Private investors have several edges over their large money-managing peers. Use this to your advantage.
One of the benefits of lockdown for me was more time to read books, and even though I read more fiction that usual, I also got in several rereads of my favourites and a few new books.
One I ended the year off with was The Smart Money Method by Stephen Clapham. It is one of those books on how to be your own stock picker and often they’re not really worth the time. But this one had several gems that made it worth the price and time spent reading.
That said, for the average private investor the overall strategy is frankly too much for us to handle in terms of time and resources required. But it still made me smarter and for those wanting to get into the professional side of research and research report writing it is very much worth the read as he details the full process of researching and writing.
The author also brings in several other people’s ideas, such as one by Phil Huber, a US wealth manager who has written about the three edges a person can have in the market. They are information, analytics, and your time horizon.
He noted that as a private investor, the first two are very difficult as we don’t have the resources such as a Bloomberg terminal nor quality access to management.
When it comes to time horizon, however, private investors have a very solid edge as they can truly be longer-term investors.
On the other hand, private investors can use this to their advantage – albeit, as I have written before, this is a double- edged sword should our expectations never materialise.
I would also add a fourth edge which the smaller private investor has, namely liquidity. If you’re managing billions of other people’s money, there is a vast number of stocks that are uninvestible due to the lack of daily trading volumes.
Now, this is also a risk for us smaller investors, but we still have a much larger pool of stocks we can invest in as our minimum liquidity requirement is vastly smaller.
Clapham also writes a lot about self-dealing where directors buy and sell assets to and from the company. In every example where I have seen this it has not ended well for minority investors.
Overall, the book is well worth a read and the author has also been a guest on a few podcasts out of the US that are worth listening to.
I especially recommend his appearance on Bloomberg’s podcast programme The Odd Lots released in late October, which is where I first heard of him and his new book. The topic is about risk in Chinese investments and he ends with three top red flags that make him pause and consider fraud or perhaps just a bad investment.
There are a few topics that Clapham didn’t discuss in the book but did on the podcasts. First off, he discusses working capital ratios. If they are rising, then at best they’re not a good investment as it indicates customers aren’t paying, either because they can’t or because they no longer like a company’s products or services and have found an alternative.
Secondly, Clapham advises to check a company’s margins against the past and the peer group. He comments that every single fraud he has dug into had margins higher than their peers. Now, high margins in itself aren’t an indication of fraud, but are a red flag and they need to be explainable in simple terms.
Thirdly, look at cash flow compared to earnings. If there is a trend where earnings are not turned into cash, then those earnings are surely suspect and at some point must start to decline.