Stephen Clapham - The Smart Money Method

Summary

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

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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..."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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."

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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.

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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.

Transcript

[Cole Smead]

You're listening to A Book With Legs, a podcast presented by Smead Capital Management.

[Stephen Clapham]

At Smead Capital Management, we advise investors.

[Cole Smead]

Who play the long game. You can learn [e-mail] or by calling your financial advisor. Welcome to A Book with Legs podcast. I'm Cole Smead, CEO and Portfolio Manager here at Smead Capital Management. At our firm we are readers and we believe in the power of books to help shape informed investors. In this podcast we speak to great authors about their writings the late, great Charlie Munger prescribed Using multiple mental models and analysis. We analyze their work through the lens of business markets and people. In this episode we are going to learn about the many ways that you can skin a cat. Investing is a complex multidiscipline process and we will discuss many different parts of that sausage making. Stephen Clapham is joining us to discuss his book the the Smart Money Method how to Pick Stocks Like a Hedge Fund Pro. Before we get started with Stephen, I want to give you a little bit of background on him. He's the founder of behind the Balance Sheet, a London based investment research and training consultancy. Also a podcast with the same namesake. Mr. Clapham spent some 20 years as an equity analyst at different investment banks covering various sectors and was highly rated among institutional investors. He served. He then moved to the buy side of the industry where he was a partner at Tosca Fund Asset Management LLP and and then head of Research at Altima Partners llp. He holds a degree in technology and Business Studies and is also, I would note, a member of the Institute of Chartered Accountants of Scotland. Thanks for joining me, Steve. How are you today?

[Stephen Clapham]

Well, thanks for joining me. I mean, I'm very surprised by the introduction because I've never been described as a member of a group of great authors and it's the only time that anybody has ever introduced me with my degree and the fact that I'm a member of the Institute of Chartered Accountants Scotland, which is the best institute if you have to be a chartered accountant.

[Cole Smead]

Well, you know what I so since this is really a liberal arts podcast, we're learning to learn. And by the way, I would say as investors, as you point out in your book numerous times, you're learning to learn. I like thinking about education not for the purpose of, to your point, degrees, but for the purpose of what we have attained on a cumulative basis, you might say so. So I wanna throw a plugin for your podcast. I mentioned it shortly, but obviously behind the Balance Sheet is the name of your podcast. I know my dad's been on that. And just for our listeners that's out there, you should really check out his podcast. I kind of feel like I'm reversing the role right now, Steve, if that makes sense. In other words, I'm doing a Charlie Munger inversion. Right? You're not interviewing me. I get to interview you. But I wanted to ask you. You wrote this book and published it five years ago. This is a cumulative collection of things you've learned over your career on both sides of the industry. But I wanted to ask you, what caused you to write this down? Was it a great check from Harriman House, or did you just feel that this was the right time and season for you to explain what you've learned?

[Stephen Clapham]

Well, no, actually, none of those things. As a child, I always wanted to write a book. I don't know why, but I imagined myself, you know, signing books, and I imagine my book on the bookshelf. The irony of all this is that my book came out in November 2020, and it was never stocked in the bookshops in the uk. So I. My. My vision was dashed, and Harriman were the only people that were even remotely interested in the book. But how it came about was I used to keep a notebook, you know, of things that I learned. So I would go to a conference, and I would talk to some other investors, and somebody would say, oh, when I have that problem, I do this. And I used to go home and write that down at night. And I had this notebook with 80 pages, okay? And each page was something I'd learned. And I thought, oh, I should really do something with this. And so I. I got home each evening, and I typed this up into a Word document, okay? And then I thought, what am I going to do with that? And what I did was I produced a. A set of. So I have these cards, you can see, and they're. They're this size. And I wrote the. The headings of each of my pages on one of these cards. So I had 80 cards, and I put them out in the kitchen table. And then I realized that actually this would make a book.

[Cole Smead]

Okay.

[Stephen Clapham]

And what I did was I thought, well, how. You know, what's the structure of the book? It should be about my investing philosophy. So what I did was I took all these things that I'd learned. 80 tricks and tips, if you like, and then just put them in around my sort of investment approach. I mean, call it an investment philosophy is too grand a term. I never set out to have a plan to be a specific type of investor. I just ended up, I started in the buy side and I figured out what worked.

[Cole Smead]

Sure, that makes sense. Well, to your point, I think the other thing, I don't want to say litter, that's the wrong term. But you put breadcrumbs throughout your book. Other books that also influenced you. So for example, you talked a lot and I think I'll reference this at some point today you talked about Phil Fisher's book Pass the wealth through Common Stock, which is a wonderful book. He's got a couple books that are out there and Buffett's often talked about him. So you put breadcrumbs out there about other books and reading that people can pick up, which to your point is just a knowledge of wealth for people. Let me kind of kick it off in a more interesting way. You discuss in your book that ideas in investing are kind of random. Okay. In other words, they come to you through various ways. Can you kind of explain the randomness of that for you? I have my own thoughts on this, but I'd love to kind of ask you, like when you get an investment idea. I think most people think it's a very rote process where, you know, X happened and you got Y and that's how you got your name. But that's not been my experience and it's in reading your book. It doesn't seem to be that's been your experience either.

[Stephen Clapham]

No, I mean, I think this is partly because I was doing. So I should explain. I was a special situations investor. So we were trying to find stocks that had very asymmetric profiles. So the Ultima Special situations fund was a 25 stock portfolio. Tosca Fund ran a financials fund. And I did the non financial stuff on the end. And so in order to qualify for either of those funds, a stock had to be pretty special. It had to have a very high potential reward and have quite a low downside risk. And when you're doing that, you, you can't find those situations through doing screens or. And, and I never had that approach. And you know, I've got this online school called I don't know if you know, behind the balance sheet it's got this, we've got this analyst academy course which teaches you everything you need to become a serious investor. And one of the things we talk about in there is how do you build a portfolio? And I think a very common mistake people make is they have hidden agendas, hidden correlations within their portfolio because they assemble their portfolio in a structured way. And I think it's actually very important to get your ideas from different sources because I think that makes a more robust portfolio.

[Cole Smead]

I agree. Let me ask you this as an example, because I think the randomness of thought can actually cause the uncorrelated nature of the underlying investments. Is that what you're saying?

[Stephen Clapham]

Yeah. And how do you find an idea? In the course, we got through half a dozen, 10 different ways of finding an idea. But usually what would happen would be I would have a watch list of various stocks for various reasons. Some of them would be thematic, some of them would be valuation driven. There'd be all sorts of reasons. There would be longs and shorts. There'd be, you know, we might be looking for a short in the United States because we had too long an exposure there. So I would be focused on that.

[C]

Sure.

[Stephen Clapham]

But what I would find is I would pick up the newspaper or pick up the Economist or pick up a piece of research, and I find something was happening, something was changing in the world and that change had not been reflected in a stock price. And that would get me interested. I remember trying to explain this to an allocator, one of the big allocation firms I was being interviewed about, how do you find stock ideas? And they found it very puzzling that I didn't say, oh, you know, we're looking for stocks with a PE below X and, you know, some rote systematic approach. And, you know, I don't mean to be critical of people that have a system, you know, if you can. If you can find a system that works, that's fantastic. But what worked for me was going looking for things that were changing in the world where something was going on and the stock market hadn't really appreciated the impact that would have.

[C]

Sure.

[Stephen Clapham]

And by the nature of that approach, you're going to end up with quite a random set of stocks.

[C]

Sure.

[Cole Smead]

No, I agree. We're based in Phoenix, Arizona, so this is not very typical for us. But you were in London. Let's say I'm the stockbroker, I call you up, you're a customer of mine, and I say, hey, Stephen, I'm hosting a dinner on Wednesday night. A bunch of other portfolio managers are going to be there. We're going to share ideas. It's a great place in the West End, in London that we're going to have dinner. You show up at that for you as a place to create ideas or find ideas. How do you look at those occasions and events that our industry will often hold? You know, I'll Give my own $0.02 when you're done. But I'm always interested to ask other people, like, do you get value out of those interactions with other ideas and people?

