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You are listening to Investing Matters brought to you in association with London South East. This is the show that provides informative educational and entertaining content from the world of investing. We do not give advice, so please do your own research.
Peter Higgins 00:17
Hello and welcome to the Investing Matters podcast. My name is Peter Higgins. And today I'm delighted to have Steve Clapham with me, he is the founder of Behind the Balance Sheet. And Steve has over 25 years of investment analyst researcher experience. And he decided to put together his experience to good use to offer training and professional investment analysis for portfolio managers. And he's gone on to develop this under his Behind the Balance Sheets brand.
There's also quite a famous author with an Amazon number one best seller. And that book I've got here is The Smart Money Method: How to Pick Stocks, like a Hedge Fund Pro. So we're going to talk a bit about Steve's book throughout this interview.
Steve, welcome. How are you doing, sir?
Steve Clapham 01:04
Hello, thank you very much for having me on, I'm really grateful to you. And just one thing I should say is that I don't just train professionals.
So I've got two legs to my business, I trained professional investors that, you know, some of the biggest, most successful funds in the world really, but I also train private investors. So I've got an online school https://behindthebalancesheet.com/, where you can sign up and do a course and improve your investment skills.
So I think it's very important to share this stuff, which is why I wrote the book, because, you know, I wanted to help people, I think there's a lot of people who feel that the stock market is a bit of a scary place.
They don't want to get involved, they don't know what's involved. They don't know how to start, they don't know, it's really an important thing to take control of your finances, and why pay professional fund managers to manage your money.
Peter Higgins 01:59
We're going to get into all of that later on. Steve, you're absolutely on point. And I completely agree with you. There's a growing force of the DIY investor and to learn and to grow, and to continue to learn is very, very important for all investors, including private investors. Now, I want to start Steve and go back a little bit and give people a little bit of an in depth analysis of your journey.
If I may, you're trained as an accountant before joining the equity research department at Hoare Govett, one of London's top stockbrokers, please can you share with us your first experience of that role? And how it initially developed you as a researcher of balance sheets of listed entities, please?
Steve Clapham 02:37
Well, I mean, Hoare Govett, was a number five broker in London and when I joined I'm very old in spite of my charming young good looks don't be deceived. I'm very old and my very first day I arrived in the office and was shown to my desk by the then head of research Bob Cowell, who people might know his name because he was the Cowell and Makinson Cowell which is the premier investor relations consultancy in London. And Bob showed me to his desk and on my desk was a phonebook and internal phone book, a phone and a key and lamp system. And your younger listeners and viewers want know lucky in lamp system is basically allowed anybody in the box or the box or 10 desks and I was in the industrials box.
Everybody covered industrials, any of the analysts to pick up anybody else's phone. There's the most important thing is when a client rings is to pick the phone up. And I turned around to Bob and I said, Bob, is there any chance I could get a personal computer?
And he looked at me and he said, a personal computer, what sort of computer would you like? I said, could I have an IBM PC, please?
He said, sure and he said, call this guy, tell them you want an IBM PC, and you're in charge of computer training, literally.
I mean, that was the first thing that I did. But I joined as the corporate finance analyst, so I used to do projects for the corporate finance department that the specialist analysts couldn't otherwise do. And so I used to spend a lot of time with Richard Westmacott who was the chairman of Hoare Govett and one of the most respected stockbrokers in London.
That was quite fascinating because Richard is a very sadly strange character because he could not make small talk. I mean, if he was with Margaret Thatcher, as he often was, he could have a chat, getting a lift with them. It was a nightmare.
I mean, I don't know I was just at such a low level that is was fascinating working with him.
I remember being in his car going into the meeting and our clients at Hoare Govett included Hanson Trust, which was the most profitable client to have is they you know, loads of hostile takeovers. I was in the car with them and Lord Hanson called, and, you know, it was all code words and code blue.
But you know, I knew exactly what was going on. They were about to launch a take over the next day. It was all very, you know, very exciting. Very, very, very interesting.
Peter Higgins 05:17
So, from that early initial going into the I call it the frying pan almost, you know, as a junior, and then being thrust into that sort of world.
What was it that as a researcher that really nurtured you that made you say, actually, this is quite deep stuff, because people think of accountancy, and they think of looking into balance sheet and they go… the ordinary person look, but it's so, so important, Steve?
