiing and is interested in investment theory, wine and classic cars. He is regularly featured in the press, including the Financial Times, the Times, Sunday Times and City AM as well as on the Today programme on BBC Radio 4, talking about accounting issues at quoted companies.
His book, The Smart Money Method, outlines his research process and will be published on November 24. Please see https://www.behindthebalancesheet.com...
Steve spent some 20 years as an equity analyst at different investment banks, covering various sectors, and was consistently rated in the top 10 in his sector in Extel, II and Reuters surveys. He moved to the buy-side in 2005 and was a partner and head of research at two multi-billion dollar hedge funds; he specialised in using a deep dive research approach to identify special situation opportunities.
Steve trained as an accountant and lives in London; he enjoys reading, yoga, and skiing and is interested in investment theory, wine and classic cars. He is regularly featured in the press, including the Financial Times, the Times, Sunday Times and City AM as well as on the Today programme on BBC Radio 4, talking about accounting issues at quoted companies.
His book, The Smart Money Method, outlines his research process and will be published on November 24. Please see https://www.behindthebalancesheet.com...
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Displaying 1 - 12 of 12 reviews
November 9, 2021
I don’t really get who this book is for. Novice investors are likely going to end up more confused than anything else, since some basic financial terms are never explained (e.g. SG&A). The author also writes about all the things he is looking at, but sometimes doesn't mention how important they are relative to other factors, or how to interpret them. E.g. "I look at whether the company hires the CEO from externally or not." Is that information very valuable or just a little side note? Is an external hire something positive since the company allows for fresh ideas to come in, thereby hinting at a more dynamic company? Or is it a negative sign, as it hints that the internal talent management platform doesn't work all that well?
At the same time, I don't think many experienced investors are going to find much new and helpful insights in this book either.
One thing that annoyed me quite a bit is when the author used a very long paragraph to describe how he build a supposedly extremely sophisticated model to gauge the riskiness of companies. Then he writes that the model would be too much too be covered in this book and moves on to the next topic. Seriously?!
2 stars (it's ok) for most people. Maybe 3 stars (liked it) for the very few people that have a limited understanding of finance, but somehow landed a job in the HF industry.
Summary
2 – Finding ideas
Contrary to popular perception, good investment ideas – especially in larger institutions – do no generally originate from the sell-side analyst community.
Markets generally overreact to events, so a sharp sell-off can often be a useful point to revisit a past stock, or an idea you previously discarded as being overvalued.
3 – Testing the hypothesis
A detailed review of a stock can take 100, or even several hundred, hours, so it’s essential to invest the time looking at fruitful ideas.
It is vital to read at least one note that has a contrary view.
There are three edges in the market: informational, analytical, and time horizon. Individual investors mostly only really can profit from the time horizon one.
If you are buying a stock, you almost need to understand the bear case better than the bull case.
The ability to abandon work and write off hours of effort is an important discipline.
In fund management, too much time is wasted on events which don’t affect the portfolio or whose impact is hard to assess. Marco-economics is a common time trap.
5 - Quality
Not only did the high-quality stocks outperform in year 1, year 2, and year 3, but their outperformance continued. It’s en vouge to identify high quality stocks by filtering for high ROIC (return on invested capital).
A company which makes a high ROIC, but has limited reinvestment opportunity is likely less valuable than one that can reinvest surplus cash at similar rates of return.
Moats do not arise because you have a high market share, a technological advantage, or a great new product – all of these advantages tend to fade over time.
Moats can be identified by:
• ROIC is stable, or growing, and high.
• Gross profit to assets is high relative to peers, and is stable or growing.
• Market share is stable or growing.
• Industry structure is consolidated (geographical or product/service)
• Elements of customer captivity (e.g. tobacco), inertia (e.g. financial services), high switching costs (e.g. technology), or high risks of switching (flavours and fragrances)
• There is a network effect (e.g. Microsoft Windows)
• Product patents, process patents, or trademarks are significant factors.
• Other intellectual barriers exist, such as technological knowhow, a complicated process, or a long/steep learning curve.
6 – Analysis of Company Quality
I am wary of industries where everyone is expanding – it can be good for a while, as the public companies may steal share from smaller rivals, but generally what happens is industry unit costs fall and prices eventually follow. Buffett likens this to everyone standing on tiptoe at a parade – self-defeating.
A sure sign of a losing stock is one operating in an industry where capacity is increasing at a faster rate than demand.
