[00:03:03] Kyle Grieve: I really enjoyed learning about laterals, which you say is how all of your best investment ideas were created. Laterals are quote, “taking a stock idea or theme and apply it to a different stock, industry, or geography.” Why do you think this method was so powerful for unveiling great ideas for you?

[00:03:20] Stephen Clapham: Honestly, I don’t know why it was so powerful. I just, you often don’t know why something works. You just sort of gravitate to the things that work. And I, I mean, I can’t really explain it other than, well, if you’ve seen something work before, it’s got a high probability of working again. And I can’t remember, it’s so long since I wrote the book, and I haven’t read it.

[00:03:45] Stephen Clapham: But I think the one that I used in the book was the, the discounters, the supermarket discounters setting up in the UK, Aldi and Lidl, and they rolled out a huge increase in the number of stores. And obviously that put significant pressure on the incumbents. And it was quite a cozy oligopoly up until that point.

[00:04:07] Stephen Clapham: And then, so when they moved to Australia, you could predict with a high degree of confidence, what would happen. These German discounters are, they’re very effective and I believe that, they’ve, they’ve started to come into the East coast now and you’ve seen the playbook before. So I guess the reason why it’s effective is it’s harder to predict something that you’ve not seen before and something you have seen before.

[00:04:33] Stephen Clapham: So I guess that’s the simple reason, but I wanted to ask you, why is my book not on your shelf? How do I get my, how do I get that product placement? 

[00:04:44] Kyle Grieve: Oh, it definitely is on my shelf somewhere. Where is it? Oh, don’t worry. 

[00:04:49] Stephen Clapham: No, it is. I’m going to get it in that, so I’ve top right corner. 

[00:04:54] Kyle Grieve: It’s definitely up there.

[00:04:55] Kyle Grieve: I promise you. So one thing you really mentioned, one thing that you just mentioned now that I liked and that I quoted was about geographies and moving from one geography to another geography. So how do you help with the analytical process of, of understanding when you think a product market fit is right for one geography and right for another geography, even if it, let’s say it’s in a different, a whole different continent and has a different culture and stuff like that.

[00:05:19] Stephen Clapham: Well, I wouldn’t necessarily be making that assumption. I mean, I, if it’s worked somewhere else and you obviously you’re hopeful, that isn’t how I would necessarily classify how I’m looking at it. It wouldn’t be the transfer of a product necessarily. It would be more like that theme, the, the discounting theme that was disruptor in one geography, then moves to another geography.

[00:05:45] Stephen Clapham: And that would be more, you, you could predict with a degree of confidence what the impact would be. I’d be less sure that Tesco opening up in California, I generally wouldn’t think, Oh, Tesco is successful in the UK, therefore be successful in America, because I can’t name a UK retailer that’s gone to America and made any money.

[00:06:08] Stephen Clapham: And sure enough, Tesco burned hundreds of millions. Trying to set up in the U. S. because they thought they were the best food retailer in the world. Turned out that they were very good, but they couldn’t compete in the U. S., which is, the most efficient, most competitive market for almost any product.

[00:06:27] Stephen Clapham: So I, I’m not confident about the application of a product to a very different geography, unless it’s something very simple, but you know, when you go to China or you go to America, there are very, very different markets and you can place a great deal of, of, Reliance on that. And also, Kyle, what you’ve always got to think about is what’s in the price, management have said, Oh, we think we’re going to go, we’re going to this new market and we’re going to do really, really well.

[00:06:57] Stephen Clapham: And there’s some anticipation of success. And you’ve got to be very careful with that. 

[00:07:04] Kyle Grieve: So another simple way that you outlined for finding great ideas was to follow the market. And by this, I mean, looking at the market to see what is currently out of favor. The market often overreacts to things like earning misses, negative guidance, litigation, decreased growth rates, departure of key executives, and increased leverage.

[00:07:21] Kyle Grieve: But these events can also be very short term in nature and offer incredible buying opportunities to those who have some patience. How do you use this strategy on a business with limited knowledge of where the price value gap may close faster than you can finish your research? 

[00:07:35] Stephen Clapham: If you’re trying to deploy a very large chunk of capital, you’re, partner head of research at two multi billion dollar hedge funds, and you don’t have that many positions.

[00:07:44] Stephen Clapham: So when you’re deploying capital, you’re deploying it usually in quite significant size, particularly on the long side, but And in order to do that, you need to be confident that where you’re going to deploy the guy where it’s going to work. And you can only generate that confidence by doing a lot of work.

[00:08:02] Stephen Clapham: So you’ve got to spend a lot of time. It just people in the stock market, they’re always looking for quick wins. And quick wins are I’m not saying there isn’t such a thing as a quick win. I have made quick wins, but they’ve been very, very rare. And usually it’s been a long and painful grind to find an idea.

[00:08:23] Stephen Clapham: So you don’t have any guarantee that where you’re doing a lot of work that the stock price won’t move in the meantime. But ironically, and paradoxically, in spite of the fact that it would take me quite a long time, we were usually too early. Because if you’re thinking about If you and I are buying a stock, we can, wait for it to bottom bounce a bit and then buy it once the, once the base is set in, if you’re wanted, if you’re a large hedge fund, you’ve got to buy it on the way down and you don’t know where the bottom is and usually the bottom was way lower than what we thought.

[00:09:00] Stephen Clapham: So if anything, it was quite the reverse rather than being late, we were being early, but you might not buy on the first profits warning. But you might not wait for the third one, if you thought that there was a good longer term opportunity, I mean, typically I wouldn’t gone and bought a stock that had had a profits warning.

[00:09:18] Stephen Clapham: Because the risk of turning round, usually stocks that have profits warnings have a second, have a third, and I would only ever sort of start to get confidence once I’d seen, that there was some evidence that the thing, that thing was going to turn around. So that wouldn’t be my sort of thing. I also, changes of management, People, and look, there’s all sorts of ways to invest successfully.

[00:09:45] Stephen Clapham: I’m not, I can only tell you what works for me. And I think there’s an extraordinarily personal endeavor. I don’t think people place enough emphasis on it. I mean, I had a cup of coffee with Anthony Bolton last week. Anthony Bolton, one of the world’s best investors, And, he said that what I hadn’t put in my book, which he thought was was missing is that you need to know yourself.