[Stephen Clapham]

Well, I like meeting other people and I like hearing the views because I like understanding what the market's thinking. And so the most useful part of that is where there's a consensus about, oh, the stock market's too high. I can remember one of those occasions where I went along and there was only one person that thought the stock market was cheap. So a bunch of these very sophisticated hedge fund guys from some very big name hedge funds. And the one long only guy said, oh, the stock market's cheap. And of course he was the one that was right. And it was that when he said that, I was thinking, I'm very bearish right now and I really shouldn't be. Sure, it's quite useful for that. I have never taken away a stock idea from one of those dinners and I've often said, oh, that's quite interesting. I remember going to a dinner and I didn't do very many of these. I mean, there was one dinner, one of my brokers did that. We got on very well and I liked his group of clients. So it was more fun than work.

[C]

Sure.

[Stephen Clapham]

But one of those dinners, there was a fund management group in London coming to the stock market and the fund manager tipped his own company and his pitch was so bad I burst out laughing and I went into the office the following day, I said, we should short this. So often the ideas weren't brilliant and it was more interesting where you had somebody and pitching an idea that they'd owned for some time and they were trying to get the stock price up or whatever they were trying to do. And you just thought that argument just isn't very strong. And if that's the best argument, well, probably we should short it because it's probably reached the end of its end of its life. But no, I didn't really get an awful lot out of those. But I did find they were very useful for making relationships. And some of those relationships I have endured to this day.

[Cole Smead]

Yeah, let's see. Holders of a security. How do you look at the holders of security? If you go into a Bloomberg and you pull up who owns a security, how do you look at that and how do you assess information like that in your own investing and how you explained in your book?

[Stephen Clapham]

Well, I think this is like one of the great secrets of investing.

[Cole Smead]

Okay.

[Stephen Clapham]

I don't understand why it's not like sort of high up on people's Priorities. Because, you know, if I go and look at a stock and it's Smead Capital Management's largest position.

[C]

Sure.

[Stephen Clapham]

I'm going to look at it and think, oh, well, that's quite interesting because I understand how you and Bill work well, but I understand a bit about how you work and I respect you. And so if you've made it your largest position, that makes it much more interesting to me.

[C]

Sure.

[Stephen Clapham]

Whereas there are lots of other people I would be less interested in. So one of the first things I would do when I was looking at a stock would be say, well, well, who owns it and who doesn't own it? Have they been buying it or have they been selling it? And you know, this didn't work hugely well for me as a professional because I was buying things that were generally disliked, unloved, often hated.

[C]

Sure.

[Stephen Clapham]

And if there were a whole load of high quality hedge funds already in the stock, it'd be much more difficult for me to pitch that to my bosses because they would be saying, well, why are you not the first? So usually we're buying things on the way down. And the shareholder register would be pretty scrappy. It would be full of dull, boring, underperforming institutions. But if you're a private investor, why wouldn't that be the first thing you do? And if you don't see a Bill Nygren or a Bill Smead on the share register or, you know, a long list of other people, if you don't see any of those, you say, well, hang on a second. How likely is it that I'm the first one to spot this? And all those guys have got large teams of people who are really smart, who are getting all the best intelligence in the stock market. How likely is it that none of them have spotted this? And I think that's really, really useful.

[C]

Sure.

[Cole Smead]

When you. I also think a lot about the institutional pressure, for example. Let's say you find something like that, and let's say in a special SITS fund that you dealt in, you might be not liquidity constrained, for example. Well, part of the reason why they might not be there, to your point, is either it's a falling rock and therefore liquidity is diminishing quickly in the security, which means that large institutional investors couldn't be present. But I also think about it, I think back a lot. You touched on this, actually, I think in your book. But I think back to like Valiant when Valeant was going on. I mean, to your point, it was a creme de la creme list of who's who in smart money. And I won't name any names to protect people, but I just say it because I remember we looked at the roster and it was like, gosh, there's a lot of smart money. And so to your point, on the dinners or holders, one of the things we always think to ourselves is we might be learning something to not do more than we are learning something to do. And I say that because if all the smart money's there, who's going to buy next? Right. And there's like, where's the marginal buyer going to come from? And we try to, you know, that's why on some level, I mean, I'm really glad I live in Phoenix, Arizona, because I don't know a lot of people that are PMs per se, but at the same time, we always kind of try to give a different region to that data than I think we've seen in the past, if that makes sense.

[Stephen Clapham]

Yeah, I mean, if you've got a stock that's a hedge fund to tell and everybody's in it, it's actually quite. Usually quite risky, because.

[Cole Smead]

Very risky. Yeah, I would agree.

[Stephen Clapham]

But what I like are to see some names that I respect, and there's a couple of them on the register, two or three of them, and it's still early. The stock's just turning and it's still early, and the rest are going to come in. If everybody owns it and it's already gone up quite a bit, then it becomes very dangerous, as you say. I completely, totally. I completely agree. But I do think I've had this conversation with a few people on my podcast. Chris Paviz and I had a debate about whether it was better to live in the Blue Ridge Mountains or in London. And I'm sure you have a high quality of life in the Blue Ridge Mountains, and I'm sure the air is cleaner and the water is better. But if you're an investor, being in London, yes, you do have a lot of noise, or being in New York, you do have a lot of noise, but you also have the opportunity to see a lot of companies. And I think seeing a lot of companies gives you a huge fabric of information that is really, really valuable. Not necessarily about current trading, but it's more about the trends that they see, more about the things that they tell you about their competitors or their suppliers.

[C]

Sure.

[Stephen Clapham]

And I found that visiting a lot of companies, even if just going to a conference and listening to a lot of companies gave me a view on what was happening in the world. So I could identify those changes which were going to be reflected in stock prices later.

[C]

Sure.

[Cole Smead]

So on that, what was a typical question that you liked to ask the company to ascertain something about their competitors? In other words, like when I asked that question, I will often ask a company, hey, if I had to give you a silver bullet to kill one company in your industry, who would that be? And you know, in a commodity business, they might say, well, the commodity, that's what I would kill. But in other industries, you know, they will give you a name. They'll say, you know, here's the company I'd love to kill. Which, as you talked about in your book, that's very good information, understand what was your favorite question that you enjoyed asking companies that you know, again, to your point, would come through town?

[Stephen Clapham]

Well, I would usually be asking this question after doing some research, and it would usually be I would have identified there was some difference in the financial characteristics of their business versus their competitors. So typically it would be, your sales are growing more slowly than company xyz. Why is that? What's enabled them to grow faster? Are they being more aggressive in price or similarly on margins? Occasionally it would be qualitatively. I mean, if it was a company producing widgets, I would be trying to understand how they perceived their product versus their competitors. So I would sometimes say, when the customer switches from yours to your competitor's product, what typically is the reason?

[C]

Sure.

[Stephen Clapham]

And that sort of question, I think can be quite helpful if you frame it in such a way that you can understand how they approach it. Because if they say, oh, we don't know, then you think, well, cricky, I don't want to invest in that. Because the one thing that you want to be laser focused on is customer losses.

[C]

Sure.

[Stephen Clapham]

So if a customer is switching to competitor, that'd be something you'd be right on top of. And so the way they answer the question is almost as informative as what they actually say.

[Cole Smead]

Hi, I'm Cole Smead, CEO and portfolio manager here at Smead Capital Management and host of this podcast. If you enjoy this podcast, I'd like to invite you to check out smeedcap.com at our firm. We are stock market investors. We advise investors who play the long game with a discipline that has proven success over long periods of time. Learn more about our [e-mail] past performance is not indicative of future results. Investing involves risks, including loss of principal. Please refer to the prospectus for important information about the investment company, including objectives, risks, charges and Expenses. Read and consider it carefully before investing Smead funds distributed by Smead Funds Distributors llc. Not affiliated. Let's pivot. I want to talk about moats. You have, like, an interesting section on the book where you discuss moats. And I want to ask you. I want to kind of be a little more philosophical in how I ask this because I love this discussion. It's something that we've gotten to a lot over the years talking about. So when I usually ask people about a moat, they don't explain to me how the moat got built or what the moat is. They usually can tell you about the attributes or the pro. The byproducts of the moat. And so I want to ask you, how do you like, you know, just as a general framework, you know, to always think about the moat? It is the drawbridge that goes across the moat, and you either get in or get out of that moat based on, you know, whether you can get through it. And that's the perfect picture of a moat. How do you think about the moat of a business? And then do we often confuse the benefits or the features or the byproducts of the moat with the moat itself?

