Behind the Balance Sheet with Stephen Clapham

Richard Kramer:

Welcome back to Bubble Trouble. I'm the independent analyst Richard Kramer. I'm with the economist and author Will Page, and we're hurdling towards our hundredth episode laying out the inconvenient truths about how business and financial markets really work.

This week, we have a distinguished guest I've wanted to have on for a while that has an estimable track record at calling out the machinations and malfeasance behind the numbers, Stephen Clapham, the driving force Behind The Balance Sheet, a podcast of the same name and education company, helping teach fund managers and others the tricks of financial chicanery and magical massaging of the numbers. In a minute, we'll dive behind the balance sheet with him and all the more topical given our recent podcast on how the BOE got its model so terribly wrong in our episode with Hugh Hendry talking about the basics of money and inflation, more in a moment.

Stephen, can you give us a bit of your background and how did you come to be one of those rare birds who actually reads these really boring filings and all the fine print, instead of just opening wide to swallow big gulps of Kool-Aid from management teams? Is this a temperament thing? What got you into this forensic dissection of financial reporting?

Stephan Clapham:

Well, first of all, I mean, thank you very much for inviting me and I'm very impressed by how you can reel off those very difficult tongue twisting commentary. But you say that these things are boring, they're not boring, they're fascinating, they're exciting.

I do a forensic accounting course for professional investors and we do a little exercise at the start and I give them the balance sheet as a percentage of assets and percentage of liabilities, and I give them nine ratios. So, there's maybe 20 numbers for four companies, and I say, "Identify the industry." And if they're good, they can identify one, two, three, of the industries and they don't get it 100% perfect. But there's a huge story particularly in the balance sheet.

So, when you look at a new company or when I look at a new company and I start off by saying, "Okay, what's the revenue of this business?" And then I go through the balance sheet, I can tell you a huge amount about the business without even knowing the name of the company or what it does. And I think that you're right. Not very many people do read the financial statements. They certainly don't read them in detail, but guess what? We're going into a period in which there's going to be a stock pickers' market.

Honestly, I launched this business in 2018, I launched a online school, so if you want to learn about how to read balance sheets, you can come to behindthebalancesheet.com, buy a course, and they'll teach you all about it. I launched it in 2019 and then my book came out, The Smart Money Method, came out in 2020. People kept asking me, "Well, what's this all about? These balance sheets?" I say, "Well, you don't need to worry about them because ... " [inaudible 00:03:16] for the last, I don't know, X years, certainly at point in the middle of a COVID lockdown, the last thing you needed to worry about was a balance sheet.

But guess what? As we go into more difficult economic conditions, balance sheets become really important. As I came into 2023, I thought, "You know what? It's going to be a really tough year for my institutional business because most of my institutional clients are going to have 20% less assets under management and therefore 20% less revenues, and they're going to have to go and find some cost to cut." And, "Oh, there's a training budget. Why don't we cut that? That's an easy one to cut."

And so, we did some initiatives where we launched a cohort-based course teaching people, mainly professional investors who were in smaller firms or on their own, how to do this. And so, we did it every Monday night for 90 minutes for eight weeks and went through similar content to the institutional course. And to my great surprise, not only was that course very heavily subscribed, but the institutional business has been busier than it's ever been.

So, in spite of the fact that people have got less disposable spending, less budget in 2023 than they would've had in '21 or '22, nevertheless, they're still worried about what is the future going to hold? And they're actually investing in themselves and learning about this stuff because this is going to be that what distinguishes the successful investor from the unsuccessful one.

Will Page:

Stephen, if I could get into one of the most famous balance sheet frauds of all time in a minute, but what would really help our audience, and I can see the quality of your training the way that you've answered the first question already, but what would help our audience is just to assume no prior knowledge. Let's assume that our audience can figure out how to fake a profit and loss account. There was an invoice, it wasn't actually an invoice, money didn't appear.