[00:10:08] Stephen Clapham: And it’s actually very true. I think knowing, understanding what you’re good at and what you’re not good at is actually very important. So I start off the book by saying, My speciality was forecasting company profitability, and that’s what I focused on, and that company profitability might be about to go down because Aldi and Lidl were about to enter the Australian market, or it might be about to go up because there was some pricing power hidden that the stock market hadn’t perceived, or there was demand, in a different sector that was going to generate demand for this sector.

[00:10:45] Stephen Clapham: I wouldn’t really get involved in sort of very obvious things. Because I think, if it’s very obvious, then there’s usually a good reason behind it. I mean, if I mean, I’m writing my sub stack for Nick Sunday about an idea that was presented at its own ideas competition. And it was one of these sort of discount to the, to some of the parts, a company with a lot of stakes in other companies.

[00:11:11] Stephen Clapham: I said, really, generally, I don’t like these ideas because anybody can add up. How could you have an edge with that? Although this particular one is so compelling. It’s such a large discount that it’s hard to see, you’ve got such a margin of safety, but it’s very, very unusual to get that. And things that are obvious usually don’t work.

[00:11:31] Kyle Grieve: So I know you like to draw wisdom from contrary views when testing your thesis for an idea. You talk about how these are much harder to come across like a bear report. So for investors investing in more obscure or less followed businesses, what are the best ways to try and poke holes in your thesis when no bearish report exists?

[00:11:48] Stephen Clapham: Well, go down to the pub with your mates. 

[00:11:50] Stephen Clapham: Tell them your idea and watch them laugh at you and rip it apart. That’s one way of doing it. I mean, I think it’s very difficult to be completely solitary as an investor. And I think being able to bounce ideas around, I find to be quite helpful. And so, at the hedge funds, we would discuss, it wouldn’t, it wouldn’t be, you would come up with an idea and just put it in the, in the portfolio.

[00:12:21] Stephen Clapham: It would be, there would be quite a rigorous debate. And I think that’s a very, very healthy thing because the discussion forces you to examine the strength of your thesis and figure out, are there any holes in it? I was usually deploying a lot of capital. So by definition, it was in a large cap stock and by definition, it would have a number of people looking at it and they might have been, 25 buys, but there’ll be one.

[00:12:50] Stephen Clapham: guy that had been a seller in the past or there would always be somebody that was less enthusiastic and so i would really spend my time if i was looking at a long i’d really spend my time trying to poke holes in my own argument if you’re looking at a small cap it’s clearly more difficult and you the only thing i think you can do really Is to say, are there any sales of comparable companies, maybe not in the same sector, but something with similar characteristics, and just to argue with your friends.

[00:13:21] Stephen Clapham: I mean, I was being slightly facetious to go down the pub. Actually, the debate down the pub can be quite helpful, and I was at an investment conference a couple of weeks ago, and The most interesting part of the investment conference is usually the chat in the bar. 

[00:13:39] Kyle Grieve: I know you’ve done a lot of work on a case study of Patisserie Valerie, a chain of cake focused cafes.

[00:13:44] Kyle Grieve: You had a really good point about the fact that it wasn’t a particularly difficult fraud to identify. Your simple measure was to look at it, and you could instantly see that its margins were higher than that of Starbucks, for instance. So why does that matter? Because coffee is a high margin business, and there is simply no way that cakes that are consumed in store can compete with the margins that a business like Starbucks, who people can just take their drinks and go, would have.

[00:14:06] Kyle Grieve: So one part of this case study I found particularly scary was the fact that the CEO, Luke Johnson, was unaware of the fraud and was never prosecuted. He also owned 37 percent of the business and had his equity wiped out. Investors looking for quality businesses might have been attracted to a business like this that had appeared to have some sort of competitive advantage.

[00:14:23] Kyle Grieve: On top of looking at financial statements and comparisons to other businesses, what are the best ways for investors to limit the risk of fraud? 

[00:14:31] Stephen Clapham: Well, I mean, the Luke Johnson case is quite an interesting one. I mean, Luke actually lived around the corner from me and at the time our children were at the same school.

[00:14:40] Stephen Clapham: And I was quite puzzled because I thought, he’s a very smart guy. How has he not spotted this? And the day, the week, I think it went bust on a Tuesday. And then the Friday morning I was dropping my younger son off at school. And who should I bump into very early on? Obviously not wanting to see anybody.

[00:14:59] Stephen Clapham: It was Luke Johnson and he couldn’t speak. It’s not every week that you lose 150 million quid at the time. And that would have been 200 and something million dollars. That’s not a good week, right? Even if you’re a very rich, and he wasn’t, he was rich, but that must have been one of his biggest holdings, it was clear that he hadn’t been aware.

[00:15:19] Stephen Clapham: And I think he was doing an awful lot of things and he, he, he was executive chairman, but there was a CEO who was running the business. And I think, he was there in the board meetings and he was told, Oh, it’s all going fantastically well. And he probably never visited the stores, and if he’d visited the stores, he would have seen that.

[00:15:39] Stephen Clapham: There was a Patisserie Valerie next door to the Caffe Nero, another coffee chain, very close to one of the offices I worked at. We always used to buy our coffee in Caffe Nero. We used to do a coffee run every day. And we never went to Patisserie Valerie. The Caffe Nero was always full. The Patisserie Valerie was always empty.

[00:16:00] Stephen Clapham: No, it could have been just that street, in central London, but the caffeinero margins started off at two thirds of patisserie valerie and fell in half, whereas patisserie valerie’s margins went up. Actually, that seems a bit bizarre, but I think this tool, I really recommend to all my students.

[00:16:24] Stephen Clapham: I train professional investors. In forensic accounting, I have an online school, which allows you to learn about investing and about reading financial statements. And I say, look, the one really powerful tool is look at the margins versus the peers. And understand why your company’s margins are where they are relative to their peer group.

[00:16:49] Stephen Clapham: And I really can’t understand how could making cakes where it’s very labor intensive, there’s a lot of material costs, there’s a lot of wastage because they’re full of cream and they go up. Coffee is the highest margin product you can get, just about. I mean, it’s got a 75 percent gross margin if you include the cost of the electricity.

