The book Sapiens by Yuval Noah Harari builds a theory that what connects us humans is the belief in a story. The story does not have to be real, in fact more often that not it contradicts with nature. How else do you get 5,000 crusaders who have no connection to each other to go and fight in a foreign land against an enemy they have never met. They rally around the story of religion, that is what connects them.
This story telling is built into us genetically, it is the reason for our success as a species. It can also be one of our greatest traps, especially in the field of investing.
In the equity markets we see this all the time. The story is told and we immediately latch on to it. It sounds reasonable, and any valuation whether qualitative or quantitative is up in the air, pick a number and justify the story.
In a recent interview with LiveWire Steve Johnson from Forager Funds made some great comments re the narrative fallacy. See the link here and the relevant point starts around 13:25.
“People are very susceptible towards believing a story rather than thinking about the value of a business”.
“The most important thing is what price am I paying for that (story) and what are the competitive dynamics going to be. What stops a lot of capital coming into that industry that’s got a great story behind it and competing away those returns.”
Over a number of years we have all seen this narrative play out. Investors have dismissed the negative cash flow in the business and hoped the narrative will turn these into profitable numbers.
Without wanting to pick on a particular share as hindsight bias is another investor demon, but look at the 1-Page (1PG) announcement made recently. 1PG sold its US based business and its liabilities for $1. Here is a company that was valued in excess of $700m a couple of years ago.
In hindsight this is obvious, $700m for a company that has minimal revenue and is burning cash quarter after quarter, c’mon. However in the middle of the journey there are lots of reasons we use to justify why this one will work out, it is never that obvious as the stock doubles and triples. Price rise reinforces the story and the flywheel feeds on itself.
So importantly we need to question the story, and as Steve Johnson pointed out, the story might be great but think about what price you are paying for this. Our job as investors is to see through the story. We have to dig deeper and we have to examine what are the factors at play and build a framework that questions the narrative.
One of my favourite articles that I regularly read to remind me of this was written in 2014 by Tom Brakke called “Cracking the Narrative“. The article discusses the idea from evaluating a prospective asset manager to place our money with. But the thought model equally applies to cracking the narrative on an individual share.
“….Those on the other side of the table — asset owners, consultants, and advisors — should have a different goal entirely: to crack the narrative. Not for the purpose of being antagonistic, but because their responsibilities demand it.”
“Superior due diligence involves an attempt to crack the narrative, not to repeat it for consumption elsewhere. An evaluation process is at its best when it exposes the shortcomings that exist (there always are some) and weighs them appropriately in the body of evidence. It is at its worst when the words and stories of those being evaluated become the words and stories of those who are supposed to be doing the evaluation”.
It is easy and sometimes very profitable to ride the narrative. When the market is going your way then price reinforces this narrative.
However when the market turns against you and you have not done the work to establish what the value of the business is, that is when you realise that you have paid dearly for the story. You are left holding and hoping and eventually you find yourself being quoted in Bagholder quotes, and that is the last place you want to be.