What would be the classic econ 101 example of balance sheet misbehavior that you could give us? Staying away from the terminology, how do you adjust a balance sheet to create a misconception that the company's healthier than it actually is?

Stephan Clapham:

Well, the most straightforward trick is to fabricate sale, and then, you then end up with a fabricated receivable. And then if you're going to be really sophisticated about it and do it for a long time, you can't have your receivables constantly building up and not converting into cash because even the people that don't read the balance sheet will be slightly suspicious of that. So, you then create fake cash.

And when I was originally asked to do ... construct the forensic accounting course, I did it for Stewart Investors, which are very old, traditional global stroke emerging markets investor, based in Edinburgh with offices in London, Singapore, Sydney. They were concerned because they'd taken on a lot of people since 2009, and those people had seen only upward markets, so they wanted them to have some experience of what could happen if things go wrong.

And so, I built this course and I thought, "Well, what's the best way of doing this?" So, one of the things I did, I sat in the British Library and I went through about 60 past frauds. This was like an academic exercise where I went through to try and teach myself. And it's surprising how many of these things have fake cash. Now, the auditor, of course, the auditor should be able to work out the cash isn't there, but surprising how often the auditor doesn't.

Richard Kramer:

And we both had Dan McCrum on our podcast and of course famously in Wirecard, the FT journalists had to go out to the Philippines to find that the place where the cash was supposed to be sitting actually didn't exist.

Will Page:

I asked just before we came onto the show, I asked Richard how long you've been in the game? He said 25 plus years. Good, so I can ask him the question I really want to ask him, which is Enron. The one reason that I want to do this podcast is I want to get Andy Fastow on the show on the hundredth episode. You were presumably looking at balance sheets when Enron went under. Could you just take us back in time to what I think is most famous example of bubble trouble in history and walk us through what they were doing?

Stephan Clapham:

Well, I mean honestly, I wouldn't have even known that Enron existed until it blew up because I mean, I was unusual at that time. I was on the sell side and I did actually follow some US companies in addition to European stocks, but Enron wasn't within my remit. I just wasn't aware of it, because when you're in the sell side, you've got sector specialism, you got blinkers on-

Will Page:

Blinkered.

Stephan Clapham:

... the wider ... and it just didn't really come across my desk until it blew up and then it was obvious what was happening. But I mean, Enron were doing, I mean, I don't know how many things wrong. It reminds me of, I've got an example of a company in my forensic accounting course where we talk about the theory of how to cheat and we look at the early recognition of revenue.

And this company was censured by the SEC this is relatively recently, I mean it's 2018. They were censured by the SEC because they're not using one, but they're using seven different ways of cheating and revenue. Seven. I've got more than seven in my course. I think I've got 15 ways you can cheat on revenue.

Will Page:

So you could fill a rugby team.

Stephan Clapham:

I mean, it's important to understand what the different ways you can do it are, in order that you can spot it because there's signals that companies give off and you go, "Oh, hang on a second. That sounds like number 12." So, I do go through the different ways you can cheat. And I mean, it's quite complicated. It's quite technical. It's actually very interesting because once you understand how people do it, then you're much better able to spot it.

Richard Kramer:

I mean, it sounds like human ingenuity knows no bounds, but one of our favorite phrases to throw out on Bubble Trouble is never expect a man to understand something when his job depends on not understanding it. And you mentioned there a moment ago, something that reminds me of the famous Manford Man song title Blinded By The Light. We see these spectacular growth numbers at companies. We hear them make incredible promises about what they're going to do in the future, and there must be some point at which it has to be one of these ingenious solutions to sustain these growth rates over time.

So, is there some sort of tipping point you can identify with companies, where it's just literally not possible that you can assume a company grows at multiple times GDP into perpetuity? Or that a company's numbers are .... I think we had a podcast of the same title, too smooth to be true because if you flip a coin a hundred times, you're going to get seven heads in a row sometimes.