[00:17:11] Stephen Clapham: I mean, it is a really, well, the beans cost tuppence and the cappuccino costs 3. 50. It’s just a very, very profitable product. And if you’re making a higher profit than selling coffee, then you’re doing really, really well. And there must be some trick to it. And if you can’t understand why the margins are where they are, then you probably shouldn’t buy the stock.

[00:17:42] Kyle Grieve: So looking at stock charts is not something that I find particularly interesting myself, but you gave a great quote by Stanley Druckenmiller on how it can be used to help improve ability as an investor. He wrote up an investment paper to his research director who after reading it said, quote, “This is useless. What makes the stock go up and down?” That comment acted as a spur. Thereafter, I focused my analysis on seeking to identify the factors that were strongly correlated to a stock prices movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stock goes up and down.

[00:18:16] Kyle Grieve: I agree with you that I’m not sure it’s necessary to completely ignore the fundamentals just to identify what makes the stock go up and down. But I am interested in whether you think this is a worthwhile exercise to add to a fundamentals based investment process. 

[00:18:29] Stephen Clapham: Absolutely. I think a lot of people write off technical analysis or they’re just drawing squiggles on charts.

[00:18:36] Stephen Clapham: But the, the chart is the single. encapsulates in one measure what the market thinks about the share. And if you’re trying to make money out of the difference between perception and reality, which is what effectively what an investment analyst does, then you need to not only understand the reality, which analysts tend to be reasonably good at, but you also need to understand the perception and you need to understand Why the perception is wrong and what might change it.

[00:19:10] Stephen Clapham: If you don’t understand that, then you’ll never make any money. And how do you understand the perception? Well, it’s quite difficult, isn’t it? I mean, how would you know what’s in the price? And the best place to start is the share price. And if the share price has been going down and down and down and down and down and down, then.

[00:19:31] Stephen Clapham: There is quite a good chance it will continue to go down and down and down and down and you’ve got to understand what is going to make it go up. I mean, a lot of people focus their energies on valuation and say, well, I buy if it’s cheap enough, I buy it cheaply enough, then I’ll be, I’ll be safe. And you know what will happen?

[00:19:53] Stephen Clapham: They’ll lose money, and they’ll lose money for a period, and then they’ll get bored, they’ll write off that loss and go and buy something else. The fundamentals and the valuation are obviously terribly, terribly important, but if you don’t overlay the real world interpretation, understand why the stock market views That business in the way it does, you’ve only got half a story and it just makes it more difficult to make money.

[00:20:22] Stephen Clapham: I’m not saying you can’t make money by buying a stock that’s very, very cheap. Obviously, if you buy stocks that are very, very cheap, the chances are that they will, that they will go up. They might get quite a lot cheaper and understanding timing is important. The problem, Kyle, is that, we don’t get everything right.

[00:20:43] Stephen Clapham: So, eliminating obvious, simple mistakes is quite a good strategy, in my view, and, knowing when to buy something is actually quite important, and so, I view charts, I’m not a great believer in, oh, it’s broken out, and Fibonacci, and, I mean, I don’t even look at a candlestick, all that stuff, but, I think it’s, it’s not that I don’t believe it, it’s just that I want to just get the basics right. I don’t want to get too encompassed in all the detail about the charts. But what I do want to understand is, is the market becoming more favourable or less favourable towards this company? And why? And once I’ve understood that, I can say, oh, well, it is cheap.

[00:21:30] Stephen Clapham: And the market is worming to this company. If it’s cheap and the market doesn’t like it and shows no sign of liking it, I might be able to find something else that is equally cheap and the market is showing some signs of interest in, and that’s where I’ll, I’ll go. All other things being equal, obviously, when you’re running a professional portfolio, one of the other things you’re looking for are complementary stocks so that they reduce your overall portfolio risk.

[00:21:58] Stephen Clapham: So you might buy the one that’s still, that’s unloved and still hated and shows no sign of interest because it also gives you something else in the portfolio. There’s all sorts of things that you might be thinking about, but ignoring the charts, I think, is why, why would you ignore the most useful piece of information?

[00:22:17] Stephen Clapham: And it’s funny that we’re having this conversation because I was in the offices of hedge fund in London yesterday and I was pitching my forensic accounting training course to them. They said they were interested in it. So I went in to chat to them, and one of the guys said this to me, he said, I don’t understand why people are so anti charts, because what you say is that it tells you the psychology of the stock market.

[00:22:41] Stephen Clapham: And why wouldn’t you want to know that? 

[00:22:44] Kyle Grieve: So in the smart money method, you wrote, quote, return on capital incentives are generally recognized by investors to be more effective than EPS targets. And this is borne out by academic as well as sell side research. I was wondering if you could elaborate more on any research you’ve come across on this, as well as what you’ve observed from any sell side research that you’ve looked at.

[00:23:03] Stephen Clapham: Oh, it’s a long time since I, I’ve looked at this stuff. I mean, Goldman’s did a piece, and I think they’ve done some, some follow ups saying, Look, the best incentives you can have are returning on capital incentives, and it’s just obvious. If you incentivize people on EPS, they’ll go and do stupid acquisitions, they’ll gear the company up, they’ll cheat on accounts.

[00:23:29] Stephen Clapham: Look, I mean, earnings for share is quite important, the stock market. It pays very close attention to it. So I don’t mean that you should ignore it. And I don’t mean that people shouldn’t have, have it as some part of their incentives. The return in capital is a much more important criterion. You don’t want people to sell off growth parts of the business in order to improve the return in capital.

[00:23:52] Stephen Clapham: You’ve got to have a, you’ve got to have a mix of incentives. But there’s all sorts of research, and there’s lots of academic research on this topic, that companies, where the management are incentivized on and other metrics tend to do better. No, showing incentives. I’ll show you that come you’ve got Charlie’s Almanac behind you.

[00:24:15] Stephen Clapham: And it is, it is so true. And the other thing that, I look quite carefully at incentives and if, if a company is like a resource company, an oil company or a minor, if it doesn’t have a safety incentive. For the CEO, I’ll be very concerned about that. I’m, I wouldn’t say I wouldn’t buy it, but I’d be much more reluctant to buy a stock who in those sorts of industries, if the CEO isn’t rewarded for ensuring his staff are safe.

