Has narrative become more important than value on the stock market ?

Has narrative become more important than value on the stock market ?

28 July 2020Reading time: 6 minutes

"What's really going on?" is a key issue in politics, economics and financial markets. We humans are governed by preconceived notions and tendencies to see patterns even where there are none. We want to identify contexts in all events, so-called narratives, stories that are logically connected from beginning to end. Most often, these narratives at best have only a small core of truth, while the rest is an illusion created by the brain for us to feel in control of what is happening.

Reality is basically random, ie many more things could have happened than actually did. A roll of the dice can just as easily have an outcome of 1 as 6, or 3, 4, 5 or 2, but in practice the roll will only result in a single one of these. This outcome was only 1/6 likely to materialize, but did so nonetheless. Our desire to find stories still means that, for example, the number 6 (and maybe even one) is considered more unusual than the others, simply because it is most worthy and desirable.

Trends, hype and bubbles often begin in some kind of truth, a positive development for an innovation, a company, an industry or a country. A positive feedback loop between the economy and the financial market can drive the trend both in reality and on the stock exchange at the same time. During the IT frenzy in the late 1990s, newly listed companies used both their issue money and the stock market platform for marketing, which drove demand for both the products and the shares. We see similar phenomena now in e.g. electric cars, teleworking software, entertainment and vaccine development. There is, or at least was, a core of truth, but since then the narrative has taken over developments in both the real economy and the financial markets.

The development has been driven further by generally supportive narratives such as TINA (there are no alternatives to equities, because it is the only place with potential for positive returns), High Risk Gives High Returns (which misses that risk means probability of negative returns; the narrative is misleading deleted the word “can” in “can give high returns”), Do not Fight The Fed (do not sell stocks as long as central banks lower interest rates or print money), and Time In The Market (this narrative suggests that the biggest risk one can take is not to be invested in risky assets, which dangerously ignores the importance of paying the right price for an asset).

A narrative that has been on the rise in recent years concerns value-based investments, ie the idea of paying the right price for an asset, a price that reflects the cash flows the asset can be expected to give rise to. For over ten years, the so-called Value stocks underperformed Growth. The other day, the giant asset manager BlackRock spoke on the issue. Chief Quantity Officer Jeff Shen believes that there is no point in trying to make investment decisions that compare the share price with the so-called fundamental accounting data such as sales, profit, equity or cash flow. It is better to look for useful connections between the course and completely different types of data on, for example, social media or news sites. It can be said that BlackRock considers it easier to find the market's next incipient narrative in other data series than in the final value variables. That happens to be exactly what a value investor does.

Of course, a true value investor does not search one-dimensionally only among stocks with low multiples for accounting measures such as sales, cash flow and equity, and rates them with high multiples. No, a sophisticated value investor (ie all value investors worthy of the name) is looking for all companies, fast growing or not, with high or low multiples today, which with a sufficiently high probability and safety margin (please read Margin Of Safety) can deliver a future cash flow that is sufficient high to give an approved return on the amount invested.

Personally, regardless of the interest rate environment, I usually demand at least a 10% annual return to be interested in an investment, but I can wait for five years before the investment's underlying cash flow reaches that level. Even further if I judge that the growth and future profitability means that the effective annual interest rate will later exceed my requirement. It is simply a matter of the right price, the degree of uncertainty in the forecasts and a risk-compensating safety margin regarding the level of return.

In summary, narratives are extremely important for choosing the right investments on the stock market. The sooner you can identify and ride a story that many will join, the more you can earn. But make sure you know when you are riding a hype or bubble with minimal seed of substance, and when you actually have a protective value base. MFANGST companies have attractive narratives and unparalleled share price developments, but if these cannot be exchanged for actual cash flows in the future that correspond to the price you pay, sooner or later the shares must be sold to someone who can eat up the difference as a loss. If you pay 200 for a cash flow of 100, you have lost 100 if you do not manage to sell it for 250 to someone else, but then you end up with a loss of 150 instead. Right now, the narrative is that the chain can last forever and that no one needs to take the loss. I think that narrative is really dangerous to get carried away with, if you do not have a plan B to step off the pyramid scheme in time and invest the capital in something that is likely to create a higher cash flow than you pay.

No, Value is not dead forever, but Value can of course still continue to underperform on the stock market for a while longer. In the meantime, you may dare to ride narratives based on V-recovery, positive profit warnings, vaccine successes, winning the presidential election, video conferencing and video streaming. Still, think about how you should time when the stories turn to focus on new stories such as small companies and the business cycle. Do not try to be first or dot the top perfectly, but it would be a shame if you were last in both FANGS / TINA and in the transition to Value. The next phase may come after the presidential election this autumn, or it will take another four years. The probability that we are in a new paradigm where a cash flow in does not require a cash flow in repayment is as low as the fact that the basic psychology of people has suddenly changed forever. No, the economy and the stock market have always been governed by narratives, which in recurring cycles have driven economic cycles and values to extreme bottoms and peaks. Your task is to think about what the current narrative is right now, and what may be going on as the next based on what is really happening behind the spectacular and convincing spectacle.

@Mikael Syding

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06/08/2020 20:44:15


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