Stephan Clapham:

Well, I mean, I think it's a difficult question to answer. And originally I thought you were talking about valuation and I was going to tell you about Adyen. And in September, 2021, I recorded the third episode of my podcast and my guests were Spencer Crowley, who's one of the co-founders of firstminute capital and Pete Davis of Landsdowne Partners, which just celebrated their 25th anniversary last week.

Richard Kramer:

Absolutely.

Stephan Clapham:

Pete's a genius and we spent a long time talking about venture, and I was then trying to talk about the stock market, and I was trying to get him to say that Adyen was expensive and he wouldn't really be drawn. Funnily enough, we'd had a conversation earlier in the street, Spencer, me and Mark Rubinstein, who has the Net Interest blog and been talking about the valuation of Adyen. And I remember saying to Mark, "How does this make any sense?"

And he says, "It didn't make any sense a month ago when it was half the share price." And so, I think the problem ... So, inverting this, the problem is that when you own a stock like that, you think you're a genius. If you asked Dan McCrum, why did people not listen? Wirecard, it's on the front page of the FT, saying it's a fraud. I don't even need to open the accounts because it's obvious they're a fraud. But then when you open the accounts and you find that it's got three billion euros in cash, it had a billion and a half in cash two years ago, and it's raised two euro bonds, one of 500, one of 750 million, you ask yourself, "Well, why does it need all that cash?"

The answer obvious, that it needed all that cash because the cash was fictitious. So, it needed to raise debt because have any money, but how could people look at that, so the juxtaposition of this bizarre balance sheet structure and the ft, how could people still own that share? And I've asked this of Dan, I mean I've interviewed him twice now, and he just says, "Well, when you believe you're a genius, the evidence to the contrary is not top of your agenda."

Richard Kramer:

But when I think of one particular fund manager at Jupiter who recorded a video talking about how Wirecard was exactly the sort of company that they'd done tons of due diligence on and felt compelled to own, then you're asking for a major cognitive dissonance event for them to renounce that belief. And isn't that market writ large?

Stephan Clapham:

And it's not just Wirecard, they have another stock in their portfolio that they shouldn't own. And I begged to go in and explain, no, wouldn't see me. So, I think Jupiter's an excellent firm. When I was in the sell side many years ago, I had a number of clients there. I thought they were really good. They're a client of mine today. Groups of them have done the forensic accounting course. But when you've got these large organizations, you've got people from all walks, you've got volume investors who tend to be more interested in my course, and you've got growth investors who don't really care about the balance sheet and they own a very dangerous stock. They've seen it go down quite a lot, but they didn't want to have the conversation when it was overvalued because they thought, why would I need to hear the opposite view?

Interestingly, I used to work with a guy who loved Goldman Sachs, so he was ... Why he got into the position that he did, I have no idea. But he was in this position because the principle of the firm thought he was really smart, he was intellectually very clever, but he couldn't run money to save his life. And he had no idea how to analyze a business, no idea how to interview a management team, no idea about anything that was of any use in the job as far as I could see.

And we owned this stock and he said, "Oh, you better put in your diary. I've got the Goldman's analyst coming in next week." And I said, "Well, why?" And he said, "Well, he's really bullish in the stock and we own ... " I can't remember how many tens or hundreds of millions of dollars we had of it, but we had a shit load of it. I said, "Well, why don't we get the Citigroup analyst in because he's a bear." "Oh no, he doesn't know what he's talking about, he's bearish."

I said, "Well, let's just think about this. If the Goldman analyst comes in, what's he going to tell us that's going to make us buy more?" "Oh crikey, we don't have enough of this." It's quite possible. But the Citigroup guy comes in, he might tell us something that we don't know and we might go, "Oh my goodness, what are we doing? Quick get out." And we might move that position by 300 bps.

So, what's the incremental return on the time invested in having that meeting? I'm not going to see the Goldman Sachs guy because A, I think he's an idiot, and B, I'm not going to learn anything.