[00:24:49] Stephen Clapham: Because it just seems to me a fundamental criterion of a good business that you would do that. I mean, I actually did some research on this. I was, I was quite staggered because not every miner, the CEO is paid to not kill his staff. You would imagine that would be quite a good, quite a, simple starting point and some quite big mines.

[00:25:11] Stephen Clapham: It was quite some time ago that I did it, but I was, I was staggered. 

[00:25:16] Kyle Grieve: So another great point on management that you made was that you look for quote consistency, honesty, and common sense, unquote. You list a few red flags such as continuous restructurings and frequent mentions of extraneous issues. Now, to some extent, extraneous issues do affect the operations of a business, but at some point management needs to take responsibility for the outcome of their business.

[00:25:36] Kyle Grieve: How do you determine when a management team is spending too much time making excuses for the shortcomings of their business and view it as a red flag? 

[00:25:43] Stephen Clapham: When they mentioned the weather. We mentioned the weather, I just I’m gone. I’m not interested. I mean, obviously, weather does affect outcomes and performance.

[00:25:53] Stephen Clapham: And ironically, we were talking about Patisserie Valerie. I mean, in 2018, we had a very hot summer in the UK. I mean, it was the hottest summer, I think, since 1976. And as a consequence of that, the ice cream vendors did very well and people selling tea and cake did less well. So obviously it does, at the extreme, it has, it does have an outcome and an influence and is a fair thing to include.

[00:26:19] Stephen Clapham: But I think generally people that look for excuses rather than blaming themselves tend to be people I’m less comfortable by investing in. I, I’d much rather hear the CEO say we missed our numbers and I was stupid because I’d assumed that we were going to have a, a mild summer and I should have had more slack in there and I’ve been a bit over, over ambitious and, and, and the projections, I mean, how often have you heard a company say that?

[00:26:56] Stephen Clapham: Rarely. So companies that use extraneous things, the weather is a, a good example. Obviously you can’t predict the weather, but you shouldn’t be assuming that the weather will be perfect either. So when you make a forecast, you should have some slack in the forecast and that these sorts of factors won’t kill you.

[00:27:21] Stephen Clapham: And there’s all sort, there’s all sorts of issues that slightly annoy me. Oh, we hadn’t expected our competitor to cut his prices. Well, you’re in a competitive industry, then that is what your competitors are going to do. And it’s not easy when your competitors are cutting your prices to grow your profits.

[00:27:40] Stephen Clapham: And that can, it can sometimes be a surprise. But often you, you hear management make not the same excuse quarter after quarter, but there’ll be a different excuse. There’ll be a new excuse every quarter. I don’t really have time for it. that sort of thing. I mean, it’s different if you’re, if you’re a long term investor and you, you think, well, three or four quarters of bad results aren’t going to affect my long term disposition towards the share.

[00:28:05] Stephen Clapham: I mean, I completely sympathize with that. And, I quite get that. But if you’re doing special situations at a hedge fund, you get paid not to buy the stock that disappoints for three or four quarters in a row. You get paid to short that stock and buy, buy something good that goes up and I just wouldn’t hang around in, in that role.

[00:28:27] Stephen Clapham: I wouldn’t hang around for those perennial disappointers. I mean, I have been responsible for money that’s been longer term money, and then I might take a different attitude, but the excuses always make me feel, just may undermine my confidence in the people. Obviously things don’t go according to plan all the time, but the way you, the way you present that is quite important.

[00:28:51] Kyle Grieve: So you had a great sentence on debt that really spoke to me, quote, if debt is quoted and trading at a discount, it is often a critical indicator of failing financial health, unquote. I recently spoke with Matthew Peterson, who discussed his experience with Horsehead Holdings, and he said if he’d only looked at the discount to the debt that the business was trading at.

[00:29:09] Kyle Grieve: It would have helped him stay away from the business that ended up being a major dud. What’s the simplest way to add this to the investing process and what resources are best to get a better understanding of the value of a corporation’s debt? 

[00:29:21] Stephen Clapham: Well, I mean, I can’t understand why anybody would buy a stock with quarter debt and not look at the value of it.

[00:29:26] Stephen Clapham: Why would you do that? Especially if it’s got a lot of debt. That seems bizarre because the credit markets are quite good at spotting financial risk. Because that’s what, they’re, they’re paid to look at the downside and we’re paid to look at the upside. So I would always look at the value of the debt.

[00:29:41] Stephen Clapham: I mean, I used to just do it on Bloomberg, but if you don’t have Bloomberg, then there are ways you can, you can do it because you can go to a stockbroker and say, you want to buy the credit and say how much, what’s the share? What’s the price? And this broker will have a, have a Bloomberg terminal.

[00:29:57] Stephen Clapham: be able to tell you. There are quotes for these things. I mean, there are, I have proprietary systems, that I, I pay to get access to the, to the price of credit. And those aren’t, they aren’t free. I mean, I’ve forgotten what the one that I use, how much is not, it’s not a ridiculous amount.

[00:30:17] Stephen Clapham: You would need to be doing enough trading or investing that it would pay you to to buy that. I mean, it’s quite an interesting thing because I did a sub stack about, what does it cost to be an investor? And I invited my readers to come back to me with, what they spend. I was quite shocked how little people spent, people just believe, oh, well, I can buy, or actually there’s now some good products that are free that you can get, quite a remarkable amount, but why would I, why would I pay for 30, 000 a year for a Bloomberg when I can get X, Y, Z for free, and and, I’ve got a certain amount of sympathy with that because you can get quite a lot for free.

[00:30:58] Stephen Clapham: But you do need to invest in your tools. You need to invest in your information sources and you need to invest in yourself. You can’t be a competent, complete, all round investor without reading some books, without having good quality periodicals. I mean, I don’t see how anybody could be an investor without reading the Financial Times and the Wall Street Journal and The Economist.

[00:31:27] Stephen Clapham: I mean, if they can do it, well done to them. I’ve got no idea how you, how they could possibly do that. 