In contrast, an industry which is unprofitable, but where capacity is being shut down, is often a highly attractive investment opportunity. Such sectors are usually out of favour and often reviled, the selling pressure tends to be exhausted and the market pays little attention. If capacity is exiting, and profits start to improve, a turnaround can occur.
I focused my analysis on analysis on seeking to identify the factors that were strong strongly correlated to a stock’s price movement, as opposed to looking at all the fundamentals. What makes the stock go up or down?
Insider buying is likely to be more meaningful if the shares are depressed, especially if there have been problems with the company.
7 - Management
Listen to the executive board, but don’t just believe them.
Founder-led businesses tend to outperform. Family-owned companies outperformed in every region, from 3.1% p.a. in Asia exJapan to 5.1% p.a. in Europe. It is a trend across all sectors.
The opportunity to invest profitably with crooks arises because the majority of institutional investors will shun stocks associated with people of doubtful reputation, let alone former criminals. Hence such companies often trade at a discount, but that discount will generally dissipate over time with cash flow and performance delivery. The bad deeds also tend to become less relevant over time.
8 – Company financials
I operate on the iceberg principle – if I see something I don’t like in the accounts, I assume there may be a lot worse hiding “underneath.”
Long-term trends in gross margin are incredibly useful in understanding a company’s ability to maintain pricing power.
Because there are no accounting standards for cost of sales, companies have a great deal of flexibility in where they book distribution and similar costs – some book this as part of cost of sales, some include this in overheads.
Montier’s C-score (how to spot earnings manipulation):
• Difference between net income and CF from operations is growing
• Days sales outstanding (DSO) is increasing
• Days sales to inventory (DSI) is increasing
• Ratio of current assets to revenues is increasing (can be used to disguise accelerated sales recognition)
• Depreciation rates declining (asset lives are getting lengthened)
• Total asset growth is high (serial acquirers trying to distort earnings)
9 -Valuation
For cyclical businesses, P/E ratios are not helpful at extremes and the EV/sales ratio is much more meaningful.
Book values are generally so low these days and prices so high that the P/B ratio has fallen out of favour. Its utility has also been degraded by the increasing relevance of intangible assets to business prosperity.
I always use P/E, EV/EBITDA, EV/sales, and FCF yield.
12 – Macro economic analysis
In my experience, the macro factor that has the most important impact on equity portfolios is FX. It is also extremely difficult to get right.
The factor that people spend a lot of time debating, and probably shouldn’t, is interest rates.
Hundreds of experts predict GDP growth for the next year or two, and hundreds of other variables, but they have limited success and it’s dangerous to rely on them.
Professional economists are generally useless at predicting recessions.
It is much more important to worry about the valuation of the stocks in your portfolio, than about the level of the market or macro-economic data, such as GDP growth rates.
but it’s rarely the same person twice.
At the same time, I don't think many experienced investors are going to find much new and helpful insights in this book either.
One thing that annoyed me quite a bit is when the author used a very long paragraph to describe how he build a supposedly extremely sophisticated model to gauge the riskiness of companies. Then he writes that the model would be too much too be covered in this book and moves on to the next topic. Seriously?!
2 stars (it's ok) for most people. Maybe 3 stars (liked it) for the very few people that have a limited understanding of finance, but somehow landed a job in the HF industry.
Summary
2 – Finding ideas
Contrary to popular perception, good investment ideas – especially in larger institutions – do no generally originate from the sell-side analyst community.
Markets generally overreact to events, so a sharp sell-off can often be a useful point to revisit a past stock, or an idea you previously discarded as being overvalued.
3 – Testing the hypothesis
A detailed review of a stock can take 100, or even several hundred, hours, so it’s essential to invest the time looking at fruitful ideas.
It is vital to read at least one note that has a contrary view.
There are three edges in the market: informational, analytical, and time horizon. Individual investors mostly only really can profit from the time horizon one.
If you are buying a stock, you almost need to understand the bear case better than the bull case.
The ability to abandon work and write off hours of effort is an important discipline.
In fund management, too much time is wasted on events which don’t affect the portfolio or whose impact is hard to assess. Marco-economics is a common time trap.
5 - Quality
Not only did the high-quality stocks outperform in year 1, year 2, and year 3, but their outperformance continued. It’s en vouge to identify high quality stocks by filtering for high ROIC (return on invested capital).