[Stephen Clapham]

That's a difficult question for me to answer. Let me just explain why. Doing special situations investing, you're obviously interested in the quality of the business, but it's not the primary driver as to why you want to be in the stock. This is something that I've developed more after the hedge funds, actually, and I've become more interested in, more curious about. And I think there's a lot of. I think a lot of people get very confused about this. So one of the things that I often hear people talk about is, you know, economies of scale. And that's a mold. And to me, you know, if you're Amazon or Walmart, your scale might be a malt.

[C]

Sure.

[Stephen Clapham]

But it's very, very unusual. And I think there's lots of things that people talk about that aren't really malts. And the thing that I really tend to focus on is pricing power.

[Cole Smead]

Okay.

[Stephen Clapham]

And I just asked myself, well, why has this company not raised prices more? And sometimes it can have very strong pricing power and have a very legitimate moat, but it simply not increasing the price allows it to widen the moat. So that would be the argument in favor of Costco, I suppose.

[Cole Smead]

You're effectively gaining market share in lieu of profitability.

[Stephen Clapham]

Yeah. And so I tend to start off with pricing power and ask myself, well, can this company put up prices? And why is that?

[C]

Sure.

[Stephen Clapham]

And your drawbridge and Malt is quite interesting. I've not really thought of it in those respects. In those terms, I really tend to focus on pricing power and why a company would have one. But I think this is something, you know, for me, this is still a learning process.

[C]

Sure.

[Stephen Clapham]

I listened to a podcast with Sir Chris Horn by Nikolai Tangen and the In Good Company podcast. Nikolai's, you know, been an incredibly successful investor. A founder of Ako Capital, now runs Norgus Bank Investment Management. He just been reappointed as CEO and he does this fantastic podcast. And he was talking to Horn and Horn. Interestingly, he described physical infrastructure as a moat. Now, I, I'd not thought of this before. So Chris has been a big investor in airports.

[C]

Sure.

[Stephen Clapham]

And, and in toll roads. And you know, obviously if you've got a toll road or an airport, it's a monopoly type product.

[C]

Sure.

[Stephen Clapham]

It's a monopoly business. And in fact, I, you know, having done the transport sector, when I talk about quality in my course, I talk about the difference between British Airways and baa, the. The formerly publicly quoted owner of Heathrow Airport.

[C]

Sure.

[Stephen Clapham]

And it's obvious if you own Heathrow Airport, nobody's going to build another airport next door, Right?

[Cole Smead]

Correct.

[Stephen Clapham]

I mean, they can barely build another Runway. And I hadn't, I hadn't thought of that as a malt, but obviously it is a malt.

[C]

Sure.

[Cole Smead]

Well, it's your point. So it's funny. And here's why. Here's why. So most people like to talk about a mode of a business after it's done really well and they have trouble identifying what a moat is when there is consternation or headwinds or. So to your point, let me just use the analogy you're using. Okay. If I asked you. Okay, Steve, let's use, I'll use the US as an example because I know the UK and Europe are a little bit different on this, but if I said to you, hey, Steve, do you think anyone's gonna build a retail mall in America over the next three years, what would be your response?

[Stephen Clapham]

Well, my response would be, I'm sure there'll be someone somewhere building a mall, but probably not very many.

[Cole Smead]

And so here's why I say it, because there's two things I always think about, and I think people often get confused in the money. And then there's a big aspect of our life that we have to account for, which is the time. Right. So to your point, there is the, well, you can't build one next door. There is the outright cost of what would it cost to do that? But then the point that no one would do it next door is what would be the entitlements in the time needed to actually get all the approvals to build an airport next door. And if it's not the money, it's actually the time that keeps most investors out. Because in a time value of money, if it takes 10 years and you have to put up all that money, you have opportunity costs that are going to haunt you over that period. And so to your point, I think a lot about those things the time it takes beyond the money, because I think in this world where it's like, you know, there's so much capital out there and so much wealth and, you know, there's so much, you know, private and public money, but then the one element that we have trouble getting around in almost every case is in some cases not. It's not the capital, it's not the money, it's the time. Right. And so we think a lot about that. And I don't, you know, to your point, I think if I use Terry, Terry Smith, he looks a lot at gross margins as a way to understand pricing power. Right. If you have high gross margins, you have the ability to raise price and any pricing pressures affect you less. So to your point, I think that's what Terry writes a lot about in his past. Let me pivot a little bit. So you talk about Coca Cola in your book and a lot of people have talked about Buffett with Coke. Okay, so now let's talk about a feature or a benefit of strong moats. Historically speaking, strong moats exhibit high returns on capital or sustainable returns on capital. Okay, so let's use Coke. How do you look at Coke? You know, at least using the example used in Buffett, because I guess I have a very different view of Coke as like a 41 year old versus I think when I talk to a lot of baby boomer PMs, they talk about Coke as this incredible investment looking back and when Buffett bought it in the late 1980s. But as I fast forward, for most of my adult career, it's actually been a laggard. And if you look at the returns on capital, they actually don't really tell you what's going on in the business. And so how do you look at those kind of situations where there's a preponderance of huge investment success off of returns on capital, where everyone can perceive the moat and then you wake up 10 or 15 years later and that moat is less perceivable and therefore the returns have gone to the wayside.

[Stephen Clapham]

Well, I'm not sure that Coca Cola's moat is any smaller, narrower, however you define it than it was 20 or 30 years ago. You know, it's got an incredibly powerful brand and agree, you know, it's a well run, I mean clearly a well run and attractive business. The problem with, with Coca Cola for me is, you know, when I look at Coca Cola. So I did a, I did a project for a wealth manager here and they, they had, they felt they had a lot of expertise in the UK stock market.

[Cole Smead]

Okay.

[Stephen Clapham]

But they didn't really know anything about stock markets outside the UK and they felt that they needed to have a product for their clients, international stocks. So I built an international model portfolio for them. One of the stocks they had in their portfolio was Coca Cola.

[Cole Smead]

Okay.

[Stephen Clapham]

And I, I said well, you need to get rid of that. And they said, well, why? And I said, well, it's not healthy. You know, if you, you know, if you look at a stock like Coca Cola, it's making people less healthy, more obese and that sort of negative externality today or when I've looked at it didn't have a cost by the, well, you know, over time this will have an increasing cost because every western country has got an aging population. And what happens in the aging population? You have more health care costs.

[C]

Sure.

[Stephen Clapham]

And you've got, you know, we've got an aging demographic, fewer young people working, more old people in the, you know, taking medical aid and in the National Health Service in the UK. And there's Coca Cola is, has got a very high externality cost and therefore I think that cost is going to be a bigger risk for it going forward in time. And I said, I can't remember what the valuation was at the time. You know, it's not that cheap. And how's it going to grow, you know, from. It's already got a very, very high price penetration.

[C]

Sure.

[Stephen Clapham]

So, you know, I think Coca Cola is well managed and they've done, you know, clever things about broadening their product range and, and so forth. But to me it wasn't a stock that wealth manager should be recommending for their private clients to have in their portfolio and own for 10 or 20 years because of those issues.

[C]

Sure.

[Stephen Clapham]

Now does that mean it's got less of a moat when we think about the malt that, that externality doesn't really factor in. So you know, all I'm trying to say is yeah, a more is useful but you've got to look at the, you've got to look at the total total picture.

[C]

Sure.

