People love a good story and the market is an endless supply of tragedy and possibilities. You just have to pick the right script.
Tales get told every day about why the market did what it did, why a stock went up or down, or how some bit of news affects markets going forward.
It’s just stories…tall tales…fairy tales…sometimes…that can help make sense of the information because a narrative is easier to digest than all the data. This works out well if the stories take an objective view, but that’s not always the case.
Instead, we often get cherry-picked data to create a good story or fit some preconceived conclusion. Or we string together a series of data to explain how and why something happened and how it impacts the future when really it was a series of random events (since random, luck, and chance don’t add a sense of certainty, we create a story instead).
Story stocks thrive on this:
Today’s investment herd loves a good story. Last year, the story of rapid growth leading eventually toward profitability topped investors’ bestseller lists. Widely portrayed as non-fiction and sometimes masquerading as biography, it turned out to be science fiction. Today, a popular tale involves more elements than growth alone; a good story stock must occupy a compelling and growing business niche, and possess strong market share, an able management, present or foreseeable earnings (or at least cash flow), and results that repeatedly exceed analyst expectations. These factors usually cause a stock to possess a high valuation multiple and an esteemed position in a major market index. Then, in a virtuous circle, this stock market success allows the attraction and retention of able employees through the use of stock options in compensation. Frequently, bookkeeping strings are pulled to manipulate reported results into a steadily rising pattern. The net result is that management and shareholders, for at least a while, become wealthier.
If Paul Harvey’s serialized radio program “The Rest of the Story” were applied to Wall Street, it would describe the sad denouement of many such “story” stocks. The unraveling of the virtuous circle of growth is not pretty, with earnings shortfalls, plunging share prices, employees with underwater options jumping ship, overzealous shareholders receiving margin calls, accounting chicanery exposed, lawsuits filed, and, to come full circle, the final insult of deletion from the relevant major market index. — Seth Klarman
Every once in a while these stories have dramatic effects on markets like the epic driving Internet stocks. They were an endless sea of possibilities.
“Just monetized all the eyeballs,” they said.
The market was right to a degree, it just failed to understand how long it would take. The internet became a hugely profitable business opportunity. But it took over a decade for the technology, hardware, infrastructure, and business models to catch up to the possibilities.
But it all happened because investors were convinced that “eyeballs” was a better valuation tool than earnings or cash flows.
As most companies are losing money, traditional valuation tools have been rendered useless. In addition, the public markets are quite eager to accept companies at an earlier and earlier stage in terms of both revenue and earnings. The average time from venture capital investment to the year of an IPO has dropped from 6.5 years in 1995 to about 2.5 years in 1999. We even have begun to see an increase in Internet companies going public with little or no revenues (Stamps.com, for example). It’s hard to have even a proxy when your company has no revenues or customers.
As public market investors begin to evaluate younger and younger companies, their valuation tools become limited to subjective notions such as quality of the team and the uniqueness and boldness of the idea. In other words, if there isn’t enough proof that a business already exists, then they must make a judgment as to whether one will.
This typically boils down to the executive’s ability to convince the investor community that (1) the opportunity exists, and (2) his or her company will execute against this opportunity. Like it or not, the skill we are talking about here is storytelling, and just as with proxy valuations, the executive is now trying to influence the consideration of the investor. — Bill Gurley
These stocks needed a great story because the fundamentals didn’t exist. CEOs had to spin a yarn just to get people interested. And what a yarn they spun.
The better VCs understood the risks and had the mindset and longer-term commitment to handle it. The average investors in the public markets didn’t (still don’t).
So what happens when a bunch of early-stage startups with a great story – requiring a specific mindset – are dumped onto a public market – with the opposite mindset – showing second by second price updates? The aftermath tells that tale.
Seth Klarman: 2000 Baupost Letter
Bill Gurley: The Importance of Storytelling
- Following The Stock Market Is Bad For Your Returns – The Fat Pitch
- The Freakishly Strong Base – M. Housel
- Interview with Morgan Housel – Safal Niveshak
- Jason Zweig Interview: Guard Against Complacency – ETF.com
- Lessons for 2017 from a Man Who ‘Called’ the ’29 Crash – J. Zweig
- The Bubble That Never Came (and Other Misconceptions about Treasury Bonds) – Research Affiliates
- Investors Expect Returns of 10.2%. Millennials Hoping for More – Schroders
- Low Returns Are a Feature of Markets, Not a Bug – B. Carlson
- Follow The 10,000-Experiment Rule – Medium
- The Trouble With Scientists – Nautilus
- The Web Began Dying in 2014, Here’s How – A. Staltz
- Bitcoin Backlash: Back to the Drawing Board? – Musings on Markets