A Book with Legs Podcast: Stephen Clapham - The Smart Money Method

Release Date: July 7, 2025
Host: Cole Smead, CEO and Portfolio Manager at Smead Capital Management
Guest: Stephen Clapham, Founder of Behind the Balance Sheet

Introduction to Stephen Clapham

The episode kicks off with Cole Smead introducing Stephen Clapham, the author of The Smart Money Method: How to Pick Stocks Like a Hedge Fund Pro. Clapham, with over two decades of experience as an equity analyst and buy-side portfolio manager, brings a wealth of knowledge in value investing. He emphasizes his background, holding a degree in Technology and Business Studies and being a member of the Institute of Chartered Accountants of Scotland.

Stephen Clapham [01:40]: "I'm very surprised by the introduction because I've never been described as a member of a group of great authors..."

Inspiration Behind The Smart Money Method

Clapham shares his motivation for writing the book, highlighting his long-held aspiration to author a book since childhood. Initially, his publisher did not stock the book in UK bookstores, but his persistent note-taking and organization of investment insights led him to compile his 80-page notebook into what became his book.

Stephen Clapham [03:08]: "As a child, I always wanted to write a book... I realized that actually this would make a book."

The Randomness of Investment Ideas

Clapham discusses the non-linear and often random nature of generating investment ideas. Unlike systematic screening, his approach involves gathering insights from diverse sources like newspapers, The Economist, and conversations with other investors. This method results in a varied and uncorrelated set of stock picks, enhancing portfolio robustness.

Cole Smead [06:33]: "You discuss in your book that ideas in investing are kind of random... Can you explain the randomness of that for you?"

Stephen Clapham [09:53]: "By the nature of that approach, you're going to end up with quite a random set of stocks."

Networking and Industry Dinners

The conversation shifts to the value of industry events such as dinners with other portfolio managers. Clapham reflects on how these gatherings offer insights into market sentiments and consensus views. While he found limited direct investment ideas from such events, they were valuable for building enduring relationships.

Stephen Clapham [12:01]: "One of those dinners... there was a fund management group tipping their own company, and the pitch was so bad I burst out laughing and decided to short it."

Assessing Security Ownership and Insider Holdings

Clapham emphasizes the importance of analyzing who owns a particular security. He advocates for looking at reputable investors and avoiding stocks overly favored by high-quality managers. This approach helps identify undervalued stocks overlooked by major institutions.

Stephen Clapham [13:07]: "If I look at a stock and Smead Capital Management's largest position, that makes it much more interesting to me."

Understanding Business Moats

A significant portion of the discussion revolves around business moats—the sustainable competitive advantages that protect companies from rivals. Clapham differentiates between moats and their byproducts, focusing primarily on pricing power as a true moat. He cites examples like Costco's ability to maintain pricing power without frequently raising prices, thereby broadening their moat.

Stephen Clapham [22:33]: "One of the things that I often hear people talk about is economies of scale. To me, the real focus is on pricing power."

Case Study: Coca-Cola's Moat and Investment Performance

Clapham critically examines Coca-Cola, questioning its long-term returns despite its strong brand moat. He argues that growing externalities like health concerns and an aging population pose future risks to Coca-Cola's profitability and valuation, despite its enduring competitive advantage.

Stephen Clapham [29:14]: "Coca-Cola is well managed... but it's not healthy... there's an aging demographic increasing healthcare costs, which poses a bigger risk moving forward."

Insider Transactions and Capital Allocation

The conversation delves into insider dealings, cautioning against blindly following inside purchases unless multiple directors are involved, indicating genuine confidence. Clapham shares anecdotes about renowned capital allocators like Lord Simon Wolfson and Michael O'Leary, highlighting the complexities of interpreting insider actions.

Stephen Clapham [34:54]: "I like to see more than one director buying. If you have genius managers like Lord Wolfson, you need to be careful in interpreting their actions."

Dividends vs. Share Buybacks

Clapham articulates his preference for special dividends over regular dividends and share buybacks. He argues that special dividends demonstrate management's commitment to shareholders without creating recurring liabilities, unlike regular dividends. Additionally, he critiques share buybacks for often being executed for superficial reasons rather than strategic capital allocation.

Stephen Clapham [41:00]: "I like special dividends because it shows management is thinking about their balance sheet and shareholders."

Cole Smead [41:06]: "It's a stupid reason to do stock-based compensation if you're going to use buybacks to offset it."

