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Further Reading: The stockpickers fight back

Former hedge fund analyst Stephen Clapham’s Smart Money Method is the survival handbook for stockpickers
Further Reading: The stockpickers fight back
  • Stephen Clapham's Smart Money Method offers a comprehenive way to asses shares
  • Investors should produce an investment thesis for every investment
  • Covid-19 has reminded us that we constantly need to asses portfolio resilience

At the heart of the long-running debate over the relative merits of active and passive fund management sits an assumption that would render much activity with the financial services industry redundant: that stockpicking is simply too hard for most investors, self-directed or professional, to do effectively. It’s an assumption that also appears well supported by hard data – two-thirds of actively managed US funds failed to beat their benchmark last year – and a well-known experiment by Warren Buffett.

Rightful claimant to the title of world’s greatest stock picker, Mr Buffett famously won a $1m bet that “a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals”. Over the bet’s 10-year duration, the tracker returned 125.8 per cent; on the other side of the wager, the best of five fund of funds picked by hedge fund manager Protégé Partners managed just 87.7 per cent, the worst a pitiful 2.8 per cent.

Of course, Mr Buffett didn’t make the bet to win the money for himself – that went to charity. What he wanted to illustrate was that the huge amounts of money paid by American investors to advisers might, in fact, be wasted. As he pointed out when recounting the lessons learned from the bet in his annual letter to Berkshire Hathaway shareholders, the five experts chosen by Protégé employed hundreds more and all were well incentivised to perform – an “elite crew, loaded with brains, adrenaline and confidence”.

Mr Buffett concluded that investors should “stick with big, ‘easy’ decisions and eschew activity” – over the course of the bet, the army of analysts made tens of thousands of buy and sell decisions, and still lost. And if hundreds of investment professionals with access to management teams and years of experience scrutinising financials couldn’t beat the market, what hope has anyone else?

Former analyst Stephen Clapham may have an answer. After a career making investments for multi-billion-pound hedge funds, he has turned teacher. As well as training analysts at several major investment houses, Stephen has now shared his 30-years of experience in a new book, The Smart Money Method. Investors’ Chronicle’s own analyst, Phil Oakley – himself the author of a highly-regarded book on stockpicking, How to Pick Quality Shares – is a fan: “It is by far the best book on the process of researching companies and stocks that I have ever read. It confirms that investing is difficult and getting an information edge is very hard. But a diligent approach can achieve both.”

That difficulty and diligence is perhaps why there is always a temptation among investors take short cuts in their research process, even the professionals. Stephen is somewhat critical of the sell-side research reports published by broking firms, describing them as” very similar in structure and content, and…not as effective as they should be,” and outlines what a good research process should look like. Methodology, he says, is essential.

One method he encourages is for all investors to write an ‘investment thesis’, because “the discipline of setting down your thoughts on paper forces you to think through the potential investment outcomes.” It is a process he admits not all private investors enjoy – but it’s a method that Stephen’s found, through bitter experience wryly recounted, leads to fewer investing mistakes.   

If you are the type of person who enjoys the “detective work” of assessing companies’ investment worthiness, then Stephen’s instructions will help you make sure no research stone is left unturned. But there is encouragement – and a useful a one hour plan for testing ideas - for those who worry that they simply don’t have the time to put in the hours. “As with most such endeavours, the Pareto rule applies: 20 per cent of the work will take you 80 per cent of the way. And that’s enough for 99 per cent of stock decisions,” he writes. “You do not have to, and should not, do a full, drains-up intensive research straight off.”

But even the most diligent investor will have struggled in the face of the unusual challenges of Covid-19, though, and in Stephen’s case the teacher has continued to learn: “Thinking the unthinkable is one of the lessons I am trying to take away from this crisis.” Alongside the nitty gritty and war stories of company and industry analysis, the book explores some of the big themes that may deliver investors a few more surprises in the years ahead. “You should assess the resilience of your portfolio against every eventuality”, he concludes. Armed with Stephen’s book – and a copy of Investors Chronicle, of course – the stockpickers can now easily do that – and may win that bet against Warren Buffet next time, too.    

   

The Smart Money Method: How to pick stocks like a hedge fund pro is published by Harriman House