Steve Clapham 05:41
Well, you know, I was doing very interesting projects, which weren't necessarily related to the stock market, so I did a lot of privatisation work.
So I published privatisation note, I can't remember how many I did. But you know, looking at the performance of privatisations, I used to go in with West McCall and, you know, a team of corporate financiers to present to the government when they were privatising a new industry or a new company and then work on the flotations.
So stuff I was doing wasn't actually heavily accounting focused, because I was looking at new industries, which had never before been in the stock market. So for example, I was heavily involved in the privatisation of BAA. And that was a fascinating time, because there wasn't another airport in the world that was hosted.
So yeah, I mean, there was usually sort of financial analysis skills required. But you also had to understand a completely new industry, and then work out well, there wasn't a comparable to compare it against. There wasn't another airport listed. An airport had never changed hands commercially. So we had no transaction multiples, we had nothing to base it on.
So obviously, the stock market flotation price, was what the broker is advising the government felt they could get it away at, we were advising the company, which was in many respects, the more interesting job because it wasn't our job to try and get the best possible price for the government.
Our job was to ensure that the investors understood not just the opportunities and investment but also the risks. And this was a business that was incredibly capital intensive, obvious, right, owns Heathrow Airport, and a new runway, a new terminal, these things are a massive, massive investment.
But the opportunity, once it was closed, it was to get really good shareholder base, help the company communicate its message. And I did a huge amount of that, because obviously it was a part of the Civil Service didn't have an investor relations function, they had to go out and find somebody to do it. And so I help train investor relations people, I help them formulate their investment message, you know, how they presented themselves to the stock market. And of course, six months after the flotation, we had the Stock Market Crash, 1987 Crash, which was very interesting, because, of course, this was a partly paid share. And until that time, the partly paid shares, which were floated in the stock market, were geared bets on a bull market.
But when the stock market goes down, the gearing works in reverse. And I remember going to a meeting with the chairman of BAA, the chairman of Schroder's, which was a merchant bank, and the head of corporate finance at Hoare Govett.
So I was asked, I really didn't have anything to add, you know, there was, you know, 100 years of stock market experience in the room plus me with like, two years, or not even two years a year. But it was amazing to me that I was able to sit at the table with these very important people. And, you know, there was one or two things that they might ask me about how the people I was speaking to viewed the business. And you know, so I had an important role to play. And it was a very different from my previous roles. And in fact, I ended up in the city because I'd originally been planning to go and work for the fifth largest company in the UK, and I had a role that was to off the finance director and I, they offered me the job, I'd accepted the job. And then he called me up and he said, obviously, we made a mistake, you're actually too young to be this grade.
And next year, we'll promote you and you'll get a raise, but you'll have to come in and I can't remember what the numbers were but like £1,000 a year or less. I just thought I said, well hang on a second. You know, I'm going to have to do the job where I can and they said, Oh, of course you can do the job.
You'll be doing exactly the same job. It's just The technicality, I said, You know what, I don't want to work for a company that promotes you according to how old you are, you stick your job. And that's how I ended up in the city.
Peter Higgins 10:09
Brilliant, I love that, Steve. Now, obviously, one of the major things that I think has happened is the development of hedge funds over the past 20 odd years, and you've had the good fortune to work for some behemoths.
So I wanted to talk about that, if I may jump forward a bit a little bit, you're the former partner at a hedge fund Steve, and investors have a lot of misconceptions and ideas about hedge funds and their behaviours. In layman's terms, please, could you firstly give our listeners an overview of a typical hedge fund, and then an explanation of the hedge fund that you were part of and your role?
Steve Clapham 10:46
I can't really talk about my former role because I've signed a 65 page agreement not to say anything, so I don't want my former boss to sue me because he's very rich, and could afford to spend, you know, quite a lot of money. I mean, I'm not saying you would, but I've signed an agreement, I don't think there's really such a thing as a typical hedge fund.
I mean, you know, every fund that I've worked with, and, you know, I've got lots of hedge funds that are clients, I mean, one of my clients is one of the most successful hedge funds in the world. And in fact, I was there not that long ago, training some of their new recruits, you know, every fund is very different, because there are pod shops like Millennium and Balyasny, where they have reams of individuals, and individuals are given money to manage on a very narrow band of risk.