[Stephen Clapham]

And I'm, I'm very wary, particularly, you know, when I'm thinking about doing long term investing, which wasn't my specialty when I was at the hedge funds. But when you're doing these long term investments, I think you've got to really factor in how those sorts of things may change because those are the sorts of things that come from left field sometimes very explosively and spectacularly, more often gradually. And they just erode your valuation.

[C]

Sure.

[Stephen Clapham]

So you see the valuation shrink over time.

[Cole Smead]

Well, yeah, because when Buffett originally bought it, it was producing like 25% return on equity that then jumped up as like the German, the Berlin Wall fell in 89 and the emerging markets, the world expanded massively as a customer, so it went to 50%. And so I always point out to people like Buffett made incredible money from a 10 year perspective. And then I don't remember this, but he wrote about, he talked about Coke and Gillette as the inevitables. Right. It's just inevitable that they're going to be the ubiquitous product in their category. You know, we'll call that a wide moat, you know, in our parlance that we're using here. And it was like the kiss of death. Because if you look since like 98, I think Coke's produced a single digit return. Even though to your point, it's had a strong moat, it's produced high returns, they bought back stock, et cetera. And to your point, I think it can show that you can take an incredibly high moat business like Coca Cola and you could take high returns and you could take what could be okay capital allocation. And you can still take a security that over 20 years does terrible for volatile common stock risk. And that I think that's something that, you know, especially with the era we're coming out of, most people are like, oh, it's high, it's a, it's a great mode, it's high returns. I'm going to make money. And it's like that's not why the stock market was formed. It wasn't formed to find those two things and get rich. Like that's not. The point is now are there times it can do that? More often than not, yes. I want to pivot a little bit. So insiders, you talk about insider buying. I also love it because you're like going through a bunch of my hit list of like people I followed. So you talk about like Mark Dixon, iwg, full disclosure. We used to Own it. I got tired of watching Mark take margin calls, which also you commented on your book in that I think the last iteration of the margin calls, like that's it. If he can't run his own personal balance sheet appropriately, I'm just kind of done with this because if he can't do his personal balance sheet, how can he run his corporate balance sheet? But then you also mentioned like Lord Simon Wolfson who's you know, obviously an incredible capital allocator at Next. We own Next. How do you think about insiders like them, you know, in both in transaction form but also ownership form as you analyze investments?

[Stephen Clapham]

Well, I think, you know, directors dealings I think are slightly dangerous because I think people are. People follow them blindly.

[C]

Sure.

[Stephen Clapham]

And you know, the most dangerous thing is you get the, the chief marketing officer buys a stock after it's been cut in half and nobody else does and he's never bought a stock before and he doesn't actually have a clue what he's doing. He doesn't understand investing and you know, the thing carries on falling. I like to see, you know, more than one director buying. You know, I like to see them all, you know, all believing in it because then it's much more likely to be. Be right. But you know, if you've got genius capital allocators, genius managers like Lord Wolfson or my favorite is Michael o' Leary at Ryanair. You got to be quite careful. You know, Michael o' Leary sold shares every single year. And I said to him, michael, why are you, why are you selling shares? What are you buying with the shares? Was actually why I asked them and he said, I'm buying gilts. And what he was doing was he was de risking his portfolio. And although Ryanair has been an incredible investment, he was buying gilts and made quite a lot of money out of zero risk government securities.

[C]

Sure.

[Stephen Clapham]

So, yeah, I mean, I think it's quite easy to identify now that Michael O' Leary is a genius. It was actually quite easy 20 years ago. I mean I tell this fantastic story about, you know, I used to do transport. So I initiated in Ryanair with a cell recommendation and I sent the draft of my note to the company to o' Leary for comments.

[Cole Smead]

Okay.

[Stephen Clapham]

And he, he sent a fax back. I don't know why he didn't like to use email, but he sent a fax back saying, steve, thanks for your note. You're wrong and we'll prove you wrong and good luck, you know, and by.

[Cole Smead]

The way, I love that I, you know, we want the ball because we're going to score and win the game. And we'll see you later.

[Stephen Clapham]

Yeah, no, absolutely. And the Stock fell by 40% and I upgraded from a sell to hold and I emailed him and I can't remember what he said. He writes the most funny, funny letters. So he said something about, well, how long will it be before it's a buy sort of thing, you know.

[Cole Smead]

Yeah. We hope you're enjoying the podcast. You know, we work hard putting together this show, but we work even harder for our investors at SMEAD Capital Management. At smead, we believe in disciplined investing, which is why the SMEAD funds have a proven track record of long term outperformance. If you're an investor who plays the long game and want to invest in wonderful companies to build wealth, we invite you to visit smeedcap.com Past performance is not indicative of future results. Investing involves risks, including loss of principal. Please refer to the prospectus for important information about the investment company, including objectives, risks, charges and expenses. Read and consider it carefully before investing. SMEAD funds distributed by Smead Funds Distributors llc. Not affiliated.

[Stephen Clapham]

There are very few of these people and they're hard to identify before their skill is reflected in the share price.

[C]

Sure.

[Stephen Clapham]

The problem with most of these brilliant managers, Mark Leonard at Constellation Software, you've got. You're paying quite a few turns on the multiple for the fact that it's Mark Leonard.

[C]

Sure.

[Stephen Clapham]

And he's got to continue being Mark Leonard, delivering on a much larger scale, which isn't.

[Cole Smead]

I agree. I agree. So to your point, where these are really valuable is where their industry has gone into a downturn. You know, I look at it as like you want to buy those people when they were a swear word. So to your point, when no one wants to touch Ryanair, that's the time to be interested in the great capital all cater. And I think people tend to use that as a reason to pay up. And the danger in that is paying up might already inhibit their better capital allocation. You mentioned, and I want to make sure I got this right, in your book you mention that special dividends are a mark of a good capital allocator. I think you commented on that in the book. Explain that because I totally agree with you. But there's also a balance sheet implication that I think people often miss when thinking about dividends, Specials versus regulars. But I'd love for you to kind of comment on that.

[Stephen Clapham]

Well, I think the attraction. So if you put yourself in the shoes of the director.

[C]

Sure.

[Stephen Clapham]

Put yourself in the shoes of the CEO, he's not necessarily a stock market expert. Obviously there have been amazing people like at Teledyne, where they were very good at reading the share price.

[C]

Sure.

[Stephen Clapham]

But not everybody is. And you know, I've talked to a number of CEOs where they feel very uncomfortable about buying back their shares because they genuinely don't want to overpay.

[C]

Sure.

[Stephen Clapham]

This is, you know, in the us you buy back your shares and it doesn't really matter because the stock market's gone up and nobody's going to hold you accountable.

[Cole Smead]

Correct.

[Stephen Clapham]

If you pay a special dividend, you're accepting that your balance sheet isn't as efficient as you would like it to be and you're just saying to your shareholders, look, I'm going to give you the money back and you can buy more shares if you want. The buyback is, you know, I think too many people buy back shares for the wrong reasons. They buy back shares because they've issued a lot of stock to their employees and they don't want the share count to go up. Well, that's a stupid reason.

[Cole Smead]

It's a stupid reason to do stock based comp in the first place. I might add in there. It's like, why do you stock based comp if you're going to do that?

[Stephen Clapham]

Well, I mean, that's a separate argument. I mean, I can understand why people want to give their employees stock.

[C]

Sure.

[Cole Smead]

I think, I think from an accounting perspective to your point, like, I can understand why the employee wants it, but from a pure business accounting perspective, it's a net, net nothing if you buy those shares back. In other words, like, in effect, nothing really happened on the balance sheet.

[Stephen Clapham]

No, exactly. But cash has gone out the door, but it's kind of evaporated.

[C]

Sure.

[Stephen Clapham]

And nobody, I mean, the problem is that investors find it difficult to see that money going out. I liken it to stealing money out your back pocket. But I think I like special dividends because it shows one, that management are thinking about their balance sheet and they're thinking about their shareholders. So it's evidence that you've got shareholder friendly management. And the other reason I like it is because buybacks only work sometimes.

