The Smart Money Method is a book about investment strategy. The author presents his investment process from finding the original idea to buying, monitoring and selling. He would like to improve the readers’ investment performance with this book. I would like to know how hedge fund managers choose the stocks to be included in their portfolios and see if I could implement some methods to improve my returns.
Stephen Clapham is the founder of Behind the Balance Sheet. He 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. He moved to the buy-side in 2005 and was a partner and head of research at 2 multi-billion dollar hedge funds; he specialised in using a deep dive research approach to identify special situation opportunities.
The Smart Money Method has a preface, an introduction, and 14 chapters.
The chapters are 1) What Makes A Good Investment?, 2) Finding Ideas, 3) Testing the Hypothesis, 4) Understanding the Industry, 5) Quality, 6) Analysis of Company Quality, 7) Management, 8) Company Financials, 9) Valuation, 10) Communicating the Idea, 11) Maintaining the Portfolio, 12) Macro-Economic Analysis, 13) Looking Forward, and 14) COVID-19 Postscript.
The Smart Money Method contains the author’s own blueprint to pick stocks and picking winning stocks is a key objective of every investor. He says that successful investment requires methodology and process and I totally agree.
The author delineates his whole process from where to get ideas, doing initial checks, researching the industry, the qualitative (including nature of the business, quality of the company, key factors driving profitability, and management) and quantitative (most important being level and volatility of returns on capital, and financial leverage) attributes of the company, making valuation, and monitoring the portfolio. He also includes many examples to explain his method.
The author opines that focus on the now is a distraction from the long-term fundamentals. He advises investors to look for companies with asymmetric pay-offs to invest. These stocks should have upside pay-off that is significantly greater than downside risk. Patience will reward us because the volatility of public markets will give investors the chance to own companies we like at our price. When the market has misunderstood the basis of pricing, we have the best protection and greatest upside.
Regarding stock ideas, the author has the following saying: “Understanding what is happening is the first step. Determining the lateral, the best stock idea, is the real skill.” Some of his best stock picks were the suppliers or customers of the stock that he was initially researching. Thus, it requires some critical thinking to find where the highest value resides.
The author cautions that calculation of future returns are fraught with uncertainty but many people overlook this in their zeal for academic answers. Investing is common sense and academic content can be confined to understanding a few valuation multiples and financial ratios.
Valuation is important but it should be a measure of calibration of the stock price, rather than being a reason to purchase a stock. He advises us to find some valuation techniques that we understand and feel comfortable with, instead of using everything available. Furthermore, finding a tool which nobody else uses can be a really useful strategy in the investment world.
Monitoring the portfolio is an important exercise because watching for trouble and getting out before it happens is the single exercise most likely to add value to performance. He recommends the readers to produce research note for every stock. It will serve as a useful reference point to determine whether to stick or cut and run.
We should also readily admit mistakes and move on as none of us gets everything right and what is important is what will happen tomorrow, not what happened yesterday. In short, we should avoid sunk cost fallacy.
In the book, the author acknowledges that private investor may not have the resources that hedge fund managers have to generate huge data sets, but we can use common-sense principles and basic analysis to understand the most likely future prospects for a stock and whether today’s stock price properly discounts those fundamentals. This is a sound advice that is the most important takeaway for me.
In the last chapter, the author shares some structural trends that he thinks will continue. These are climate change, ageing population and the emerging middle class. Perhaps we should pay attention to stocks related to these trends.
- The best ideas are always the simplest and the quickest ones are usually the most profitable (although they still require due diligence).
- Investing is often about exploiting a gap between perception and reality.
- It’s really important to recognise that you have no control over the timing of the share price appreciation.
- The moral of the story is that it’s better to look stupid than lose money.
- Understanding what you need to worry about, and when, can save a lot of wasted effort.
Interested in The Smart Money Method?
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