And capital is allocated or withdrawn from them according to how well they performed. You know, those are fairly universal, fairly standard. But aside from that, most hedge funds are very heavily influenced by their founder.
So you know, almost every hedge fund, the guy that started out or a girl started, is still there, and they are the people that dictate how the fund is run the culture of the firm. But I think there's a lot of misconceptions, you know, the funds that I've worked for, have tended to be very fundamental in nature.
So they've actually on the long side of the book, and you're aware that there's a long side of the book and a short side of the book. And on the long side of the book, very similar to a good long only institution, looking for good fundamental ideas, why no secret, publicly available information, the first one I worked for, I mean, we would own shares for three to five years. And, you know, the ones we own used to go up quite a lot. But there were other than the performance of the stocks, because we did, and we could afford to do much more work, much more intensive work much deeper work, have a much better understanding of a business. And because we were a very large fund, we took very large positions, we were very close to the management of the business.
So we're invested in, you know, there is no difference from a traditional long only fund that would be a client of mine, not today, the short side of the book, obviously, it's a very different type of endeavour.
So though we would be quite concentrated on the long side, on the short side of the book, we would take smaller positions. And I think this is a fairly typical, fairly typical strategy. I mean, the last hedge fund I worked for, we had equal positions in both sides of the book, because we were on short term timing.
So the principal was the former prop desk trader. So he didn't really make a distinction between the short and long. But for most equity, long, short hedge funds, the short positions will be smaller. And the reason the short positions are smaller is generally do less work on them, because you're not planning on owning them for as long a period. So you need to have shorter positions, because if they go against you, when you are short of something and it goes off, your position increases, when you go into a stock and you're too early, as often happens, you can have to reach down, you know, you check, have I missed something, obviously, you need to make sure that you haven't made a mistake.
But if you're still confident you're on the right thing, then you can buy more of it, if you're sure to increase the short is a much, much more difficult. I mean, just psychologically, it's much more difficult. And generally what happens is if you're short, something that goes off, you'll reduce the position to reduce your risk.
So you end up on the short side of the book, having more positions, smaller positions, less work on each and you're owning them for a shorter period, because you're doing your trading more. I mean, that's not to say you wouldn't take a short position in a fundamental stock or something you thought was a fraud and hold that for a long time or a short position that you were doing thematic short, so you might be short have exposure to a particular segment of the US economy, for example.
So you might just say the US consumer 70% of the US economy, they've got a whole lot of debt. And they're going to suffer in the next downturn. So you might be short of a big US consumer stock that you could give a massive short on, because it's very liquid. And you might have that run that short for, you know, today, you might run it for 12 months, and the expectation that, you know, the US economy will dip and but generally speaking, the shorts were specific and quite trading oriented and put it that way.
Peter Higgins 15:39
No, thank you for that explanation. Now, Steve, you set up Behind the Balance Sheet in 2018, as a training business initially dedicated to helping professional investors, and then you built it, and then developed it further to help private investors.
Can you give us an overview of the whole business, please?
Steve Clapham 15:55
Sure. Well, I mean, the business has got three legs to it. So the first leg is I do mainly a forensic accounting course, which I give to professional investors is a one day course. And I go through in great detail how to spot companies that are managing their earnings, or presenting their earnings, inflating their earnings.
I mean, so it all happens, we study some past frauds, because obviously, there are extreme cases of companies that are managing their earnings. But it's really about spotting companies that are presenting themselves as high quality that aren't as high quality as they really are. And I do some bespoke training, I do some bespoke research. So you know, we mix training courses for a very big quants fund. And I train their quantitative analysts in just how to understand the financial statements I've got an advanced valuation course, I've got various content.
The second part of the business is the online training school, we've got students in over 50 countries, something like that. And we have the most popular product is the Analyst Academy, which is basically everything you need to know to be a competent and confident investor.
So I've got five modules, the first module teaches you how to look at their accounts, how to read the financial statements, how to spot companies that are cheating, how to understand the balance sheet, how to look at the cash flow statement. So it's much, much more intensive than just looking at the P&L.
The second module is about finding a stock idea and researching it, you know, how do you find an idea? How do you find a good stock? How do you research as you check whether it's a good one? The third module is valuation, how do you value a business and we go through all the different ways that you can value your business?