[00:31:34] Kyle Grieve: So I like how you emphasize the importance of back-of-the-envelope checks for valuations over more complicated models. I also prefer this method, although more complex models are important too. It seems like different investors do this math in different ways.

[00:31:46] Kyle Grieve: Can you give an example of a business that you’ve analyzed using back-of-the-envelope math and what specific numbers that you would look at? 

[00:31:53] Stephen Clapham: The problem with spreadsheets is that they look like the answer is right. And a friend of mine was working with a major international oil company and at board level and they, the board couldn’t understand how the analysts came up with their forecasts.

[00:32:10] Stephen Clapham: And so he got three of the top, so the II top three analysts on the oil majors and asked them for their models of this company. And they then had somebody audit the models, and every single one had not one error, but multiple errors in the model. And that’s quite shocking, but I can’t tell you how many times I’ve emailed an analyst at a bulge bracket firm and said, I don’t understand how you get to this number, and they’ve changed their forecast, because their forecast, their model’s been wrong.

[00:32:44] Stephen Clapham: This isn’t Oh, once in a blue moon occasion, this happens regularly and you got, and you can’t really blame the Southside analysts because they’ve got like huge amount of work to do. And, this is, this is a difficult process. So what I would do is I would always have very simple models and then whatever the model spat out at the end, I would ask myself.

[00:33:11] Stephen Clapham: Does that make sense? And we used to call it the back of the fag packet. calculations. Oh, your cigarette packet, you, there’s not much room for calculations. And just asking yourself, I’ve got to stop that. Dan is growing at 25%. So that means 10 percent revenue, 12 percent revenue. 12 percent on the, on the margin.

[00:33:33] Stephen Clapham: Is that realistic? Is that sensible? What, what’s it done in the past? It’s simply a case of pairing your own detailed knowledge of that specific stock with the likelihood of that sort of occurrence. So Michael Mauboussin, when he was at Credit Suisse, produced something called the base rate book, which was a sort of incidence of, how fast the companies grow, how fast do they improve their margins and, and so on.

[00:34:03] Stephen Clapham: Those sorts of simple checks are very, very important when you’re doing forecasts. They’re actually also quite important when you’re looking back in history. I was talking to somebody. a couple of weeks ago he bought Estée Lauder and he said and it’s not a stock I know or have looked at but he was saying I wouldn’t have done it if I’d thought more carefully about they’d had very impressive growth in margins and I should have asked myself how sustainable was that growth?

[00:34:32] Stephen Clapham: Because, in actual fact, what they’ve effectively been doing is stealing from the future, so they, these are his, his words, his analysis, I’ve not, I’ve not looked at it, but often you find, often you find that, and just asking yourself, does this make sense, is a hugely important question, and if you just ask those questions, you’ll avoid all the frauds, because none of the frauds make sense, 

[00:34:56] Kyle Grieve: So I liked your emphasis on doing sense checking for evaluating business, which you kind of just talked about now.

[00:35:01] Kyle Grieve: And I think this is an area that many investors refuse to look at because it invalidates their ability to buy a business, especially in bull markets. The other problem that can happen in bull markets is comparing one overpriced business to an industry full of overpriced businesses. This can help justify a purchase, even though looking at historical average price to earnings valuations or whatever metric of your choice for the industry over the last 10 years might be 50 percent or cheaper than current valuations.

[00:35:24] Kyle Grieve: So how do you best combat making these mistakes when markets are running hot and everyone is euphoric? 

[00:35:30] Stephen Clapham: I can’t tell you how to combat making investing mistakes because, if I knew that I would be rich, right? I mean, everybody makes investing mistakes. The best investors make mistakes because this is a very, very complicated endeavor.

[00:35:44] Stephen Clapham: And even Warren Buffett, the best investor in the world, I mean, he’s made mistakes. He bought Tesco. And it’s just not possible not to make mistakes. I think where I get, where I beat myself up, is where I make the same mistake a second time, or a third time. And then I get really annoyed with myself, and I think, you should have known, because remember that last time, there was a similar situation.

[00:36:10] Stephen Clapham: But in overheated markets, people get excited, they get enthusiastic. So the most important thing you can do to protect yourself against that is to start off with a valuation framework. And so, we teach that. You should look at not only the valuation of the stock, but the valuation of the market.

[00:36:30] Stephen Clapham: And there’s a huge amount of garbage talked about, Oh, it’s timing the market, not timing the market. And I don’t say that that’s garbage because it obviously, it’s a truism. It is timing the market, not timing the market. But if you just keep buying, irrespective of price level, You might do well over the very long term.

[00:36:55] Stephen Clapham: So if you’re 25 years old and you do that for 40 years, you might be okay. But if you keep doing it when you’re 65 and you’re wanting to retire at 70, you’ll lose your shirt. And, all these, all these truisms are, I think, quite dangerous in a way because people quote what Buffett says. Out of context, and if Warren Buffett were giving advice to a 75 year old, a 55 year old, and a 35 year old, he wouldn’t give the same advice.

[00:37:30] Stephen Clapham: And what people fail to understand is you’ve got to think about your personal circumstances. I’ve got, on my podcast, I interviewed a guy called Sebastian Lyon who runs Troy Asset Management in London. It’s about a 10 billion firm, and he looks at the valuation of the stock market, and if it’s very high, he holds more cash, and if it’s very low, he owns more shares.

[00:37:55] Stephen Clapham: That’s what you should do. I mean, it’s very difficult in, these recent times where markets have become incredibly enthusiastic and older investors just kind of understand that they’re going to miss the ball, not make as much money as their younger peers, but they’ll lose less money later. I mean, I was asked to look at a Dutch company, Adyen, in the payments industry.

[00:38:25] Stephen Clapham: It was valued at a hundred billion dollars and it had 1. 3 billion dollars, 1. 3 billion euros, pardon me, of sales. And, I said, okay, payments is quite a good industry and they seem to have quite a good position in it. What sales growth would they need to have for how long before I could, think about that as an investment?

[00:38:48] Stephen Clapham: And the answer was 15 years at 40%. Now, I don’t quite know what Amazon’s compound growth has been over the last 15 years, but I doubt it’s been 40%. It’s just like an almost unachievable sort of level. And when you see that happening, you’ve got to ask yourself, well, hang on a second. If this stock is at that level, what about all the other stocks?