Richard Kramer:

A is usually a good reason to stop the meeting at that point. But there you go. I want to ask one more question before we go to the break because when we look at some of our foundational podcasts and some of these things that we've called out, the one word that just absolutely drives me up the wall is adjusted.

Now, we'd all like to be able to adjust many things about our life. We'd like to adjust our looks, to look more gorgeous, or we'd like to adjust to our own personal balance sheets to make it look like we are wealthier. We'd like to adjust our ... How is it that these management teams get away with foisting these adjusted earnings numbers on the market? And fund managers accept that as somehow a viable measure of performance when it's clearly marking your own homework?

Stephan Clapham:

Why? Well, there's a huge sales job being done to convince people. I mean, I think I've got a certain amount of sympathy with the idea that having adjustment makes sense in certain circumstances. The amortization of customer-related intangibles as a result of an acquisition, it's not a very meaningful number if you're trying to calculate the real earnings power of a business. So, having a gap number and an adjusted earnings number excluding that adjustment seems to me perfectly reasonable.

Question that you're asking is why have people allowed it to become all encompassing and include things like stock-based comp? And I have no idea why people have accepted this. And if you're an institutional shareholder and one of your investee companies comes in and tries to persuade you that stock-based comp isn't an expense, I think you would have a very ... If it were me, I'd have a very long conversation with a guy and explain to him in great detail why he was stealing money out of my back pocket and how dare you misrepresent the economic performance of your business?

Because by the way, the value of the option which is frozen at the time the option is struck, is by no means a relevant economic assessment of the true cost to shareholders. And I've done this as a test and I did it on Twitter and Facebook, and admittedly I did it in times of tech where was more highly rated and the P and L charge was about 1.7 times ... The real cost was about 1.7 times the P and L charge. But the accounting rules are stupid and companies are stupid about giving the stock away because ... I mean, to some extent in some parts of Silicon Valley, you can't help but do it because you need to do it to attract people, but you should have a proper economic measurement of it and you should have proper charge of it, and you should understand what it's really costing you because it's incredibly expensive.

Richard Kramer:

Yeah, I think we should wrap up part one here on the issue of stock comp. For me, it's always been a question of duration. And if you're only holding the stock for a few minutes, you don't care. But if you're a real investor and you're going to get diluted, you absolutely should care. And I think, Stephen, you're 100% right to call it out. We'll be back in part two with Stephen Clapham in a moment to dig into some of the latest ongoings at the Bank of England and more about reporting quality and what's really happening with some of the bailouts and backstops of balance sheets. Back in a moment.

Will Page:

Back in part two with Bubble Trouble, myself, Richard Kramer and Stephen Clapham from the blog, Behind The Balance Sheet. And we are doing just that. And what I want to do to kick off part two was again, ask another dumb kid in the classroom question, assuming no prior knowledge. When I hear the term off balance sheet, where I hear the terminology of special purpose vehicles, or just getting bad news away from those accounts, again, treat me like that dumb kid in that classroom. What is the company doing when they get stuff off balance sheet? How do they set about doing it?

Stephan Clapham:

Well, they're deceiving you. They're making their balance sheet look better than it really is. And you shouldn't be surprised about this because and Behind The Balance Sheet isn't really a blog, we're training and research firm. So, we do bespoke research for a small group of institutional clients and hedge funds, and we train both professional investors and private investors in how to improve their skills. And we have a weekly newsletter and a monthly podcast, which are associated with those activities.

But the idea behind this off balance sheet, is just to make yourself look better than you are. I don't know if you remember the Green Sale explosion, so-

Richard Kramer:

It's only a couple years ago.

Stephan Clapham:

... I wrote about this two years ago. So, Mark Rubinstein and I did a joint blog just shortly after he started Net Interest. So, if your listeners haven't read Mark's Substack, netinterest.co, you definitely should go there after you've signed up on behindthebalancesheet.com for my newsletter.