A company which makes a high ROIC, but has limited reinvestment opportunity is likely less valuable than one that can reinvest surplus cash at similar rates of return.
Moats do not arise because you have a high market share, a technological advantage, or a great new product – all of these advantages tend to fade over time.
Moats can be identified by:
• ROIC is stable, or growing, and high.
• Gross profit to assets is high relative to peers, and is stable or growing.
• Market share is stable or growing.
• Industry structure is consolidated (geographical or product/service)
• Elements of customer captivity (e.g. tobacco), inertia (e.g. financial services), high switching costs (e.g. technology), or high risks of switching (flavours and fragrances)
• There is a network effect (e.g. Microsoft Windows)
• Product patents, process patents, or trademarks are significant factors.
• Other intellectual barriers exist, such as technological knowhow, a complicated process, or a long/steep learning curve.
6 – Analysis of Company Quality
I am wary of industries where everyone is expanding – it can be good for a while, as the public companies may steal share from smaller rivals, but generally what happens is industry unit costs fall and prices eventually follow. Buffett likens this to everyone standing on tiptoe at a parade – self-defeating.
A sure sign of a losing stock is one operating in an industry where capacity is increasing at a faster rate than demand.
In contrast, an industry which is unprofitable, but where capacity is being shut down, is often a highly attractive investment opportunity. Such sectors are usually out of favour and often reviled, the selling pressure tends to be exhausted and the market pays little attention. If capacity is exiting, and profits start to improve, a turnaround can occur.
I focused my analysis on analysis on seeking to identify the factors that were strong strongly correlated to a stock’s price movement, as opposed to looking at all the fundamentals. What makes the stock go up or down?
Insider buying is likely to be more meaningful if the shares are depressed, especially if there have been problems with the company.
7 - Management
Listen to the executive board, but don’t just believe them.
Founder-led businesses tend to outperform. Family-owned companies outperformed in every region, from 3.1% p.a. in Asia exJapan to 5.1% p.a. in Europe. It is a trend across all sectors.
The opportunity to invest profitably with crooks arises because the majority of institutional investors will shun stocks associated with people of doubtful reputation, let alone former criminals. Hence such companies often trade at a discount, but that discount will generally dissipate over time with cash flow and performance delivery. The bad deeds also tend to become less relevant over time.
8 – Company financials
I operate on the iceberg principle – if I see something I don’t like in the accounts, I assume there may be a lot worse hiding “underneath.”
Long-term trends in gross margin are incredibly useful in understanding a company’s ability to maintain pricing power.
Because there are no accounting standards for cost of sales, companies have a great deal of flexibility in where they book distribution and similar costs – some book this as part of cost of sales, some include this in overheads.
Montier’s C-score (how to spot earnings manipulation):
• Difference between net income and CF from operations is growing
• Days sales outstanding (DSO) is increasing
• Days sales to inventory (DSI) is increasing
• Ratio of current assets to revenues is increasing (can be used to disguise accelerated sales recognition)
• Depreciation rates declining (asset lives are getting lengthened)
• Total asset growth is high (serial acquirers trying to distort earnings)
9 -Valuation
For cyclical businesses, P/E ratios are not helpful at extremes and the EV/sales ratio is much more meaningful.
Book values are generally so low these days and prices so high that the P/B ratio has fallen out of favour. Its utility has also been degraded by the increasing relevance of intangible assets to business prosperity.
I always use P/E, EV/EBITDA, EV/sales, and FCF yield.
12 – Macro economic analysis
In my experience, the macro factor that has the most important impact on equity portfolios is FX. It is also extremely difficult to get right.
The factor that people spend a lot of time debating, and probably shouldn’t, is interest rates.
Hundreds of experts predict GDP growth for the next year or two, and hundreds of other variables, but they have limited success and it’s dangerous to rely on them.
Professional economists are generally useless at predicting recessions.
It is much more important to worry about the valuation of the stocks in your portfolio, than about the level of the market or macro-economic data, such as GDP growth rates.
but it’s rarely the same person twice.
November 29, 2020
An excellent primer for professional investors developing their career
If you are in the formative years of your investment career, this is probably the best single book you can read to understand the practical steps of idea generation, company analysis and valuation. There are a lot of investment books out there, but most tend to fall in one of two buckets. Half are dry, technical textbooks on accounting and valuation, which don’t really translate into the real world of making money in equity markets. The other half are lightweight advertorials from famous investors that sound very convincing, but tell you little of substance to help your own day to day process.