[00:39:12] Stephen Clapham: Because if people are so enthusiastic about this Maybe they’re being overly enthusiastic about other things. I mean, people are, even in poor markets, we were always over enthusiastic about something, but when you get very, very clear signs of froth, then you should just exercise a bit more caution. And that’s the best discipline I think that I can recommend.

[00:39:35] Stephen Clapham: I don’t have any, there’s no, there’s no magic to investing. It’s the same old thing, every cycle. My friend, Russell Napier, the famous financial historian, he started the Library of Mistakes and the Library of Mistakes in Edinburgh. If any of your listeners are in the UK or in Scotland, they definitely should go and visit the Library of Mistakes.

[00:39:59] Stephen Clapham: It’s a brilliant institution. It’s got, I think, 4, 000 books and lots of interesting memorabilia. And even just to walk around and look at the posters on the wall of past frauds and so on. And just keep your feet on the ground. You don’t have to make the money tomorrow. You can make the money over the long haul.

[00:40:20] Stephen Clapham: And I think, a lot of mistakes are made because people have a desire to get rich quickly. I know the motto of my courses is, I’ll teach you how to get rich slowly. I don’t know how to get rich quickly. 

[00:40:34] Kyle Grieve: So I think environmental, social, and governance is largely a buzzword used to generate interest in emerging and unproven business models, but you had a really interesting three question framework I think is actually useful.

[00:40:44] Kyle Grieve: 1. Does the company have a purpose? 2. Will it improve people’s lives? And 3. Will it improve customers lives? I think this is a great set of questions to ask to find out if a business is a true win win win for the good of the planet, the customers, and the business, but finding a business opportunities like these are quite rare, but they do exist.

[00:41:01] Kyle Grieve: How do you incorporate these questions into your investing process? If at all, 

[00:41:05] Stephen Clapham: I’m not an ESG investor and I’m quite, an ESG investor would be quite shocked looking at my portfolio today because I’ve got energy and I’ve got mining and I’ve got dirty companies. And I think those 30 companies are going to do well and I want to save the planet, don’t get me wrong, right?

[00:41:23] Stephen Clapham: I’m passionate about, about that, but saving the planet and making money are two different things. And I think we should be devoting more attention to climate change. I think the ESG has been a bandwagon, the ESG made money because the tech stocks fitted ESG. So If you had an ESG fund, you’re overweight tech, and so you did well, and then in 2022, tech fell, and ESG funds all fell, and everybody’s oh, well, maybe it’s the end of ESG, and coupled with that, there’s been this sort of backlash, particularly in the U.

[00:42:00] Stephen Clapham: S. municipalities, where in Texas, they don’t want you to own an ESG fund, Because then the ESG fund won’t be investing in oil and that’s not good for the local economy and there’s all sorts of political things come into it. But I think that when I look at the, when I look at ESG, G, governance, I mean, that is table stakes.

[00:42:23] Stephen Clapham: If you buy a company with bad governance, guess what’s going to happen? They’re going to steal from you. So buy companies that are, that have good governance. I used to invest with crooks, one of the things, one of the chapters in the book was about investing with crooks, you have to be on the same side of the table as the crook, so governance is table stakes, the S, I’m, I’m quite dubious about the S, I mean I do understand the principles and the human capital and people are the most important part of a business, you It’s pretty obvious.

[00:42:59] Stephen Clapham: You just need to look at the board and who’s on the board. I mean, whether, you need to have a certain number of executives that are female. That is a very interesting debate. And, I think that you can have a company which has got a lot of women in senior roles and a company which has few women in senior roles.

[00:43:19] Stephen Clapham: And they can both be good companies and, and not necessarily discriminating in either way. And I don’t think, I think it’s very difficult to spend too much time worrying about this. And then the E, I want to save the planet. And I want to invest in companies that are conscious of their responsibilities.

[00:43:40] Stephen Clapham: For one simple reason. I think that, the carbon price is going to go up a lot. And if you aren’t paying attention to the carbon price, well, you’re probably going to end up with a lower quality investment because the carbon price will go up and you should be wary of your environmental obligations.

[00:43:59] Stephen Clapham: But that doesn’t mean to say I shouldn’t buy Exxon or BP. Because we need oil. I mean, I, I’d be very happy if we had more electric cars and that we were producing less pollution, and I think that’s a very good thing. I don’t happen to drive an electric car myself. I think the electric technology is perfectly fine.

[00:44:19] Stephen Clapham: But of course, You can’t displace everything overnight, so, realistically, we have to provide the exons of this world with capital because otherwise we won’t have any oil and we won’t be able to go anywhere because we can’t get enough lithium to make enough, I mean, the technological changes take time to work out.

[00:44:42] Stephen Clapham: I think ESG has been an overused I think it will disappear, actually, because there’s such a backlash against it. I would be very careful about ignoring the principles entirely, and I thought the questions That I was asking are quite a good way of understanding this isn’t an ESG question, the best investors incorporate ESG into their fundamental analysis and have done since the beginning of, of investing before ESG was a thing, people were practicing ESG because they were asking themselves, is this a sustainable business?

[00:45:26] Stephen Clapham: And the actual sustainability of it, and the pollution, and the climate change, and the environmental, all those things are part today of what is sustainability, and you have to really worry about the fact that, I don’t know, when was Al Gore’s film so popular? 2006? We’re 17, 18 years on. From when Al Gore pointed out what was going to happen to the, to the weather and we’ve done nothing about it.

[00:45:53] Stephen Clapham: Why have we not spent billions, trillions of dollars on carbon capture and storage? It just, it is beyond my comprehension. The government should have been forcing us to investigate and, and the UK government, I mean, they had a competition 15 years ago to design a, a CCS scheme, never been implemented.

[00:46:16] Stephen Clapham: I mean, just pathetic. 

[00:46:18] Kyle Grieve: So I really enjoyed reading about your history in the investing industry. When you first started in one of your recent Substack articles, you discussed how you couldn’t sleep because of a buy note that you published. You were fearful you’d be wrong and you wouldn’t make a positive impression.