And we wrote about this and we just couldn't get much interest in it at the time. And it was a very compelling piece. I mean, Mark writes really well, and I did this piece about Greensill's accounts was obviously, there was something wrong. And if you then had taken the accounts of the Credit Suisse Fund, which people were investing in, which ended up being about $ billion, they listed the companies that had participated in these off balance sheet financing structures. They include some well-known companies like Vodafone.

Richard Kramer:

Wow.

Stephan Clapham:

Now, you ask yourself, what possible reason would Vodafone have for financing using Greensill? Remember, that in order to raise the money from people, you had to give them quite an attractive yield. And then you have not just Credit Suisse taking a very small piece of the pie, as you can imagine, every investment bank is very conservative thinking about their end clients, but also Lex Greensill who had a fleet of aircraft to pay for and large estate in Australia, as well as a large estate in Cheshire to pay for and all other sorts of overheads that billionaires usually have. So, this money was obviously extremely expensive. Why would Vodafone need to use that?

Richard Kramer:

Unusual match?

Stephan Clapham:

I mean, there's a blindingly obvious reason, and that is because it was trying to make itself look like it had a stronger balance sheet than it actually did, or that's what I assumed they were doing. I don't actually know what the reason is. I never asked Vodafone. But it would appear that Vodafone was using this vehicle in order to reduce its working capital and make itself look like it had a stronger balance sheet than it really did.

And in addition to Vodafone, there were a long list of other stocks that were an obvious target for shorts. One of my pals, who's a short specialist, a very large hedge fund based in London, was using this as his watch list. If you were borrowing from Lex Greensill, well, you were going on his short book and the more you borrowed, the bigger the short.

His only problem was that the top 10 holdings in this fund were ... Not one of them was a real supply chain finance customer, not one. So, anybody that bothered to look at it, including the three Credit Suisse portfolio managers who were named as managers of the fund, obviously all the credits were being sourced by Greensill but they were managing the fund, not one of them, and includes two CFAs. I have asked whether the CFA Society has banned these people because the CFA is chartered financial analyst qualification doesn't enable you to commit fraud or be negligent in the execution of your responsibilities to the 10 billion euros of customers. I haven't managed to get an answer as to exactly what disciplinary proceedings are being executed against the two of the three individuals who've got the CFA qualification or the third who's got a Swiss qualification, which presumably carries an associated responsibility to do your job properly.

And the use of off balance sheet finance has gone through the roof. And it is a funny unintended consequence of free money because particularly ... there's more of a European issue than a US issue, but in Europe, if you've got cash, you had to pay negative interest. You have to pay the bank for the privilege of holding your cash.

Will Page:

Especially in Sweden.

Stephan Clapham:

So, what would you do? You'd think, "Oh, well, let's park the cash somewhere where we don't have to pay interest." And guess what? Lex Greensill and a bunch of other supply chain finance operators were happy to take your cash and give you some money back. So, there was a flood of corporations and high net worth individuals flooding the market with cheap, short-term money because it was better than paying UBS for the privilege of having it in the bank.

Will Page:

Wow. If I could switch lanes just very briefly from the private sector balance sheet to public sector ones, back in the 1800s, I used to be a government economist working under Gordon Bruin, and that was when the Labour Party really embraced the private finance initiative way of financing public services. And that was always declared as a way of getting these things off balance sheet as well. So, rather than you build a hospital for 300 million, give the private sector 30 million for 30 years and they'll build a hospital for you. Do you have any thoughts about why PFI was so attractive then and some of the problems that we've seen with it now?

Stephan Clapham:

Well, I mean, it was a license to print money, wasn't it? Government got terrible deal, got raped by the private sector. Surprise. I mean, the government probably did better than it might have done because in the US where they tend to be a bit more sophisticated about this sort of thing, the government's done quite a lot of privatization and the end customer, or the end supplier of the finance has been private equity. And private equity have had a field day, even though the US has been tighter in the arrangement.