The fourth module is putting all this together. So you've found the stock, you've checked the balance sheets, okay, you check that it's profitable, you've checked the valuation is cheap. When do you buy it?
So we look at technical analysis, a lot of fundamental analysts tend to overlook the importance of technical analysis and understanding, you know, you can make a lot more money if you get your entry and exit, right.
So it's not about is this a good company, but when to buy it? And then how do you build your portfolio? How do you construct a portfolio? So you've got the correct amount of diversification to suit your personal requirements? And then we go into the macro?
What do you need to know you've now got a portfolio? How do you monitor it? How do you watch the macro? And I've got a whole bunch of professional economists who have contributed their views and what they think is important. The fifth module is a whole bunch of case studies. And that course, is very detailed. And you've got to want to learn, you can't become a good investor without a) losing money and b) understanding quite a lot.
And what we've tried to do is to put everything in one package, and it's £149 a month for 12 months, because we thought people don't want to pay a big cheque upfront, they may find that they don't like the course.
So we offer a 30 day money back guarantee and all our courses, you can try it out and if you test drive it if you don't like it will happily give you your money back. No questions.
Actually, I see no questions asked. I actually always ask because if somebody doesn't happen very often, if somebody asked for the money back, there's obviously something wrong. And you know, we can learn from that.
Usually people go or hadn't realised that it was quite difficult to invest in the stock market. And well, actually, it's not that difficult to invest inthe stock market, but to invest and make money and to know what you're doing. You cannot do that without a bit of effort. You know, I've got people that are students.
I've got people who are incredibly successful businessmen who have sold their businesses. I can't tell you how many people have sold their businesses and they've then gone to a wealth manager and they said, I've got 10, 30, 50, 100 million pounds to invest. And the wealth manager has said, Oh yeah, well, we'll put you in Terry Smith's fund, and we'll charge you 50 bips, I think I said, well hang on a second, I could do that myself. I've got one client who actually emailed me very recently, and he's up this year. And he said, he would never have had the confidence to pick the stocks and invest in the stock.
If you hadn't done my course, the guy has had a very large business, you know, he's a very, very wealthy guy, smart, smart guy.
But it was feeling comfortable was a battle. You know, he didn't trust his own judgement. But by doing the course, he thought, well, actually, I can do this. And sometimes it's just having the confidence. And the third part of the business is a publishing business.
So I've got a newsletter, which is published on substack. So all of these things are on my website on balancesheet.com.
I've got a podcast. So I do what you do Pete, I only do it once a month, because it's quite a lot of work. But a lot of preparations. I do it once a month. But last month, as we speak, the current episode is with Sir Clive Woodward, who took England to the world number one at rugby, really fascinating character.
I mean, I had I saw him speak. And I thought, God, why have I never thought this because the connection between sport and business, there's a really, really strong connection. And he was so interesting. And doing the research on him was so fantastic, really, really enjoyable. And next month, I've got Carson Block the world's number one short seller, who I was very surprised, you know, I said to him, look, Carson, you've done a million podcasts.
Let's not talk about how you got into short selling, because it's a really fascinating story. But you've covered it 100 times and you know, anybody who's listening to my podcast is bound to have heard of you.
So we've covered it just very, very briefly. And I said, So how'd you find these ideas? And I fully expect them to say, Oh, well, Steve, you know, I obviously can’t tell you my secrets.
He then started to say, so this is what I look for. And then I do this and then I do that. It's like a master class from the world’s number one short seller, and how to spot a bad business.
I just bought a bad company, how to spot bad management. So that I found the podcast, I don't know what your experience has been. But I find it to be really fascinating, really enjoyable, because I would never have had the opportunity to sit down in my office upstairs in the studio.
Sit down with Sir Clive Woodward for 75 minutes and 90 minutes. It's really good fun. And we've got Substack, we've got a YouTube channel. And we've got various other initiatives planned for the next 12-18 months.
Peter Higgins 22:39
Brilliant. No, I've been looking forward to those interviews and Sir Clive Woodward 2003. They won the championships that they I spoke with Steve Thompson regarding all of that as well.
Fascinating guy was got a lot of praise for him. Now, Steve, you touched on going outside the comfort zone and confidence as well there, psychology, Steve plays a huge part in investing.
