The Smart Money Method

1. Find Investment Ideas Through Multiple Channels and Asymmetric Opportunities

My favourite opportunities are those with asymmetric pay-offs. Here there is potential for considerable upside, but not a lot of downside (or vice versa for shorts).

Cast a wide net. Investment ideas can come from various sources, including personal observations, industry analysis, and market trends. Focus on opportunities with asymmetric risk-reward profiles, where potential gains significantly outweigh potential losses.

Leverage multiple perspectives. Consider:

• Competitor analysis
• Supplier and customer insights
• Expert networks
• Industry trends
• Macro-economic factors
• Random inputs and personal observations

Don't limit yourself to conventional wisdom or popular stocks. Often, the best opportunities lie in overlooked or misunderstood corners of the market.

2. Test Investment Hypotheses Before Committing Resources

Testing the hypothesis is an iterative process. I conduct the research in several waves, checking and re-checking, drilling down deeper and deeper, until the risks have been properly evaluated and I am satisfied that this is a sensible investment proposition.

Rigorous hypothesis testing. Before committing significant resources, thoroughly test your investment thesis. This process involves:

• Initial checks on liquidity and basic financials
• Understanding the reason for any valuation gaps
• Analyzing competitor landscapes
• Assessing management quality and incentives
• Reviewing financial statements in detail

Iterative approach. Be prepared to abandon ideas that don't hold up under scrutiny, even if you've invested time in research. It's better to write off research time than to invest in a flawed opportunity.

3. Evaluate Industry Dynamics and Company Quality

Quality comes in different forms, but you know it when you see it. There is plenty of evidence from highly successful investors like Nick Train and Terry Smith in the UK, that quality is a very reliable factor in investment.

Industry analysis. Understand the competitive dynamics, growth drivers, and potential disruptions in the industry. Key factors to consider:

• Market size and growth rates
• Competitive landscape and market shares
• Barriers to entry
• Regulatory environment
• Technological trends

Quality assessment. Focus on companies with sustainable competitive advantages or "moats". These can include:

• Network effects
• Economies of scale
• Intellectual property
• Brand loyalty
• High switching costs

High-quality companies often demonstrate consistent profitability, strong cash flows, and high returns on invested capital over time.

4. Analyze Management and Corporate Governance

Management is critical to investment outcomes, but assessment is difficult and hard to define in a checklist. Meeting management before you buy and regularly afterwards is essential.

Management evaluation. Assess the track record, incentives, and alignment of management with shareholders. Key factors to consider:

• Historical performance and capital allocation decisions
• Compensation structure and insider ownership
• Communication style and transparency
• Board composition and independence

Corporate governance. Look for red flags such as:

• Related party transactions
• Frequent changes in auditors or accounting policies
• Excessive executive compensation
• Lack of board independence

Remember that while meeting management can provide valuable insights, it's important to maintain objectivity and not be swayed by charismatic personalities.

5. Master Financial Statement Analysis for Deeper Insights

A detailed analysis of the financial accounts is a key facet of my analytical technique. Every investor claims to read the accounts, but the evidence is that very few do, and certainly not thoroughly.

Comprehensive analysis. Dive deep into financial statements, including:

• Income statement: Analyze revenue trends, margin profiles, and earnings quality
• Balance sheet: Assess asset quality, working capital efficiency, and capital structure
• Cash flow statement: Focus on cash generation and capital allocation

Key areas of focus:

• Accounting policies and any changes
• Off-balance sheet items and contingent liabilities
• Segment performance
• Working capital trends
• Capital expenditure patterns
• Debt structure and covenants

Look for discrepancies between reported earnings and cash flows, as well as any unusual trends or one-time items that may distort the true financial picture.

6. Apply Multiple Valuation Techniques for a Comprehensive View

There is a wide range of valuation parameters, and not all are appropriate for every company and every situation. The most important thing is to find a range of measures that you understand and feel comfortable with, and not to use a single measure in isolation.

Diverse valuation toolkit. Utilize multiple valuation techniques to gain a comprehensive view:

• Price-to-earnings (P/E) ratio
• Enterprise value to EBITDA (EV/EBITDA)
• Price-to-book (P/B) ratio
• Discounted cash flow (DCF) analysis
• Dividend yield
• EV/Sales ratio

Context is key. Consider:

• Historical valuation ranges
• Peer group comparisons
• Stage of business cycle
• Growth prospects
• Quality of earnings

Remember that valuation is both an art and a science. Use quantitative metrics as a starting point, but incorporate qualitative factors and your judgment to arrive at a final assessment.

7. Effectively Communicate Investment Ideas

Writing the idea down is a great discipline. The risk, reward and probabilities somehow become much clearer when I put everything down on a page.

Clear and concise communication. When presenting investment ideas:

• Start with a compelling investment thesis summarizing key points
• Provide a clear valuation framework and target price
• Discuss potential catalysts and risks
• Include relevant financial forecasts and sensitivity analysis

Structured approach. Organize your investment write-up to include:

1. Investment thesis
2. Company and industry overview
3. Management analysis
4. Financial analysis
5. Valuation
6. Risks and mitigants
7. Catalysts and timeline

Writing down your investment thesis helps clarify your thinking and provides a reference point for future review and learning.

8. Maintain and Monitor Your Portfolio Actively

Monitoring what you own is the top priority in successful portfolio performance. This may seem obvious, but analysts can devote a lot of time to new projects to the detriment of the core.

Ongoing vigilance. Regularly review and reassess your portfolio holdings:

• Monitor company-specific news and developments
• Review financial results and compare to expectations
• Reassess valuation in light of new information
• Watch for changes in industry dynamics or competitive landscape

Portfolio management discipline. Implement a systematic approach:

• Set price targets and stop-loss levels
• Regularly rebalance to maintain desired allocations
• Be willing to cut losses on positions that no longer meet your investment criteria
• Consider trimming positions that have become oversized due to appreciation

Remember that portfolio management is an ongoing process, not a one-time event. Stay informed and be prepared to act when circumstances change.

9. Balance Macro and Micro Economic Analysis

Macro is really tough. You only have to look at the large number of macro hedge funds, run by really talented individuals, which have closed in recent years or made paltry returns. The best I hope for is a broad understanding of the macro environment and thus a feeling for when to take risk and when to be more wary.

Macro awareness. Maintain a broad understanding of macroeconomic trends:

• Economic growth rates
• Interest rate environment
• Inflation expectations
• Currency movements
• Geopolitical risks

Micro focus. While macro factors are important, concentrate on company-specific and industry-level analysis:

• Competitive dynamics
• Pricing power
• Market share trends
• Technological disruption
• Regulatory changes

Balance macro and micro perspectives, but remember that stock-specific factors often have a more direct and predictable impact on investment outcomes.

10. Anticipate and Adapt to Technological Disruption

Disruption has made heroes out of many investors who probably didn't deserve to be, at least in my view, for many have just got lucky surfing the wave. It has also made some really smart investors look quite stupid.

Disruptive forces. Stay alert to potential technological disruptions:

• Emerging technologies in relevant industries
• Changing consumer behaviors
• New business models

Adaptive strategy. To navigate disruption:

• Continuously reassess the competitive landscape
• Look for companies with adaptable business models
• Consider both threats and opportunities created by disruption
• Be willing to change your views as new information emerges

Remember that disruption can create both winners and losers. Be cautious of overhyped trends, but also be open to transformative changes that can reshape entire industries.

Last updated: November 18, 2024