I'm reading this book at the moment. The book is called Plunder. I've forgotten the name of the author, which is very embarrassing, but it's a really good book. And this book explains these private equity firms, how they've managed to operate things like the communications in a prison. And obviously, if you're a prisoner and you want to make a phone call, you don't have anywhere else you can go. Brendan Ballou.

Richard Kramer:

Private Equity's Plan To Pillage America.

Stephan Clapham:

Yeah, it's not a plan, it's a ... Well, it's a plan, but it's been executed. And so, the PFI was a good idea, perhaps. Badly executed, for sure. I mean, the privatizations, you look back on this and the idea behind it, it wasn't a bad idea, but guess what? Thames Water have been grossly negligent. The floods in London, I mean, you can't prove it. Massive stories about the pumps not being turned on in certain pumping stations. And the knowledge I've got is that that's right. I mean, I can't prove it, and I'm not asserting that Thames Water is negligent just for the avoidance of any doubt, should any Thames Water lawyers be listening in, I'm not accusing Thames Water of being negligent, but it does seem unusual that the company, the value of the company's gone through the roof. That we've had these incidences and we haven't really seen a huge amount of contrition apology or action from the company.

And that's just a symptom of the fact that if you give these assets the private sector without putting appropriate guardrails in place, then guess what? They'll screw the customer and pay themselves a shed load of money.

Richard Kramer:

Yeah, through-

Stephan Clapham:

And Thames Water has been a shocking instance. And the non-executive directors of Thames Water have been notable by their quietness and their failure to stand up and do anything. I would be looking at the amount of money these people are making and asking myself why.

Richard Kramer:

And in this particular case, they created seven layers of shell companies to insulate the directors from any liability for actually running what is a very tightly regulated business, supposedly under a very strict regulatory regime.

I want to spin from that into your recent Substack article about a potential impending crisis in private equity, because what's been clear for us is that private equity has been built for the last 15 years on incredibly cheap debt financing and the incredible sleight of hand which is carried interest, a way to avoid taxation.

So, I guess the question here is, you've suggested in this Substack article, which was a great piece, that this bubble will be bursting. What happens when you have 300 trillion or whatever it is, some ungodly amount of dry powder sitting in these private equity funds, but the ground underneath them, first of all, the debt and potentially the carried interest exemption might open up and swallow them whole? What's going to happen to these supposed masters of the universe, which were supposed to be adding all this value to distressed assets?

Stephan Clapham:

Well, they're going to be retiring to their Caribbean islands and putting their feet up because they aren't going to be spending the dry powder because the dry powder won't be there. What's going to happen is that the vast majority of this money is coming from pension funds and they're going to realize they've been conned and that the marks to market haven't been quite as marked as they should have been. If you give the kids their exam papers to mark your own homework, guess what will happen, right?

Richard Kramer:

Yeah.

Stephan Clapham:

And that's what's happening in private equity. So, what will happen is when it's been revealed that the kids haven't passed, but they've only got 43%, not 57%, then what will happen is that people say, "Well, hang on a second. You've lied to us and we're not giving you this dry powder." And I think this is going to happen on quite a large scale, and I've forgotten what the ... it's a trillion dollars or something.

So I mean, at some point, private equity will probably rush to spend it, but I mean, I think there'll be quite a lot of resistance by pension funds to actually giving up and honoring their commitments. And if this is done in a mass scale, then private equity won't be able to force it through. And there's a related issue, the equity problem is going to be some way down the road.

The first problem that's going to hit is credit, and you've got private credit, and two weeks ago I wrote about this. And the problem in private credit is you can't get any data. So I used a report by S&P and the numbers were quite staggering, but these are only the S&P rated credits. So, I couldn't find a similar report from Moody's about the Moody's rated credits, but there's a huge other hidden market leveraged loan market, which with unrated debt, and they're already ... There was an FT article last week. They've already seen defaults in the first five months of 2023, greater than the whole of 2022.