Bond Valuation and Capital Structure

Clapham discusses the implications of bonds trading below par, emphasizing the need to analyze both nominal and discounted values when calculating enterprise value. He highlights upcoming debt maturities and the associated interest costs as potential risks not adequately covered by sell-side analysts.

Stephen Clapham [49:13]: "I use both nominal and discounted debt values to assess enterprise value and recognize investment opportunities."

The Impact of AI on Investing

The dialogue transitions to the role of Artificial Intelligence in investing. Clapham expresses skepticism about AI replacing human analysts, noting that while AI can enhance productivity by summarizing reports or understanding new areas, it currently falls short in handling the complex, multidimensional nature of investment decisions.

Stephen Clapham [56:14]: "AI can save you time and help understand new areas but isn't yet capable of handling the complex aspects of investing."

Capital Expenditures (CapEx) and Returns on Capital

Clapham critiques companies that misclassify their CapEx, often overstating growth CapEx while understating maintenance CapEx. He underscores the importance of accurately categorizing CapEx to assess free cash flow yields and overall financial health. Using the example of hyperscalers increasing CapEx as a percentage of sales, he draws parallels to traditionally low-return industries like oil, questioning the sustainability of such investments.

Stephen Clapham [55:37]: "Companies often claim more CapEx is for growth when it's actually maintenance-related."

Bezels and Fraud in Financial Reporting

Clapham touches upon John Kenneth Galbraith's concept of "bezels," referring to the underlying fraud or earnings management present before it becomes publicly exposed as embezzlement. He highlights the increasing prevalence of earnings manipulation in modern financial reporting, stressing the need for forensic accounting skills to detect such practices.

Stephen Clapham [78:06]: "Bezel is really stealing from innocent people, and it's always present until it gets exposed."

Conclusion and Resources

In wrapping up, Clapham directs listeners to his online resources, including his website BehindTheBalanceSheet.com, his substack, and his podcast. He encourages further learning and engagement with his materials for those interested in deepening their understanding of investment analysis and forensic accounting.

Stephen Clapham [79:37]: "You can find me on Twitter as Steve Clapham, on LinkedIn, and at BehindTheBalanceSheet.com."

Key Takeaways

1. Diverse Sources for Investment Ideas: Clapham advocates for sourcing investment ideas from a variety of channels to ensure a robust and uncorrelated portfolio.

2. Assessing Business Moats: Focus on genuine moats like pricing power rather than superficial attributes. Understand how these moats withstand market changes.

3. Critical Evaluation of Strong Brands: Even companies with strong moats, like Coca-Cola, may face long-term risks that can erode their investment appeal.

4. Importance of Insider Transactions: Scrutinize insider dealings carefully, preferring scenarios where multiple directors show confidence in a stock.

5. Prefer Special Dividends Over Buybacks: Special dividends are viewed as more shareholder-friendly and less burdensome on the balance sheet compared to regular dividends and buybacks.

6. Understand CapEx Breakdown: Differentiating between growth and maintenance CapEx is crucial for accurate financial analysis and valuation.

7. Skepticism Towards AI in Investing: While AI can aid in certain tasks, it currently cannot replace the nuanced judgment required in investment analysis.

8. Forensic Accounting Is Essential: With increasing earnings manipulation, skills in forensic accounting are vital for discerning the true financial health of companies.

Notable Quotes

• Stephen Clapham [09:53]: "By the nature of that approach, you're going to end up with quite a random set of stocks."

• Stephen Clapham [22:33]: "One of the things that I often hear people talk about is economies of scale. To me, the real focus is on pricing power."

• Stephen Clapham [29:14]: "Coca-Cola is well managed... but it's not healthy... there's an aging demographic increasing healthcare costs, which poses a bigger risk moving forward."

• Stephen Clapham [41:00]: "I like special dividends because it shows management is thinking about their balance sheet and shareholders."

• Stephen Clapham [56:14]: "AI can save you time and help understand new areas but isn't yet capable of handling the complex aspects of investing."

• Stephen Clapham [78:06]: "Bezel is really stealing from innocent people, and it's always present until it gets exposed."

For a deeper dive into Stephen Clapham’s investment philosophies and methodologies, listeners are encouraged to read The Smart Money Method, explore his online courses at BehindTheBalanceSheet.com, and subscribe to his podcast and substack for ongoing insights.