You point this out beautifully in the quotes in either a recent interview or or within your book, “it's twice as painful to lose a pound and it is to gain a pound.”
So when you start losing money, you get very stressed, the nature of the stock market is that the market can go up and down. So you will lose money from time to time.
Please, can you expand on why this remains the case but even the most experienced fund managers and investors?
Steve Clapham 23:23
Well, I can tell you that I was with one of my clients who started a huge, huge enterprise. And I mean, I don't know what he's worth, but he just gave 50 million quid to one charity. And that's not only the charitable donation.
You know, he's an incredibly successful guy. And he still runs money. So he's got a huge organisation, but he still runs money. He only runs one fund. He's got other people running other funds, some hedge fund managers.
There's one fund and they run it and you might have a share of the book. But at the end of the day, it says decision, the boss's decision, but this guy runs a fund one of many funds in this organisation. And he said to me, he said, well, I only get 55% things right? And he's probably a billionaire. Right? And you think, okay, so, I mean, he's also very humble. And the most successful managers, brilliantly hedge fund managers, most successful of them are usually very humble.
The simple fact is that things change. You know, if you're trying to make exceptional returns, then you're going to be taking on a bit of risk, and you will, you'll get things wrong. So things can go wrong in various ways things can go wrong, because you made a mistake, right?
Because you thought something was going to happen and it doesn't so you you know you think this business is going to get taken over and it doesn't or you think this manager is going to buy back shares or improve margins and he doesn't so that happens a lot.
Things can go wrong because the time scale doesn't work.
So you find the right stock. And yeah, I mean, in three years time it does go up. But you can't wait three years. The one thing you know, I think as an analyst, you can get the fundamentals spot on.
But you can't necessarily dictate when the stock market will recognise what you've recognised. So by definition, usually you're buying something that other people don't like or dislike for a particular reason. And just that, where's the catalyst might not happen, then you can get things go wrong, because an exogenous shock, you didn't expect Putin to invade Ukraine, because all logic said that he would be mad to do that. And you thought Putin’s the richest man in the world, he isn't stupid. And you underestimated his desire to keep his own people at bay and the repressed and the need for him to stay in power.
Because otherwise, if he doesn't stay in power, he's a dead man. And he was highly, highly motivated to to invade, but you kind of got that calculation wrong, and you were short of oil are long of BASF for all sorts of things that you can get wrong from an exogenous shock. So and then, you know, the stock market can just be completely irrational, summer of 2021.
I mean, the stock market is a very funny animal. And I remember having discussions about Zoom in the middle of COVID. And Zoom I think it got 170 billion. Am I right in saying that? Is it 70 billion? I've forgotten, I've forgotten anyways, just like a stupid number. And you know, I was saying, well, this is this is really stupid number.
But loads of people telling me I didn't know what I was talking about and then I did a podcast, with Pete Davis of Lansdowne partners, and Spencer Crawley of First Minute Capital and I'd been doing a valuation course for a very well known, multi trillion dollar fund. And it asked me to look at Adyen, which is, I think it's a Dutch payments company. And it was capitalised at $100 billion. And it had 1.3 billion euros of sales. And I had a conversation as I was going into the Lansdowne offices with a friend of mine, Mark Rubinstein, who writes a newsletter, Net Interest, and is, you know, a real expert on all things financial. And I said to him, this is insane. And Spencer, who's just arriving said, Well, you know, I was just talking to some of the guys in Venture Capital and Stripe who are looking to come to the stock market next February at $250 billion. And you think, well, I mean, Stripe’s a very good business, I've got no idea what the financials are. At that point, I had no idea what the financials were. So you know, 250 billion it sounded like a big number, and Adyen $100 billion.
I remember it, the client asked me to do a valuation on Adyen for the course. And I said, well, look, you know, if you'd asked me, when Adyen was $50 billion, I'd have said, this is daft. $100 billion. It's twice as daft you know, there's a certain level of daftness, you can’t double it, you know, and I just said, so let's just see what this company would have to do in order for you to make money, I think, if I remember correctly, I said have to grow its revenues at 40% compound for 15 years, maintain its 56% EBITA margin. And in 2035, it would be fair volume, so you wouldn't make any money unless it did better than 40% compound growth rate for 15 years and flat margin.
I don't know if there is a company that's growing at 15% compound for 40 years.
