Monday, September 30th, 2019
narratives everywhere

If you’ve followed my writing or been at one of my presentations, you know that I’m hung up on the narratives that pervade the investment ecosystem.

A posting from five years agothe research puzzle | It was titled, “cracking the narrative.” outlined the need for asset managers to craft an “effective and truthful” narrative, while stating that the main job of the allocators of capital is to crack that narrative.

My subsequent speech at a CFA conferencetjb research | Here is the transcript. included the word “narrative” sixteen times during a relatively short section (among them, referencing asset management firms as “narrative-creation machines”), and my workshopstjb research | I offer both public workshops and customized ones for individual organizations. on due diligence and manager selection offer strategies to sort the real process, philosophy, culture, etc. from the marketed version.

Like I said, I’m hung up on narratives.  And I’m not alone.

Robert Shiller is coming out with a book this week, Narrative Economics.Princeton University Press | Here’s the publisher’s description.  The subtitle, “How Stories Go Viral and Drive Major Economic Events,” indicates his basic premise, that economists should be paying closer attention to those viral stories and the impact that they have on economic behavior.  (An articleNew York Times | The article lays out Shiller’s basic thesis. and academic paperSSRN | It was released in 2017. by Shiller provide shorter examinations of the topic.)

The popular Epsilon Theory website has been influential in sharpening the focus on the economic, political, and cultural narratives that form the conceptual framework within which we operate.  Writing for the site, Ben Hunt takes exception to Shiller’s point of view:  “I can't express strongly enough how dangerous I think it is to conceptualize narrative as a contagious disease, rather than as the medium of a social game — the Common Knowledge Game.”Epsilon Theory | The posting is called, “Narrative is not a Disease.  Narrative is Us.”  If you read ET regularly, you’ll find yourself thinking more about that game and the “common knowledge” that drives the practices of the investment world.  (A bonus question for you:  Which tenets of it will crumble over the coming years?)

Taking a step back from the big picture to focus on the micro, Aswath Damodaran’s Narrative and NumbersColumbia University Press | It was published in 2017. is required reading for those who analyze companies.  In it, he references two tribes of investment people — the number crunchers and the storytellers — but makes a persuasive case that valuing a company well (and communicating your views effectively) requires using both sets of skills.

Throughout the book, Damodaran offers several frameworks to use, starting with the steps of “the story-to-numbers process”:  1) develop a narrative for the business you are valuing; 2) test the narrative to see if it is possible, plausible, and probable; 3) convert the narrative into drivers of value; 4) connect the drivers of value to a valuation; and 5) keep the feedback loop open.  He then uses a number of case studies of well-known companies and the actual valuations that he had prepared over the years to illustrate those five steps.

As with broader narratives, our job is to bring skepticism and analysis to bear to see whether the stories told by companies and the analysts who cover them make sense.  It’s usually not easy; there’s nothing quite as powerful as a well-told tale.  And when that tale leverages the power that we ascribe to numbers, we are subject to illusions of precision, objectivity, and control (by those who appear to have their hands on the wheel).

Damodaran’s categories of the possible, plausible, and probable are a helpful place to start, although, as he points out, flipping the frame to impossible, implausible, and improbable can work better to analyze a situation.  In the impossible category, for example, you can find examples of analysts whose assumptions lead to a company being bigger than the economy or the market it’s in — or having greater than 100% margins or costless capital.  Basic mistakes, to be sure, but ones that can be implicitly embedded into forecasts and stock pitches without much scrutiny.

Forecasting comes with the territory in putting together the valuation of a company, but most of us aren’t very good at it.  (See Superforecasting.Penguin Random House | Despite the popularity of this book, very few investment organizations have incorporated its precepts into their processes.)  As Damodaran writes, “After all, if you have a woeful track record in forecasting oil prices, and the bulk of your story on Conoco is built on your oil price forecasts, I should be skeptical about your final valuation.”

Among the strategies for improving your own valuation work (or vetting that of others) are getting away from single-point estimates, considering the different shapes of distributions that are appropriate for different variables, creating alternative narratives to the one being presented, and asking a series of questions to help you deconstruct and evaluate the reasonableness of the valuation at hand.  Always important:  getting out of the echo chamber of confirmation and using feedback loops to change your mind when warranted.  Damodaran’s examples demonstrate how his thinking evolved over time regarding the companies that are examined in the book.

The author’s ability to clearly explain his choices will be familiar to those who regularly read his blog.Musings on Markets | Here, for example, are his thoughts about recent events in the IPO market.  His simple layouts of assumptions are models for analysts who struggle to convey their ideas in a logical fashion.  And I particularly liked a series of corporate life cycle charts throughout the book that showed at each stage the varying connection between narrative and numbers, the migration across investor types and preferences, the relationship of price to value, the questions that are most important, and many other considerations.

While Damodaran focused on companies and their stocks, I found the material broadly applicable in a world where there are narratives everywhere.  I have notes inspired by it that relate to a small (non-investment) private company I’m working on, a project regarding the challenges facing asset managers today, the quarterly newsletter that I send to “young analysts,”Gumroad | They are sent to the buyers of “Letters to a Young Analyst.”  Damodaran was a contributor to the book. and the manager research workshops that I lead.

And the themes also apply to those big narratives that Hunt and Shiller address.  No matter the size of the issue at hand, we must recognize the stories that drive our perception, admit our attraction to them, and design disciplined ways to analyze and react to them.