[00:46:30] Kyle Grieve: You then discussed how you got over imposter syndrome by building skills to outperform your peers. Now, many listeners are not professional investors, but love the art of investing. So what are the biggest bang for your buck areas to build skills on when you are a newer investor? 

[00:46:44] Stephen Clapham: I still have imposter syndrome.

[00:46:46] Stephen Clapham: I think it’s very hard to get away from and that was early in my career and it was a new sector, a new company, very important company, big coal, and, if it had gone wrong, my career was at risk. And so the night before you, you worry, don’t you? You can’t sleep, but there’s all sorts of ways of gaining skills.

[00:47:09] Stephen Clapham: If you’re a private investor today, you don’t even need to spend a lot of money, but you should, because taking things for free creates two risks. One is the risk that it’s rubbish. Because there’s a, well, you laugh, but there’s a lot of really, really good stuff on the internet, whether it’s on Substack or on YouTube, there’s some great quality content.

[00:47:30] Stephen Clapham: So I’ve got some fantastic videos on YouTube. But if you have not heard of me and you just arrive at my YouTube channel, you get no idea whether I know what I’m talking about or not. So it’s very difficult to know where to go. It’s the trick with the free stuff is knowing where to go. So that’s very difficult to resolve.

[00:47:52] Stephen Clapham: And there’s quite a lot of good free stuff on Substack. I mean, I’ve got, I save my best stuff for my paying subscribers. I put out quite a lot of free stuff that’s quite useful and lots of other people do the same but finding the, finding the right ones is quite tricky and you’ve got to worry about what the value of your time is.

[00:48:13] Stephen Clapham: Because the free I think is a false economy because you spend so much time on garbage that you shouldn’t be wasting time on that you spend 10 times the amount of time so you get 10 percent of your of that time that you you’ve put as a output and that you’ve got your time is going to be pretty cheap to make that worthwhile.

[00:48:33] Stephen Clapham: I recommend reading books. I’ve got a list of books. I think there’s 10 or 20 books on my website. I think are a must read for every investor. I believe, and look, I’m very biased in this because I’ve got an online school, but I believe that online education is a very, very effective way of improving your, your investing skills.

[00:48:59] Stephen Clapham: Because if you do one of my courses, You not only get the videos from an experienced practitioner telling you here’s how I went about it and here’s some tips, but you also get exercises to do. So you download a model, you can fill out that particular exercise and then you can look at the model answer.

[00:49:18] Stephen Clapham: And in my school, I have a community so you can ask me questions. If you don’t understand something, you can get some proper help and we’ve thought quite carefully about this, but sadly there aren’t too many of these types of opportunities. I mean, there are a few people I came across somebody yesterday who a German guy who has got an investing school.

[00:49:43] Stephen Clapham: I mean, unfortunately it’s in German, so you know, it limits the audience. But I’m told his stuff is quite good by a German investing friend of mine, and so I wouldn’t discount using that as an approach. And find some good substacks and substack publish the most popular finance substacks. So it’s kind of like the top charts and some of them are good.

[00:50:10] Stephen Clapham: Some of them not quite as good. But if you’ve got somebody that’s got a big following. On Substack, the chances are that they’re, that they’re reasonable. So books, newsletters, be very careful about the newsletters though, because there are a lot of charlatans in the newsletter world. I think Substack is probably a better, safer place than some of the other sources of newsletters and online courses, I think are a good way.

[00:50:40] Stephen Clapham: And going to university is a good way of learning. I’m less keen on the CFA. I’ve been getting a lot of flack for criticizing the CFA. I think the CFA does a good job of teaching you about the theory of investing. Gives you three letters after your name, but only after an immense amount of effort and work.

[00:51:02] Stephen Clapham: And I really don’t know that that’s And the problem with investing is the theory is all rubbish. The theory gives you like, I mean, completely the wrong answer. So I don’t really understand why people are so keen on investment theory. I mean, in my courses, I teach you, here’s what the theory is and here’s why it’s rubbish.

[00:51:22] Stephen Clapham: So do it very quickly, because you don’t need the capital asset pricing model to beat a complete, not, I mean, I think it’s garbage leads you to wrong answer as often as not. So why worry about it? 

[00:51:34] Kyle Grieve: So you recently attended the London quality growth conference and you shared a very interesting photo of the drop off in quality businesses and an even more severe drop in quality plus growth.

[00:51:43] Kyle Grieve: I’m interested in your opinion on the drop in quality business over the past five years. What factors do you think are driving this drop? 

[00:51:50] Stephen Clapham: I’m trying to remember the chart that you’re referring to. I mean, I think the, what we were trying to look at was the persistence of quality. It’s quite a new conference.

[00:52:02] Stephen Clapham: It was reasonably well attended, but I was interested to go along. just to see how people define quality and I think 14 of the 17 speakers, something like that, don’t quote me on the exact numbers, define quality as sustainable, competitive advantage. And I said, well, what is that? How did you find what? And the reason that Berkshire has been so successful, I mean apart from the fact that Buffett and Munger are obviously geniuses, or Warren Munger was a genius.

[00:52:38] Stephen Clapham: The reason is that See’s Candies today is as successful as it was when they bought it 50 years ago. It’s a lot bigger and it’s still making exceptional returns. Now, even Warren Buffett today would have a much harder time identifying stocks that were going to be winners in 50 years time. You might say, oh, okay, Apple’s going to be a winner in 50 years time, but don’t get me wrong.

[00:53:05] Stephen Clapham: When he bought See’s Candies, it wasn’t obvious that it was going to be See’s Candies and, but people were still going to be buying chocolate in 50 years time. Will we be using the iPhone in 50 years time? I’m very, I’d be very surprised. I mean, it may be that we’ll have an implant in our ear that is an Apple implant.

[00:53:24] Stephen Clapham: I mean, who knows? And it may be that Apple will be in the forefront of creating that technology. It certainly has as good a chance as anyone, a better chance because it’s, got more resources to throw at it. There’s no guarantee that it will be successful and there’s no guarantee that it will even identify the right resources, the right technology.

[00:53:43] Stephen Clapham: And I, I think. Technology is so pervasive today, there’s barely a business in that you can look at in which technology isn’t a critical component, even C’s candies. I bet you, I mean, I’ve never, I’ve never eaten a C’s candy. I, America is a wonderful country. And I love it. We go there and holiday and my kids love it.