Listeners should be aware that compound interest 40% For 15 years is a big number.
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Peter Higgins 29:38
Now, your brilliant book, Steve, I want to focus on that now if I may, you said something really beautiful in your book, and it shows the level of humility given your vast experience. You stated in your book, The Smarter Money Method isn't really about anything other than your investing philosophy.
Therefore, please, would you be kind enough to share with our listeners the framework process that you've developed over the decades as an Investment Analyst, starting from the moment you've identified an idea to auditing it, checking the balance sheet to when you go, okay, I'm gonna buy that. A quick synopsis of that, if you may, please?
Steve Clapham 30:14
Well, how long have you got? The book’s two hundred and something pages. So you know, the book, The Smart Money Method, I've always wanted to write a book. And I used to keep a notebook. And if I got a good idea from a competitor as to how they did something, I used to write it down in this notebook.
Eventually, a notebook got full. And then the notebook was actually the genesis of the book. Because when I was thinking about, well, what should I write about? And then I had all these notes and you know, what I should do, is I should formalise how I do this.
But I'd never written it down before the notebook was the closest thing I had to anything about my process. And that was only just so I could remember things I learned from other people I could copy, you know, as you go to, you go to a conference and you're talking to one of your competitors, one of your pal's works for a rival fund. And you're talking about the last thing you got wrong or whatever. And he says, Oh, I would have spotted that because I do this. So oh, that's clever. I'll use that next time. And so, you know, I just thought, well, let's write a book about how people can invest.
Because as I said, at the beginning, the thing is that people are scared of taking control of their own future. And honestly, you know, we're sitting in 2022, we've seen, you know, a bit of a bear market since the summer of last year.
But we're in what look like incredibly difficult times. And the one thing that you can be 100% sure of is that what has worked in the last 40 years, isn't going to work in the next 20 years.
So we had 40 years of falling rates. And Albert Edwards, the famous Soc Gen strategist who came up with the Ice Age, and all you needed to do was buy bonds.
Even Albert Edwards has thrown in the towel, I listened to him yesterday, he said, it's the end of the Ice Age. So you can't do 60/40 equity bonds, you can’t give your money to a wealth manager, you can’t give your money to even brilliant investors like Terry Smith, you know, I've got the greatest admiration for Terry, he's done incredibly well.
But the stocks that he owns have gone up a huge amount, it's highly unlikely that he'll be able to do as well in the next 10 years, as he's done in the last 10 years. And I think that next 10 years is going to be very different.
So I think in order to not even make money, but in order to preserve your wealth, preserve your capital, you need to do something very differently in the next 10 years. I think you need to be much more active in holding equities, and turning them over.
So you need to be much more nimble. That's my personal view. And so the idea of the book is to enable you to do that. And so, you know, I give you tips for where do you find stock ideas, and you can find stock ideas everywhere, you can go to the supermarket and say, oh, that's a fantastic product. And you can go and work out where it came from, I did a competition on my newsletter. And I let I gave everybody a mini course recorded the three days stock idea challenge. And the first challenge was what product have you bought that you would like to invest in? And we got some were great.
I mean, there was one lady who was amazing. I mean, she did three emails to me, absolutely brilliant, which I wrote up and newsletter a few weeks ago. So find the idea. And then once you find the idea, you go, is it a good idea, and then you've got to do a bit of research into the financials.
So we explained, I'd always been in a huge amount of detail. One person gave the book one star on Amazon because they said it was all about me selling courses. And I was like, What are you talking about?
But you know, I don't go into the detail I go into in the courses in the book about how to check the financial statements, because it would be a whole book on its own. But I'll give you a bit of colour on that. And there's lots of places you can learn that explain how to check whether this company that’s making good returns on capital and this cash generative and then how do you check that the management are honest and are sensible allocators of capital? And how would you check the company's got future? So I go through all of that, I'd say a little bit about valuation.
I don't go into a huge amount of detail on valuation. You know, I didn't want to write a thousand page book.
Peter Higgins 34:44
But the beauty of what you did to Steve is that you're focused on your three pronged checklist which is essentially margins, conversion of earnings to cash operating profit into cash flow, and working capital ratios.
So if you wanted to share with our listeners, the aspects of that, and those why those three are important?