[C]

Sure.

[Stephen Clapham]

And, you know, I can't tell you how many times I've heard people say, oh, you know, it's a great company, great management, they're buying back shares, nobody ever looks at what price the shares are bought back at.

[C]

Sure.

[Stephen Clapham]

No, I agree under some amazing examples of this. Xerox, Xerox bought back. I mean, I can't Remember how much their share count shrank and their stock still tanked? If Xerox had given special dividend every year, their shareholders would be rich and happy. Why wouldn't you do that? As a management, I mean, I know that there's this excitement about share buybacks, but you know, buying your shares back when the stock market is collapsing, that is a good idea. Nobody ever does that.

[Cole Smead]

No, no, no. Yeah, because I'd often have to borrow money or do something like that to get enough excess cash to meaningfully move the needle. Because here's why I like the special dividend. So like let me give you an example today. So we own U Haul, that's ran by the show and family. They do specials. That's just kind of the nature of the beast there. And they own 50 some odd percent of the business as a family. So I agree with you. I always find specials interesting because I actually don't like regular dividends. Now why? Because you're a balance sheet person. I'm a balance sheet person when I state a regular dividend and people expect it every quarter. You and I both know, Steve, that that is a recurring liability when it comes to the balance sheet. And as we all know, if your liability gets too high, what we call a high dividend yield, eventually those usually get cut because it costs too much in your capital base. Right. So what I don't get, also let me go one step. Like the, the second level of that liability is I don't even get the entire liability as the equity owner. If I own a Stock in the UK, the UK government and as a US holder is going to take I think 15% of my dividend and then my government's gonna take another 8.6% of my dividend. So as I point out to people, I don't even get the full amount of that dividend when I get it. The governments of the world are in the dividend business. But to your point, if we can buy stock depressed, they're actually not in the buyback business in the same way. So I think about the all flow through after tax effect of these capital allocations. And so at least on the special you're saying, hey, I can't use all the capital and I don't think my stock is attractively priced. So you're saving me from two problems. One, the overpaying for the stock, but two, just sitting on it and doing nothing with the capital as an opportunity cost. Obviously I lose part of that. But I don't hear like, I'll give you an example, we just watch a bunch of oil and gas businesses lower their leverage from high leverage ratios down to low. So they reduce their, call it, their debt liabilities. And then some of these people, not all of them, but some of them stupidly turn around and say, and we're gonna raise the dividend, which is like lowering my liabilities on one side of the ledger to increase my liabilities on the other side of the ledger. I mean, the Martians would look from space and say, what are these guys doing? To your point, or it's just as foolish as a company that has an obscene multiple saying, hey, don't worry, we're gonna buy back stock. Cause we're good stewards. And to your point, it's like, what does that mean?

[Stephen Clapham]

I mean, there's a couple of things in dividends. So I often see people talking about dividend yield as a measure of valuation, which I think is very, very dangerous.

[Cole Smead]

I agree.

[Stephen Clapham]

I really don't think it's a measure of valuation. I don't mind companies with high dividends, especially if I don't really trust the management, because I feel that a high dividend liability is a constraint.

[C]

Sure.

[Stephen Clapham]

It's hard for the management to go out and do anything stupid. So you know, they've got that in the back of their mind they've got to pay that dividend and so it makes them more conservative. So I feel that if you've got that as a requirement, in a way it's a safety net for the investor.

[C]

Sure.

[Stephen Clapham]

The other thing I like about dividends is if you've got companies with a long history, looking at the dividends tells you quite a lot about is it a good company or not. I like to look at the book value per share over a long extended period and the dividend record over a long extended period. Because if you look at that, that tells you the kind of nature of the, of the company. I don't, I mean, I don't tend to own companies that pay high dividends. I mean, it's not. But I have, I have done an occasion when it's been, you know, something that's been a bit beaten up. And I think, well, you know, what are they going to, you know, change of management beaten up? High dividend is quite risky because then often cut the dividend. But if you've got a company with a stable management, it's a bit sleepy, good chance that it'll get taken over, good chance that things won't go badly wrong.

[C]

Sure.

[Stephen Clapham]

If it's a stable business. So I do paid some attention to dividends, but I don't dislike them in principle.

[C]

Sure.

[Cole Smead]

Let's talk about debt trading at a discount for an issuer. So, you know, I think you talk about this in your book. In light of if the credit markets are showing lower prices on the bonds than they should be, that's, it's a flag, obviously, because there could be a possible credit risk or bankruptcy risk or whatever that may be. But you know, and I think, you know, in the, in the era of low rates, that was all very plausible. We're now in an environment where everyone's bonds trade for below par because they issued them at lower rates. How do you think about bonds trading for below par? Because obviously businesses still carry those at their stated book value even though they could actually buy them back in the open market at a lower value. In other words, if you do an adjusted book value, you're buying the stock cheaper. But conversely, as we all know, if I adjust the book value, I adjust the returns. So it's kind of like this. I always point out to people, like, when you get into these situations, what I love about accounting is it's like Newton's third law of physics. He said for every action, there's an equal and an opposite reaction. So, hey, the bonds are worth less than we're showing. Great. We had just book up. The opposite reaction is it brings return on equity down. Okay, how do you think about those? And do you think there's, have you seen a lot of things like that out there where it kind of intrigues you and says, but wait, because this is a complex adaptive system. The system has adapted, but not fully yet.

[Stephen Clapham]

Yeah. So I have a very simple way of handling this when I calculate the enterprise value and you know, I like to use a series of equity based multiples and a series of enterprise value based multiples.

[C]

Sure.

[Stephen Clapham]

So when I calculate that enterprise value, I use the discounted value of the debt.

[C]

Sure.

[Cole Smead]

So.

[Stephen Clapham]

I say, well, I do it in both bases. I do it on a nominal basis because it's unfair to just do it on a discounted basis because eventually they'll have to repay that debt at the full amount. But I look at it in both ways and I say, well, hang on a second. If I look at it at the discounted value, I'm buying this actually quite.

[Cole Smead]

Cheaply because it's a total capital. That's. That there's a total cost of capital. To your point.

[Stephen Clapham]

Yeah. So I should, you know, I should recognize, I should recognize opportunity. I also look at it as well. Hang on a second. When's the debt maturing? A parameter that I look at is the weighted average age of the debt and I look at that over time. So is a company lengthening or shortening its debt maturities? And that can sometimes tell you about the psychology of the cfo, which I think I'm quite interested in understanding. But today you've got a bunch of US companies in particular that cleverly extended their debt maturities when money was very cheap.

[C]

Sure.

[Stephen Clapham]

But lots of them didn't extend it for that long.

[Cole Smead]

Yeah.

[Stephen Clapham]

And there's a huge amount of debt maturing in 26, 27. That's going to cause quite a big uptick in the amount of interest these companies are paying. And the thing that I think is quite interesting, Cole, is the sell side is so not switched on to this. So I don't know if you're familiar with Global Payments, the payment processor. So they bought worldpay a couple of months ago. And worldpay is owned by private equity. So there's no, I mean, I don't know if it's got any publicly quoted debt. I haven't checked that. But in the release, nowhere did it tell you what was the debt in the company they're acquiring. Worldpay is quite an indebted company and it's buying another private equity owned. Private equity owned, highly indebted for certain company and they're issuing some stock to pay for it. But at no point did they tell you, well, what's the total debt pro forma today or based on last year end or any number like that in the earnings call in the transcript, not one analyst asked that question. One analyst asked the question, will you still be buying back shares? I was like, hello. And I think the quality of the sell side has been significantly dumbed down over the last 20 years. I don't mean this with any disrespect to, you know, sell side analysts are listening to this. I'm sure you do a very good job. You don't get paid as much you used to and you have to work a lot harder. But the job has become juniorized. And I'm. If I were doing, if I were at a hedge fund today, I would find I spent, I had much less reliance on, on the sell side because the quality of the work just isn't what it used to be. This whole idea about the balance sheet, balance sheet is completely overlooked. And I was delighted when Mr. Buffett talked about how he looked at years and years of balance sheets before he even Picked up the P L And I was hoping that this would generate a lot of interest for my training courses. Well done, Mr. Buffett. Please do more of this. Because it did.