This book provides a really clear and comprehensive framework of the various processes of in generating good investment ideas. I run an equity hedge fund, and found this book reflected the day to day reality of how I do my job far better than any other investment book I have read. I could easily see myself recommending this book to analysts as they transition towards a decision making role
It’s clearly and engagingly written and so should appeal to amateur investors who have some previous experience and are familiar with the most common financial acronyms and jargon. The author acknowledges that private investors won’t have the same access to Bloomberg terminals, sellside research and good excel modelling skills. But there’s still a lot of very relevant suggestions in here.
But the audience that will find this most useful are buyside and sellside equity analysts, as well as portfolio managers who haven’t totally settled on their own process yet.
If you are in the formative years of your investment career, this is probably the best single book you can read to understand the practical steps of idea generation, company analysis and valuation. There are a lot of investment books out there, but most tend to fall in one of two buckets. Half are dry, technical textbooks on accounting and valuation, which don’t really translate into the real world of making money in equity markets. The other half are lightweight advertorials from famous investors that sound very convincing, but tell you little of substance to help your own day to day process.
This book provides a really clear and comprehensive framework of the various processes of in generating good investment ideas. I run an equity hedge fund, and found this book reflected the day to day reality of how I do my job far better than any other investment book I have read. I could easily see myself recommending this book to analysts as they transition towards a decision making role
It’s clearly and engagingly written and so should appeal to amateur investors who have some previous experience and are familiar with the most common financial acronyms and jargon. The author acknowledges that private investors won’t have the same access to Bloomberg terminals, sellside research and good excel modelling skills. But there’s still a lot of very relevant suggestions in here.
But the audience that will find this most useful are buyside and sellside equity analysts, as well as portfolio managers who haven’t totally settled on their own process yet.
October 5, 2021
Lots of noise, little signal
The book adds no value to neither the private nor professional investor. Reading Buffett’s letters to shareholders or any book that summarises them (e.g. The Warren Buffett Way) is much more insightful.
This book contains a lot of chattering about what the author looks for when analysing a company, but it’s not practical at all. It doesn’t explain what metrics (above the obvious revenue and cash flow growth, etc.) the author looks for and how.
Since the author has a background in accounting and has been investing for many years and teaching pros, I was expecting practical examples and know-how. I found none.
The book adds no value to neither the private nor professional investor. Reading Buffett’s letters to shareholders or any book that summarises them (e.g. The Warren Buffett Way) is much more insightful.
This book contains a lot of chattering about what the author looks for when analysing a company, but it’s not practical at all. It doesn’t explain what metrics (above the obvious revenue and cash flow growth, etc.) the author looks for and how.
Since the author has a background in accounting and has been investing for many years and teaching pros, I was expecting practical examples and know-how. I found none.
August 30, 2021
Fantastic book about investing,,,should belong in the canon
July 10, 2022
Overall an interesting book that felt inappropriate to recommend to beginner/retail investors. There are many interesting stories and insights that could be useful to a casual investor, but most of the analysis in this book seems like it requires more than a working knowledge of accounting and finance.
Ultimately, i agree with some other reviews that mention some confusion about who this book is for. I'd guess that most of the analytical/research portion of this book will go over the heads of beginners, while the more advanced sections don't go into enough depth to be truly beneficial to professionals in this field.
Ultimately, i agree with some other reviews that mention some confusion about who this book is for. I'd guess that most of the analytical/research portion of this book will go over the heads of beginners, while the more advanced sections don't go into enough depth to be truly beneficial to professionals in this field.
May 22, 2023
Covers the different angles the author does day to day for investing. But mostly impractical for private investors due to time constraints. Also lacks detail on some of the valuation methods.
February 21, 2021
A slightly strange book that I bought by accident when trying to sample it on a Kindle that was glitching. Which I mention because I hadn't had chance to read many other reviews before accidentally buying it, so didn't have much idea whether it was something I wanted or not.
Anyway, it's strangely named, as the book isn't really about a tightly defined "method". Clapham does set out his investing technique, but it's more a collection of practices he recommends - like writing up an investment argument even if you're just a private investor - than an easily followable set of instructions.
The book itself is part-memoir, part investing guide. It's apparently aimed at intermediary investors, but for someone (me) who's been dabbling for a year or so, reads the financial press and is on their 5th investing book, I'd say it's not really for anyone who still considers themselves a bit of a beginner. Nothing is really explained in detail, and quite a lot of knowledge is taken for granted.