Steve Clapham 35:04
I mean, these are three things that I say if you want to avoid frauds, these are three things you need to look at first is margins, because you've got to understand how does the company make money. And frauds often have margins which are much higher than their peer group.
You've got to ask yourself, Well, if he's got very high margins, why is that? And if it's got low margins, why is that? And could that change?
Because you know, people often don't realise that a company with low margins may have low margins being badly managed, or because input costs have happened to be high, and will change the conversion of earnings into cash flow. I mean, funnily enough, I'm talking about this on my Substack, this week, is fundamental, you know, how much of your earnings turn into cash?
Because if your earnings don't turn into cash, A), the earnings might not be honest and B) they won't be as lucrative to use a shareholder unless their cash earnings. And the working capital ratios, I think people just, you know, they sort of look at a return number, and they don't really think through what is what does that represent, businesses need a certain amount of fixed assets.
Even if you're Amazon or Google, you need a certain amount of fixed assets, and you need a certain amount and working capital, and you know, how much working capital in the form of customer receivables, inventory finance by supplier, are payables? How much of that you need for an incremental dollar or pound in sales?
And that dictates how much cash you're going to generate from any growth. And so those three parameters, I think, are very critical to understanding a business understanding whether it's going to make money for you.
Peter Higgins 36:52
Brilliant, I love that response. Thank you. You also touched on something that's quite important. You phrased it differently to most people I've read in the past.
You've called it the collection cycle. Steve, can you expand on that? And why that's so important for a company?
Steve Clapham 37:04
The collection cycle, I mean, I think it's I thought it was I generally used term, but the collection cycle is simply you make widgets, so you buy steel, and you make it into a finished product.
So you've got a supplier for the steel, how long does it take you to pay them? How much steel? How many widgets do you have in inventory at any point? And how long do your customers take to pay you, that adds up to a number. And so how many days of inventory you have less how long it takes you to pay your suppliers, and how long your customers to pay us the total number. And if that total number is very small. So if you look at Facebook, or Meta, that number is zero.
So they don't have any capital tied up in working capital, I say, is zero. I don't know what I haven't looked at it for a couple years. But last time I looked it was zero. If you look at a company, that Electrolux that make house goods, they've got, forgotten the exact numbers, but they've got something like 60 days of inventory, and it takes customers 50 days to pay them.
So you know, they've got 110 days, they take 110 days to pay their suppliers. So they've also got a working capital of zero, a collection cycle of zero, same as Facebook or Meta. But in a much less robust environment.
Because guess what, if it's taking you 110 days to pay your suppliers, they're not going to be supplying you for very well, if you take any longer than that they're not going to be supplying you. And they're probably charging quite a lot for that privilege.
So you know, my guess would be and again, I looked at Electrolux last time in 2018. So they don't go looking at the numbers for December 21 was often looked at, I don't know what they're like, but I've just got it's just an illustration, I would have said that, you know, they'll find that very difficult to improve their collection cycle, and therefore they're returning capital, how's that going to improve?
If it's going to improve, they either need to figure out how to use less fixed assets have less money tied up in the production line in the factory, in the machinery, or they're going to have to improve their margins. And in a cutthroat business like appliances where there's competition from the Chinese from the Koreans from the Americans. It's quite a competitive business. So you got to ask yourself, well, how How's Electrolux going to improve its business? It's going to be quite difficult.
Peter Higgins 39:46
Yeah I get that. It's quite important. Now it's good to go seamlessly to the difficulties which you've spotted in the past, and some people didn't spot. Please, please share with us some of the red flags that institutions, fund managers, and private investors clearly missed with the likes of Conviviality, Patisserie Valerie, Carillion and others recent stocks that have imploded?
Steve Clapham 40:07
Well, I mean, Carillion, the working capital cycle, the collection cycle would have told you all you need to know, because the collection cycle was very negative, which meant Carillion when it completed a project, it had to get another project to fill the gap.
Because, you know, it's, I mean, in typical construction business, very low margin, the way it makes money is it gets its cash from its customers before it pays its suppliers.
So it's constantly got to fill its backlog, otherwise, it will run out of cash. There was one year where it's collections, it went from being I forgotten what the number was 30 or 40, 50 days negative to zero.
So you know, that cash just evaporated. That was quite a good warning of what was going to happen to Carillion but gonna make trillions, obviously, two years before it went bust. I did an interview on Radio Four, where they did a whole segment.