[Cole Smead]

I was at the meeting too. Both dad and I were at the meeting. And when he said that, I had the same thought as you. I thought, no one even knows what a balance sheet is today, like in my mind. So to your point. So you have this in your book. I love this. You, like, mocked the idea in a way of like dividend yield, like we talk about, but also like pe Like PE tells you absolutely, in my opinion, nothing about a business whatsoever. Because as we know, E can be manipulated. E does not tell you anything about the capital structure of the business. It doesn't tell you about its ability to grow its returns relative to that capital structure. So I want to, I want to, I'm going to hit it a couple things that I have here in my notes, but I really want to kind of. So returns on capital, we know are important to long term equity returns. That's provable using as a general guideline, return on equity. But you also talk about, some people use like return on invested capital. That's typically my preference because I think about total capital structure. You know, that you can also use return on in incremental invested capital is another one that you see out there. There's all these ways of looking at returns. But the reason why returns, I think are so important is because Buffett was asked the question at the Berkshire meeting. Someone said, hey, Warren, what do you think about all this capex in AI? Which was like, oh my gosh, we're hours into the meeting, Steve, and they finally ask a good question. This year. This is like actually an exceptional year of the last five. There's a good question. And so Buffett doesn't answer it because that's just not his normal course these days. But he says, you know, that's a good question and we'll see. But he said, we all know the best kind of businesses are ones that don't need capital. And it's just like, ah, it's like, you know, this is not Jesus speaking, but it's like Paul or John, one of his apostles are speaking. And you're like, let that sink in. Because in my mind, you know, as you and I think about a balance sheet, what he's saying is this capex goes onto the balance sheet whether you make money on it or not. And one of the questions I want to ask you out of that is you talk about growth, Capex and maintenance capex, which are important components to understand. But have you seen more of a history where growth capex can be dangerous versus maintenance capex? The danger to it is it could be understated.

[Stephen Clapham]

Well, I think what I've seen quite a bit of is companies that claim more of their capex is for growth.

[Cole Smead]

When it's maintenance and it really is.

[Stephen Clapham]

So they understate the maintenance capital expenditure. I always like to think about the maintenance capital expenditure because if you're looking at the free cash flow yield, looking at the free cash flow yield after the growth capex is, is unfairly penalizing the company.

[C]

Sure.

[Stephen Clapham]

But I had this discussion on my podcast with George Michalakis about why.

[Cole Smead]

The.

[Stephen Clapham]

Tech companies significantly boosting their capex, which almost inevitably will reduce their returns. I mean it would be just by.

[Cole Smead]

Mean reversion, just pure mean reversion by the spend.

[Stephen Clapham]

Well, I mean these are all very high returning capital businesses. So it's just impossible that these investments in AI could possibly return do anything other than depressive returns even if they got some profile that can in a million years be equal to the, to their normal investing. So.

[Cole Smead]

Well, no, real quick, let me stop there because I want to, I want to dig in on that because there's so the history of these businesses. To your point, if we're thinking about analyzing this, are opex, right, they used expenses in their income statement that created the profitability. So it was not a hard good like we're seeing today in how they account for this spend on AI. So I tell people like, you know, if you say, Cole, I'm really good at creating asset light businesses through OpEx, I'd be like, well that's totally plausible. And then you come in two years later like, you know, I've decided that I'm more of a physical asset person. I'd be like, I'm sorry, I don't tend to see people that can transition that well from being a, you know, non tangible, I'll call it a non tangible person to a tangible and to your point, they will by nature grow their book value. The real question like Buffett was pointing to is, you know, really, what's the profitability? And. Or the second question could be back to our framework idea is time. How much time will it take for that to grow in? Is that a fair? Do you think that's a fair? Yeah, I mean, I think that's the $20 trillion question today, if you will.

[Stephen Clapham]

And you want me to know the answer.

[Cole Smead]

I mean, I want, I'm expecting you to tell our whole audience that.

[Stephen Clapham]

Well, I think, I think AI is terrible. No, I think, But I think AI is terribly interesting. And, you know, I've been trying to learn about it and I'm actually writing in my substack about how I use AI and I'm scared I haven't published it yet because I'm scared people will think I'm an idiot because, you know, what do I use AI for?

[Cole Smead]

But isn't that how we make a bunch of money is we choose to look like idiots from time to time and it, you know, once in a while it pays us well to do that.

[Stephen Clapham]

Well, the point I find very interesting is I hear people talking about how they're going to use AI to replace analysts.

[C]

Sure.

[Stephen Clapham]

And you know, AI, I mean, there's no question that it's a productivity boost. I mean, no question about that. And you can definitely use it to help you with investing, but it's a long way from having the power of an analyst. Now, I'm sure it will improve over time, but I think it's been, it's been slightly overrated. You know, when you think we're two and a half years into ChatGPT.

[C]

Sure.

[Stephen Clapham]

And it's still not that good. I mean, it's not unhelpful, don't get me wrong. It can, it can really save you a. Save you time. It can really help you particularly understand a new area. You know, I was writing about the difference between the valuation of a different American sports teams, and obviously I'm Scottish.

[Cole Smead]

Yeah.

[Stephen Clapham]

And you know, we.

[Cole Smead]

Which means you're brilliant. But go on.

[Stephen Clapham]

We don't play sports very well and we've only got a limited number of them. And so just trying to understand what, what should be the relative valuation of a baseball team versus a football team versus a nice hockey team. Chat GPT or perplexity. I mean, they're very good at explaining that sort of thing. I mean, that, that's fantastic. And it would have taken me a long time otherwise, but they're, they're, they're good for the first step. They're not good at the, the seventh, the eighth, ninth, tenth steps. And as you said at the start, investments are multidimensional, very complex game.

[Cole Smead]

Yeah.

[Stephen Clapham]

And I don't think they're very good at multidimensional complex games yet. And I always laugh because I, you know, I hear people say, oh, you know, AI has been, you know, amazing for me. And when you ask them what they do with it, they don't really do very much. They use it to summarize a report.

[Cole Smead]

Yeah.

[Stephen Clapham]

And I'm like, well, that, yeah, I mean, you know, that's table stakes.

[Cole Smead]

Yeah.

[Stephen Clapham]

No, and I haven't seen very many examples of investors that have been able to use AI to really make their process more effective.

[C]

Sure.

[Cole Smead]

Hey, I want to give a big shout out to everyone who's been working so hard on this show. You know, we recently hit the top 10 in investing podcasts on Apple Podcasts and even number one in the business category in several countries. As you may know, this show is brought to you by Smead Capital Management. Smead Capital Management understands how frustrating and illogical the stock market can be. If you're searching for funds with a proven track record, give the SMEAD funds a look. Or better yet, reach [e-mail] and don't forget to mention you're a fan of the podcast. Past performance is not indicative of future results. Investing involves risks, including loss of principal. Please refer to the prospectus for important information about the investment company, including objectives, risks, charges and expenses. Read and consider it carefully before investing. Smead funds distributed by Smead Funds Distributors llc. Not affiliated. So let me, let me walk you through so and again and I enjoyed this because like, as I was reading your book, I was thinking a lot about our process and things you talked about in your book. So we talked about stock based comp earlier. So let me just use an example because again, I think about this as like, how do I learn and practically use this in what I do. So when you talk about the spend they're doing, we've tracked this. We like, we're super glued in on this. So these businesses used to do 12% of CapEx as a percentage of sales five years ago. Okay. This year, last year they did about 18% capex to sales. This year they're on target to do 21. If you said, cole, predict me the future, what's next year going to be in 26? I think, Steve, it's going to be 26% CAPEX to sales among the hyperscalers. Okay. Now you talked about common sizing in your book. I loved that. I frigging loved that you had your students common size the balance sheet before you'd tell them what the company was because you'd ask them what industry is this? Because to your point, industries overnight usually don't change. And so you can look at common size balance sheets and you can kind of predict what type of business, what's its capital intensity, things like that. But using an example like this, if I go out and say, you know, what's an oil company? Capex to sales, it's about 30%. And so if you came to me five years ago and said, Cole, the most marvelous technology businesses in the world are going to end up being 26% capex to sales, I'd say to you, well, sounds like we have holy hell to pay because that's what an oil company does. And those are low return businesses. And yet to your point, everybody loves that. They love the idea of them spending that money. And I don't get it.