[00:54:05] Stephen Clapham: But the chocolates terrible. It really is. I mean, chocolate doesn’t hold a, I mean, it’s not nearly as good as chocolate in Europe. You’re probably going to get also don’t invite that anti American guy on but anybody that knows chocolate and I’m a great chocolate fan knows that if you want chocolate, you go to Belgium, not to the United States.

[00:54:26] Stephen Clapham: But even See’s Candies, I bet you you can, will have a website and you can order it online and there’s a technological aspect to every business today. And I think that makes the idea of a sustainable competitive advantage. A much more ephemeral thing. It’s much harder to get your hands around and I’d love to hear Buffett being interviewed about that.

[00:54:51] Stephen Clapham: I’d love to hear what he, what his perception is and as a consequence of that, I think the sustainability of competitive advantages is probably eroding. And that’s kind of what the research that we looked at told you was that Although companies that have high returns on capital, that tends to be persistent, the duration of the persistence From here, I would question.

[00:55:19] Stephen Clapham: Obviously, looking back is easier. But the problem you’ve got is, it’s very easy today to look back and say, Amazon is a great company, or Google is a great company, or whatever. But at the time, we didn’t know how good Amazon was going to be, or how good Google was going to be, or Facebook, Meta, whatever they call themselves this week.

[00:55:46] Stephen Clapham: I mean, Facebook came to the stock market in 2012, and I refused to invest in it, because I just said, well, I don’t know what it’s going to be able to do. on mobile. I don’t know anybody that is, spending more time on Facebook. Kids don’t want to go on it. I don’t see what it’s more is. And I didn’t buy it when I bought it when it had the very controversial setback, where the Cambridge Analytica fair, where the stock collapsed.

[00:56:19] Stephen Clapham: Then I understood that it could do mobile and that kids didn’t like it, but older people did, and that I, and I saw that, my own business used it to advertise and that it was quite cheap and quite effective. And I thought, Oh, actually, it’s a better business than I thought. And I then was given the opportunity to buy it.

[00:56:40] Stephen Clapham: But I wouldn’t have done so otherwise. I just think that Sustainable Competitive Advantage is easier said than analyzed and delivered. And I’ve got great admiration for people that are, that are excellent at the qualitative aspects of investing, understanding the sustainability of an advantage is it I’m a numbers guy.

[00:57:07] Stephen Clapham: And so I tend to look at things through through a financial Data lens and the sustainability of the advantage, you can look back and see how the return has been very high in the past, and if they have been, you tend to pay a very high price unless you get like those temporary setbacks and understanding a business that’s still developing a sustainable competitive advantage that will be there in five or 10 years time.

[00:57:36] Stephen Clapham: I don’t think is one of my particular strengths, and I don’t know how you do that, except from your own experience as a customer, so you can say, Oh, well, I bought that because it’s, it’s that product miles better than this competition, but then if you look at, so take an unquoted company, as an example, Dyson, the UK technology manufacturer makes vacuum cleaners and hair dryers and all the rest of it, You pay a high price for a Dyson product, will they be able to maintain that price differential in 10 years time?

[00:58:11] Stephen Clapham: Will they be able to keep the same technological lead? These are very difficult questions to answer, and I don’t have any real magic solution for that. I think, owning quality businesses is obviously something we all aspire to. And personal experience, I think, is an amazing help in that. I did a competition.

[00:58:34] Stephen Clapham: For my Substack readers, I did a mini course, which was like 10 bucks, and there were three things that you had to watch, and then you had to create examples from your own experience. It was about how do you find good stock ideas. I should do it again, because I’d probably be more interested in it.

[00:58:50] Stephen Clapham: And I, I said, the winner got a free course and the winner was a lady in, in the UK and she had taken some brilliant examples from her personal experience. And she said, Oh, I tried to, I tried to buy this product and I found this one that did this. And this one did that. And this one was by far the winner because it wasn’t that much more expensive.

[00:59:12] Stephen Clapham: It was much better quality. And she really understood the product. And she really understood why the company could have higher margins than its peer group. And she explained why the valuation was competitive, because it would continue to make higher returns. And that’s what I kind of look for. And she did it brilliantly.

[00:59:32] Kyle Grieve: Stephen, I appreciate you so much for joining me today. Before we say goodbye, where can the audience connect with you and learn more about your book and your course? 

[00:59:40] Stephen Clapham: Well, the book is available, sadly, not all good bookstores, but it came out in November 2020 when all the bookstores were closed, but you can get the book on, on Amazon.

[00:59:51] Stephen Clapham: The book’s called The Smart Money Method by Stephen Clapham. You, the best place to see what I do is behindthebalancesheet.com If you, on the top right of the homepage, there’s a sign up button and you can go and you can sign up for the free sub stack. I also have all the investing courses on there. So there’s courses online and in person.

[01:00:13] Stephen Clapham: In person courses I only do for institutional investors, but I charge quite a lot of money. But the online courses are, are, there’s a whole range of different courses. My favorite is the Analyst Academy, which is everything you need to become a serious investor. And there are some investing resources on there, so some of the videos that we’ve done about, we did a series of videos on investing tips, a series of videos on accounting red flags, so that, those are things that, I’ve tried to put into the public domain just to help investors and you can find me on Twitter.

[01:00:48] Stephen Clapham: I’m very not there very much these days because it doesn’t seem to generate much engagement. And we’ve got a company page on LinkedIn, which I have a social media person who helps me, who puts out a lot of content on that that’s worth following. And I just want to say thank you very much for having me on.

[01:01:08] Stephen Clapham: I’m hoping that when I next watch your podcast, that I’m going to see my book up there in that poll position, top right corner. And thank you for your questions. I really, really enjoyed talking to you. 

[01:01:21] Kyle Grieve: Thank you, Stephen. 

[01:01:23] Kyle Grieve: Okay folks, that’s it for today’s episode. I hope you enjoyed the show and I’ll see you back here very soon.

[01:01:29] Outro: Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

[01:01:50] Outro: This show is for entertainment purposes only. Before making any decision consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.