I never listened to it when it went out. But you know, it's 10-15 minutes about why Carillion was… I don't think we said it was fraudulent. But you know, we said it was an unsustainable business.
Conviviality was a tax thing I don't really remember too much about, I didn't really look at it. But Patisserie Valerie is one that I thought was a very good illustration of all sorts of things that you could easily have spotted as a private investor. And as rather embarrassing because I was asked to speak at Mello, on a panel about Patisserie Valerie after it.. and you remember they injected, they had a rights issue injected some capital when you know, when he couldn't pay the VAT man. I did a few slides. And I said, who in the room holds Patisserie Valerie and I had no idea who held it. And about one in three people, no one in 10 people.
There's about 300 people in the room and 35-40 people put their hands up, and then proceeded to tell them how stupid they were i which was, you know, was probably not as diplomatic I think as I could have done but you know, I just said look, they was reporting 15% margins,Caffè Nero.
So I reworded 15% margins, which had actually gone up slightly over the previous five years, Caffè Nero, which was a very, very similar business had reported margins of under 10%.
Five years previously, and its margins had halved, in the past five years. For very simple reasons, including the vote to leave the European Union, the Brexit vote meant that Sterling collapsed. And guess what, coffee’s imported, most of our food is imported. Most of the stuff that they were selling was imported, unless they've managed to put the prices up which wasn't evident in the revenue goal.
In fact, their sales per restaurant had not moved and actually it declined slightly over the previous five years to just revalue. They said, look, it was reporting 15% margins. Costa was reporting margins which were underlying six points, five or six points lower, Costa are similar business.
Starbucks was reporting the same margins. You ask yourself who do you think is more efficient? Patisserie Valerie, who, mainly selling cups of tea and cake to people sitting down in a restaurant, or Starbucks selling coffee globally, half of it to take away I don't know more, maybe more than that, maybe 70% to take away.
As soon as you've got a table. You've got floor space, you've got rent, you've got waiters, waitresses, what's the single biggest cost in the restaurant 36-38% of revenues is labour rents, 10%,11% of revenue is inconceivable that a business that was not selling product to take away similar products, right?
Coffee is one of the highest gross margin products that you can get coffee and tea. Coffee is actually even more expensive than tea but very, very high gross margin product. I mean, depending on what you include in the definition of cost of goods sold, if it's just the coffee is 90%, if you include the direct costs of production is probably 72-73%.
Starbucks, you know, selling coffee to take away, obviously is going to be you know, much, much, much more profitable.
Peter Higgins 44:41
Now, Steve, I'm caught. I'm conscious of the time. We're going to run out of time. So I'm going to just fast forward and ask you one final question. Now, Steve, you share with us your strategy regarding how to find good companies. I'd like to ask you that in your own investing strategy. And a little aspect about its diversification if you can for our listeners, please?
Steve Clapham 45:01
So my investing strategy is I own equities. That's it. I mean, I very, very rarely own bonds.
I bought Glencore bonds, when people thought Glencore (GLEN) was going to go bust and they had a bond maturing in 12 months time that was covered easily. And I made 40% or something stupid on like that.
But generally, I own equities. That's what I know. And I don't believe bonds will be a good investment for the next 10 years. And I'm a global investor.
So I don't own very many UK stocks. I tend to own stocks overseas, I've got a big position. And I've had a big position for the last 15 years in India. And I believe India has, you know, a massive opportunity, but I can't buy individual Indian equities, but I don't have I'm not Indian domicile, but India is my biggest position through funds and ETFs.
Peter Higgins 45:50
Brilliant. Now, Steve, what I'm gonna try and do is at some point, we're going to try and come back to interview again, since I've got through about half of my questions here. So I do apologise for rushing the ending at the conclusion of this. And hopefully we'll come back. So that was Steve Clapham, Behind The Balance Sheet, business consultancy platform for informing and educating institutional investors and private investors alike can find Steve across numerous platforms, please visit his website, you can find him also on Twitter.
Steve has been an absolute pleasure speaking to you and I hope we can get you back to conclude this interview at another stage. Thank you ever so much for your time.
Steve Clapham 46:29
Thank you. Good to be on. Thanks.
Peter Higgins 46:31
Thank you Steve.
LSE 46:44
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