[Stephen Clapham]

Well, I mean, it's a, I'm going to say that AI is a fad in the stock market. AI is clearly not a fad. AI is.

[Cole Smead]

Well, we're going to use it. The Internet wasn't a fad either, our lives.

[Stephen Clapham]

But from the stock market perspective, the stock market's view of AI is that it's the next big thing and everybody's going to profit from it. And that's clearly nonsense.

[C]

Sure.

[Cole Smead]

Let me ask you about a couple other adjustments because again, the other thing that I think is touch on, it's multidimensional. So for example, to your point on the sell side, if someone asked me what are sell side analysts good at, I'd say they're really good at one thing. They're really good at predicting quarterly earnings and they're extremely good at that. That's what like as a child, they drop crayons and they predict how many crayons they dropped. And the mother is like, gosh, you should be a sell side analyst. You're really good at that. And from then on, they go to great schools and they go through their pedigree and their internships and become sell side analysts. Now here's why I say it to your point, how earnings affect returns on capital, I think those are very confused today. I think it's that whole idea of what that is. So for example, to your point, you talked about in your book how stock options used to not be expense. And as we know from history, Buffett used to say, well, it's not an expense. What is it? And then PCAOB came in, changed that. So it's now expense and gap. But the sell side doesn't really care about GAAP earnings. What they do is they make their adjustments to get to how they want to view it. And I'll just use a primer of this, but they'll commonly say, well, here's the free cash flow of the business. Now, as owners, you and I would Say, well, let's use Google. I think the Street's expecting Google to do 73 billion in free cash this year. And everyone says, great, that's awesome. They have a $325 billion book and therefore look at my returns on capital. But you and I are, we're not the village idiots. We're not very smart, but we're not the village idiot. We do know that. And so we might come in and say, well, you know what? But 30% of that free cash is actually stock based comp. So let's remove that out of the free cash flow. You know, Buffett used to call this owner earnings. And at $53 billion, that means that Google, one of the most successful businesses in the world, one of the biggest moats, one of the biggest monopolies I've ever seen in my lifetime, is actually only producing about 16% returns on capital. And this is supposed to be the most climactic opening to the next era. And I again, to your point on returns, I can't figure that out. I can't figure out why from an accounting perspective, this is saying that this is not that great. And to your point, from a stock market perspective, people just think this is the greatest era that we're walking into. And here's the other catch. And you said this earlier, Steve, it's like you're bringing all my thoughts to a single point when I walk into a room. And I've interviewed a lot of people on this and I'd love to ask you this question too. If I asked them, hey, Steve, would you rather take the 10 year treasury at its 4.2% rate today or would you take the s and P500? What would be your response to that?

[Stephen Clapham]

Oh man, that is a terrible decision. Because I wouldn't touch the 10 year treasury with a long barge pull.

[Cole Smead]

Okay?

[Stephen Clapham]

And I don't think that's. Well.

[Cole Smead]

Here'S what I love about it. So it's funny you say this. This is the same response I get out of everybody, though. That's what's weird to me. Everyone's on one side of the boat. So, you know, as a general rule, over decades. I'm with you on that, but I don't think the S and P is going to make 4.2%.

[Stephen Clapham]

Well, the thing. So you're confusing return on capital with return of capital.

[C]

Sure.

[Stephen Clapham]

I think that the, I think that the US Treasuries are going to have an existential crisis.

[Cole Smead]

I mean, I agree because of the new talk about this in your book. The debt buildup is massive. I'm totally with you. But I mean, it's the risk free rate.

[Stephen Clapham]

Yeah, it's the risk free rate, but it's not a risk free instrument.

[Cole Smead]

Correct. So let's take that one step further. So it's, it's your, to your point, there's risk.

[Stephen Clapham]

I mean, do I need to have The S&P 500? Could I not have the ACWI or, or the UK stock?

[Cole Smead]

No, no, no, no, no, no, no. But here's what I say when I go across the world and I don't, I don't think most people know this, but I'll go sit with an institutional investor or an insurance company, say in Thailand. And if I say, hey, what does your equity portfolio look like? 70% of theirs is the S&P2 because it's just a misci. World benchmark portfolio. And so I point this out because this is not like a US investor risk. This is a global investor risk. The S and P is more over owned. And I find it interesting. Like again, back to the dinner analogy. I can't find a stock picker that says, I'll take the 10 year because I think the equity risk premium is terribly negative today. Terribly negative.

[Stephen Clapham]

Well, I think, you know, I think the issue is that there's actually quite a lot of good companies in the United States and there's quite a lot of cheap stocks even in S&P 500.

[Cole Smead]

Agree.

[Stephen Clapham]

I think the problem is that the, you know, it's very, very skewed. And the problem is that I can't see the US treasury being a market in which anybody should reside in the next 10, 15 plus years.

[C]

Sure.

[Stephen Clapham]

If you'd said to me, would I rather have German boons, Chinese government bonds, Indonesian government bonds, I mean, there are loads of government bonds. I would rather have less than P500. The US that would be a very difficult call for me.

[Cole Smead]

Well, to your point, Steve, I always tell people, you could get a drunk, you could get a monkey drunk, have it throw a dart on the world map and you're probably going to hit a stock exchange that's going to beat the S and P. That's the preponderance of likelihoods. So I agree with you there.

[Stephen Clapham]

No, I mean, no question. The S&P 500 is overvalued. The US stock market occupies too dominant a position in global stock markets. Your economy is a very small, I mean, it's a large economy, but it's small relative to the global economy.

[C]

Sure.

[Stephen Clapham]

I mean, emerging markets, if you look at it in terms of population area, population growth, I mean, any sort of real world parameter. Emerging markets look much more like America does as a proportion of the global stock market. And things are the wrong way around. And I can't believe that in 10 years time, go 20 years time, if we were having this conversation that we wouldn't look back and say, oh, wasn't that exceptional that America was so dominant? And it seems inevitable that this will decline. But I don't know what the trigger is because when we had these problems with the tariffs in early April, I wrote a long piece for my substack because I kept seeing people talk about buy the dip. And I said, buy the dip. Have you looked at what's going on? And of course, the people that said buy the dip were absolutely right because we're back. And you know, I said, well, hang on a second, I've got no idea what President Trump will do.

[Cole Smead]

Yep.

[Stephen Clapham]

I actually said, I'm not sure that President Trump knows what he's going to do, but if I look at what the people on the other side are going to do, I think that's quite predictable. And yeah, I think The S&P 500 is overvalued.

[Cole Smead]

So let me ask you a follow up to that. So cost of capital is going to be higher. You sound like you, you have an inflationary heir to that sentiment. And I think the history of the world is governments, you know, fight wars, borrow too much money and they figure out ways to pay it off later. The only two ways ultimately in the long run are taxes and interest costs. Funny enough, that's the primary driver of corporate profits are interest costs and taxes. That changes margins hugely. But because of what's gone on the last couple of years, the other thing that I think, and you touched on this in your book, and you're kind of co Postco notes on shoring and supply chain movements. Do something on the balance sheet though, which is that they're going to reduce or they're going to increase the working capital that businesses have to retain because we're out of the cheap money. I'm going to go hire an Asian company to go do it. They're effectively my off balance sheet financing unit to build my widgets and therefore I can run negative tangible capital because it's sitting on their balance sheet. I see, whether it be through taxes or interest costs or a balance sheet movement like that in this more fragmented world that the returns on capital, I'll just use US businesses, since we're on the subject, the Returns on capital, US businesses are going to decline, corporate profits, percentage GDP will decline, because those are real things that anywhere from your 27 debt overhang that we're going to have to roll that debt or out to these capital structure issues. These are going to have to be met and they're just different than the risk that was there 10 years ago.