And guess what? Interest rates, well, they've stopped going up for a month, but well, the interest rates are going to carry on going up a bit further, maybe not forever, but what you always underestimate are the time lags in the system. If you put interest rates up, it might be 18 months before that increase in interest rates actually affects one of these private equity, highly leveraged investee companies.

So, I think it's going to be quite interesting because most of the private credit is owned by private equity companies. They're doing all the lending, as well as the borrowing. So, I think there there could be a huge mess. And we're going to look back on this and say, "How did they get away with not marking the marks properly?" I mean, anywhere you look, the Chinese tech sector, when was the last time you saw a goodwill write down in Chinese tech?

Richard Kramer:

Oh well, what you see instead, and again, I have a long experience with this, is acquisitions where the remainder of a business is bought out and then the goodwill is written up massively because now you get a control premium. But the complicity of the accounting firms in doing what the client has asked, or a recent podcast we had talking about SVB where they were damned by duration and they had the inconvenient issue of having to mark to market some of their treasuries sitting on their balance sheet, that these things do come out in the end with striking regularity.

Stephan Clapham:

I mean, the SVB thing was quite bizarre because I mean, if you looked at SVB balance sheet, the potential mark to market was actually noted on the face of the balance sheet. You don't even need to look at the notes. They're on the main page. I mean, how could you not know that?

Richard Kramer:

It may also have explained why there were a bunch of buy notes from Wells Fargo and Goldman Sachs on SVB the week before it went bust.

Will Page:

Real quickly, the GitHub Copilot case, which you may not be aware of, but just when this development between GitHub and Copilot came around the coding industry, people who code for living, thought they were toast. Oh my God, machine learning's going to replace the need for coders. That was the threat. Within six months, it's the opportunity. I know coders today say they're four times as more productive thanks to GitHub Copilot doing the donkey work so they can move themselves up market.

But your course trainer on where this could go is interesting. Where I would push back a little bit is, well, why bother with a waste and expense? I always quote a chief operating officer from a large international bank, a very large international bank, who said to me, "I spend $110 million a year on economic research and 97% goes unread." How many of those PDF reports, which are pouring out the banks today, just get lost in the long grass? And if you're a chief financial officer looking to cut costs, surely that's going to be an area where you can cut costs?

Stephan Clapham:

I don't disagree with that. I don't know why you would have $110 million on economic reports. That seems stupid.

Will Page:

That's head count, salaries, production costs, the whole shabam, my unit of producing this PDF Waterfall-

Stephan Clapham:

JP Morgan produce 150,000 reports a year and-

Richard Kramer:

Wow.

Stephan Clapham:

... there'll be three or four good ones in there, I'm sure. But the thing is, I mean, I think particularly with economics, people place far too much emphasis on the wrong things. So, I did my podcast this morning, recorded it with a guy who manages that $4 billion balanced fund. So, it's got equities, it's got commodities, it's got government bonds, it's got corporate bonds, very big mix. And we were talking about the influence of macro because obviously, if you're buying treasuries, you do have to have some understanding of what's happening in the wider economic picture.

But even there, you don't need a huge amount. And the people spend all their time worrying about the wrong things in finance. Love the conversation about, "Well, when will interest rates go up?" I was a member of an investment committee, and every month they would talk about when they thought interest rates would go up. And I kept saying to them, "Just forget this conversation because we're spending half an hour of our investment committee meeting every month and A, we don't know, and B, it doesn't matter because once they go up, then we can worry about it because the stock market carries on going up until well after interest rates have risen."

Now, the first interest rate rise never causes a stock market to crater, so you don't need to worry about it. And the same with a large number of-

Richard Kramer:

That's interesting.