On the memoir side, the book is peppered with little asides from Clapham's investing career - often stories about what some CEO or fellow investor told him over dinner. These are sometimes interesting-ish, but often not that revelatory and just a teensy bit grating, perhaps. There's a touch of the pub bore about it.
But maybe I'm being unfair: if you buy the book expecting and wanting anecdotes and little tips from a professional investor that can help you put the finishing touches to your already-proficient skills, then you'll probably value this. I might well re-read it in a year or two and find it more helpful.
Some of the other reviews seem to be from professional investors, and this might be manna from heaven for fledgling pros, for all I know.
Even total beginners will probably find some stuff useful, but for people at the beginner-ish level I think it's more likely to be intimidating than helpful, overall. Perhaps the biggest lesson I took from it was: this stuff is complicated. That's good to know, and cautionary, but not going to help me improve very much.
(Addendum to last para: Investing doesn't *have to* be this complicated. Clapham is a kind-of "special situations" investor, which is essentially looking for stocks that seem under- or overpriced. It's more specialised than basic value, growth or momentum investing. A non-professional can easily improve their financial position through investing by cautiously following simple principles over a long time - think decades. So don't be put off.)
Anyway, it's strangely named, as the book isn't really about a tightly defined "method". Clapham does set out his investing technique, but it's more a collection of practices he recommends - like writing up an investment argument even if you're just a private investor - than an easily followable set of instructions.
The book itself is part-memoir, part investing guide. It's apparently aimed at intermediary investors, but for someone (me) who's been dabbling for a year or so, reads the financial press and is on their 5th investing book, I'd say it's not really for anyone who still considers themselves a bit of a beginner. Nothing is really explained in detail, and quite a lot of knowledge is taken for granted.
On the memoir side, the book is peppered with little asides from Clapham's investing career - often stories about what some CEO or fellow investor told him over dinner. These are sometimes interesting-ish, but often not that revelatory and just a teensy bit grating, perhaps. There's a touch of the pub bore about it.
But maybe I'm being unfair: if you buy the book expecting and wanting anecdotes and little tips from a professional investor that can help you put the finishing touches to your already-proficient skills, then you'll probably value this. I might well re-read it in a year or two and find it more helpful.
Some of the other reviews seem to be from professional investors, and this might be manna from heaven for fledgling pros, for all I know.
Even total beginners will probably find some stuff useful, but for people at the beginner-ish level I think it's more likely to be intimidating than helpful, overall. Perhaps the biggest lesson I took from it was: this stuff is complicated. That's good to know, and cautionary, but not going to help me improve very much.
(Addendum to last para: Investing doesn't *have to* be this complicated. Clapham is a kind-of "special situations" investor, which is essentially looking for stocks that seem under- or overpriced. It's more specialised than basic value, growth or momentum investing. A non-professional can easily improve their financial position through investing by cautiously following simple principles over a long time - think decades. So don't be put off.)
July 18, 2021
A good primer for anyone involved in equity analysis. Without intending to narrow the potential audience, I would say it’s must-read for young analysts or anyone considering entering the equity analysis field as a career.
Some notable sections that stood out to me include: origination of investment themes, actionable tips regarding financial statement and disclosure analysis, and many good “warning flag” suggestions.
Some notable sections that stood out to me include: origination of investment themes, actionable tips regarding financial statement and disclosure analysis, and many good “warning flag” suggestions.
January 18, 2021
I found this to be an extremely informative look at the stock market. Learning Stephen's process was absolutely fascinating and although some of it I was already doing, there's always something new to learn. Recommended for anyone looking to gain some insight and the covid chapter alone makes them a timely addition to any finance-focused library.
March 17, 2021
I would not class this book as entry level. I think you would need quite a few years in the game to fully appreciate and understand what this book is offering. If you are up to it, it is most certainly worth the read.
July 27, 2021
Good for a financial analyst to read, helps to ensure no stone left unturned in the investment process. Be an incredible book for someone right at the start of their career.
Well written and interesting, but not sure how much it would appeal to the non finance humans.
Well written and interesting, but not sure how much it would appeal to the non finance humans.
October 17, 2021
Very detailed outline of Stephen's investment process - well worth a read.
Displaying 1 - 12 of 12 reviews