[Stephen Clapham]

Yeah. I mean, I slightly regret adding that chapter, which I added in at the end after I'd sent everything to the publisher, but I just thought it's daft to have a book come out when we've had the pandemic without saying anything about it.

[Cole Smead]

Yeah.

[Stephen Clapham]

And I'm not sure that that chapter has stood the test of time as well as the rest of the book. But the one thing that I did think in there was that the reshoring has two implications. It inevitably depresses your return in capital because you got twice the assets. So before you had one set of assets in China or wherever and nothing here. And as you say, you're extending, you're inflating the inventory, so you're depressing returns in that way. And yeah, I mean, corporate taxes, I guess have to go up. Right. And I guess we're going to have more inflation, so I guess interest rates are going to be higher. So all those things point to lower returns. The only sort of light at the end of the tunnel, if you like, is AI, because AI could remove quite a bit of labor expense.

[C]

Sure.

[Stephen Clapham]

And I've got no way of gauging how much of a benefit that will generate. It should generate some benefit.

[Cole Smead]

Let me ask you a follow up to that then. If I said to you that the Internet was revolutionary, can anything be more revolutionary than the Internet when it comes to access to goods, price discovery, etc. Can anything really rival that? Because I don't think so. To your point, I think we're going to use AI ubiquitously. I think we're going to use it constantly in our lives. But it's evolutionary relative to the Internet.

[Stephen Clapham]

Oh, I'm not sure. I'm not sure. I mean, I genuinely don't know the answer to this and it's quite a big philosophical question, but you would have imagined that the Internet would have been revolutionary in terms of improvements in productivity, but it wasn't really. AI does have the potential to improve productivity significantly. It may or may not arrive, but obviously there's lots of processes that can be done by a machine.

[C]

Sure.

[Stephen Clapham]

That couldn't. That were previously done by people.

[C]

Sure.

[Cole Smead]

Well, to your point, costs came down with The Internet though. In other words, the cost of goods came down. So consumer savings went up because of cost of goods sold were coming down. So it's the expense side that was benefited there versus you're arguing that it's a human activity, human economic progress and productivity. In other words, you're just getting far more and therefore maybe that's good for incomes.

[Stephen Clapham]

Yeah, well, I mean, it could be very good for corporate profitability and, and returns. Although at the end of the day, you know, you need workers to be able to buy the product.

[Cole Smead]

Yeah, because we have this other thing that we don't have enough people in the Western world because we seem to not be able to figure out how to mate with the opposite sex anymore. I don't, I haven't figured it out myself. I have four children in full disclosure, Steve. So. But if we don't have people, I can't see how labor doesn't get more expensive because scarcity always creates value.

[Stephen Clapham]

You would, you would imagine so. But you know, I, when I look at the uk, you know, graduates finding it very difficult to get a job.

[C]

Sure.

[Stephen Clapham]

So, you know, I'm not familiar enough with the situation in the United States, but certainly in the UK we're not seeing that escalation. And it's only in, I mean, it's very pronounced. The wage escalation is very pronounced in certain sectors, but those are quite narrow sectors.

[C]

Sure.

[Cole Smead]

Well, to your point, I mean, like what we're seeing here is if you're a white collar person, guess what, there's just less demand for you than there was, say 10 or 15 years ago, versus if you're a tradesperson, like you can, you have a trade, you do tile work, you're, you know, a plumber. Insane demand for you. So to your point, and it's a very different group of people who are on demand today versus what was 20 years ago, let's just say last thing, you quoted a book and a section of a book that I don't ever hear anybody talk about. It's right at the end, you talk about Galbraith's book, the 1929 Crash, and you talk about his idea of Bezel. Okay, can you quickly just comment on this? Because I love this and nobody, I don't ever hear people talk about Bezel. So as I was finishing up your book, I was like, he mentioned Bezel. Steve is such a great Galbraith student. I love Galbraith. So could you just kind of explain what Bezel is briefly?

[Stephen Clapham]

Well, I mean, it's really fraud Isn't it? You know, one of the things that I've been quite focused on and when I was writing the book, especially in later stages, I was very focused on, I was building my forensic accounting course. So I, you know, my main business is I train professional investors and how to be faster, better, more effective at reading 10Ks and annual reports. And I was building this forensic accounting course. I spent six weeks in the British Library and I was thinking about, well, how do you build a forensic accounting course? I thought, well, the most extreme example of cheating is fraud. And So I studied 60 or 70 frauds. So when I was writing the book, I had fraud in the back of my mind the whole time. And that's why I mentioned the bezel. And the bezel is really, you know, stealing from innocent people, isn't it?

[Cole Smead]

Sure, it's scammed. And I think he points out that when it comes to light, it goes from being bezel to what we refer to as embezzlement. Right. Once it comes to light, it's embezzlement and bezel is always present, I think Galbraith says. And yet it doesn't get exposed until certain junctures and then we know it. As to your point, embezzlement and fraud, let's see, you have your courses. Steve, you have your podcast. What are other places people, our listeners can follow you going forward.

[Stephen Clapham]

Oh sure. And I should just say on the subject of bezel earnings management and the inflation of earnings by CFOs is more widespread today, Cole, than it any time in my career. It's exceptionally prevalent. But you can find me on Twitter. Teve Clapham. I'm not on there that much. I don't like the environment as much as I used to. I'm on LinkedIn. The website is BehindTheBalance Sheet dot com. The top right is a sign up button. I've got a free weekly substack where I write on all sorts of subjects. I've got the podcast behind the Balance Sheet which is on all podcast players. It's much less popular than yours. I'm jealous of your, of your, of your audience, but hopefully some of them will be attracted. And if you're interested in learning about investing, I've got the online school which is on the website behindthebalance sheet.com and I do these courses for institutional investors mainly. Again, all the information is there and if you want to get hold of me info behind the balance sheet.com I appreciate it.

[Cole Smead]

And what I haven't said to our listeners yet is to a UK audience. I think you are, you're pretty, you're, you're, you're kind of famous to UK audience. So I love this because like we're taking a bunch of American Yankees and, and saying, hey, you know, there's a world outside the United States. And oh, by the way, you know, Steve's dealt a lot of his career in that and you have quite a bit of following there. And so I, you know, kudos to you. I in the uk, I'd rather be you, frankly. So Steve, thank you for your time. Your book is a great way to prospect. Prospect, pardon me, Process the many aspects of investing, whether you're just starting out. I think you do a really good job of we're in intern season in the investment business at a lot of the banks and so if you're an intern and you're how do I get into investing? I think your book's a great way. Great way drug or reminding yourself like a person like me. Great elements of the process that you already use. You provide some great things to think about, particularly in red flags like we just talked about a second ago, and issues that investors must understand or just frankly avoid at all costs. Go get a copy to the Smart Money Method to dive deeper into your analysis. If you enjoyed this podcast, go to Apple, Spotify, YouTube or wherever you listen to A Book with Legs, give us a review. Tell others about the books and great authors like Steve Clapham that we have the chance to study the world with and through for our tribe. If you have a great book that you'd like to recommend, email podcastmeecap.com that's podcastmeecap.com. you can also send your suggestions to us on X. Our handle is meedcap. Thank you for joining us for A Book with Legs podcast. We look forward to the next episode. Thank you for listening to A Book.

[Stephen Clapham]

With Legs, a podcast brought to you by Smead Capital Management.

[Cole Smead]

The material provided in this podcast is for informational use only and should not be construed as investment advice.

[Stephen Clapham]

You can learn more about Smead Capital Management and its products at smeedcap.

[Cole Smead]

Com or by calling your financial advisor.