Stephan Clapham:

... these economic forecasts. What advantage is there from having a bunch of people tell you what their target is for S&P 500 for the year end? I mean, I don't know who finds that information useful? I learn something new every day in the world of investing and maybe there is a use for that, that I just ... In all my years of experience, I've never come across to date. In a Substack towards the year end, rounding up 20 or 30 pieces of macro research, and I think there were one or two that were bearish and one or two that were bullish and most of them were somewhere in the middle.

I mean, I'm not saying that they were all garbage. There were a few things that I thought were genuinely interesting, but I didn't read 1,000 pages, but I had probably a couple of thousand pages in the folder that I just skimmed through and looked at executive summary and occasionally I would dig down into ... and I managed to summarize those thousands of pages into that many words. And the fact is that there's a huge amount of garbage produced by investment banks around the world that's a complete waste of time and nobody reads.

Richard Kramer:

And we need to get to the final bit of our show, which is when we ask our guests for a couple smoke signals. A couple of the kind of things you just said a moment ago, that people always focus on the wrong things. Well, what are those couple things that ... The phrases you hear, the excuses that get pushed back at you for why people don't want to know about flawed balance sheets, what are the kind of things that people should look out for?

Stephan Clapham:

Well, my favorite one that gets my hackles up is, you don't understand. So, the finance director or sometimes even the IR guy, will say, "Steve, I wish you hadn't published this note. You don't understand." The very first time I had this conversation was with the CFO of the fifth largest company in the UK and I'd written a sell note on the company.

It was overvalued, the accounts stank and they were doing all sorts of shenanigans. I had an hour on the phone with her and she concluded, "Steve, you don't understand." So, I just put the phone down and I said to the people in the print room, "Go ahead, publish, no changes." The next morning, I got a phone call from the bank. So, I was working in the research department of the investment bank part of a commercial bank. And the commercial bank called up and said, "Well, thanks very much." And I hadn't been there very long. And I said, "I'm sorry?" And they said, "They just pulled their credit line from us." So, they'd paid the commercial bank for the privilege of getting access to a line of credit.

And I said, "Well, look, I'm really sorry because obviously you've worked hard, you've nurtured this relationship and you've managed to get these fees, and I can see that if I were in your position, I'd be really cross. But all I can tell you is I'm doing my job to the best of my ability. And the fact that this finance structure has done this, suggests to me that they're really pissed off because I've pointed to the truth. And that company fell by 95% over the following three years, and they probably were glad that they didn't have a credit line because the last thing they wanted to do is give the company more money. So, that would be one of the smoke signals.

But there are three things that I teach students or young people to look at. When you're looking at company, there are three tests that will keep you out of trouble in the main. Are the margins sensible? Compare the margins with peers, with history. Ask yourself, do these margins make sense?

The second is, examine the working capital ratios. Are the working capital ratios reasonable? Has the company got rising debtor days? Rising inventory days? That's usually the sign of a problem because sales have been inflated or sales have been made up, or whatever. Another thing is to compare the earnings per share with the cash flow and ask yourself ... And I tend not to do it in earnings per share or earnings level, I tend to do it a slightly different way, but just look at the amount of ... People focus on profitability and have a look at the cash and is the cash, does that marry up? And if those three things are okay, then you're probably all right. And if one isn't right, or two isn't right, or three isn't right, you got more and more problems. And for most companies, for most frauds, all three are a negative signal.

Richard Kramer:

I think that's a great point to wrap up a lot of lessons for anybody listening in looking to spot the next bubbles, whether it's in private equity or just companies telling us, "We don't understand. We don't get it." There's a bright new future over the shining hill, just keep trudging up the mountain and don't worry about those boulders coming down. I want to thanks our guest, Stephen Clapham, renowned educator Behind The Balance Sheet author and teacher, and we'll be back next week with myself and Will Page to have another episode of Bubble Trouble. Thanks very much.

Stephan Clapham:

Thanks for having me.

Richard Kramer:

If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to your podcasts. Bubble Trouble is produced by Eric Nuzum, Jesse Baker and Julia Natt at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Until next time, from my co-host Will Page, I'm Richard Kramer.