The Smart Money Method by Stephen Clapham;

Author:Stephen Clapham;
Language: eng
Format: epub
Publisher: Lightning Source Inc. (Tier 2)
Published: 2020-10-28T17:48:37+00:00

Montier claimed that the strategy was highly effective, both in the US and in Europe, with stock-market performance over a ten-year period, from 1993–2003, being highest for companies with a score of 1 (companies with the least manipulation) and reducing steadily as the score increased.

Whether this works as a quantitative approach is debatable. First, there has been limited commentary on the execution by practitioners (of course, if it worked perfectly people would not necessarily advertise that). Second, I suspect that the sixth factor, eliminating serial acquirers, may play a big part in the performance by eliminating some big losers. Nevertheless, the issues he has identified are relevant and incorporating these into a screen might be a sensible way of avoiding traps.

I also may use the Beneish M-Score and, at a very high level, the Piotroski Score, which are good snapshots of company health and are worth looking at early on in the process. I tend to use them as a filter in various screens.

Leverage

I pay close attention to company leverage and think of it not just as financial leverage, but also operational leverage and share-price leverage (companies with debt see magnified movements in their share prices for a given movement in the business valuation).

The first question is on financial leverage. I look at interest cover, cash-interest cover and fixed charges cover – the ratio of earnings before leases and interest, to the sum of the operating lease rentals and interest on both a profit and cash basis. I do monitor balance sheet gearing and debt to EBITDA multiples, but this is the key metric. I also look at the weighted average age of debt, and how this has changed over time, and monitor maturities closely.

But financial leverage is only one part of the picture. Besides this, I pay great attention to operating leverage. What will incremental revenues contribute in profit and what will be the impact of a decline in revenue. The ratio of fixed to variable cost in a business is a critical factor, although it’s often hard to determine precisely.

A good illustration is a commodity producer. Many investors tend to gravitate to producers that have the lowest marginal cost of production and are highest up the quality curve. If you are looking at a 12–18-month position in a commodity stock, on the basis that you have reason to believe the price of the commodity will rise, it’s usually more profitable to buy the lowest quality producer, as it will have the greatest operational and share price leverage.

This sounds slightly counterintuitive, but a simple example will explain how this works. Two gold producers, one with a cost of production of $400m and one with $800m, each producing 1m oz pa, and with $100m of HQ and finance costs.

With the gold price at $1,000, Company A makes $500m profit ($1,000m – $400m – $100m) while Company B makes just $100m ($1,000m – $800m – $100m). The gold price rises by 50%, to $1,500, and Company A now makes $1bn profit, i.

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