The Eye of the Beholder

Securities represent different things to different people over different time horizons.

Over very long time horizons, common stocks represent residual claims on assets and cash flow and will trade accordingly.

Over different time horizons, common stocks can represent other things, and their “meaning” will vary across market participants. Sometimes a stock is a correlation. Sometimes it’s an industry exposure. Sometimes it’s liquidity (or the absence of liquidity).

You’ll often hear traders, analysts and portfolio managers say “such-and-such trades as a whatsit.” What they’re talking about is the dominant meaning of the security in the minds of market participants at a particular point in time.

For fundamental investors, valuation multiples are straightforward examples. They’re quantitative markers of meaning. Embedded in every valuation multiple are assumptions about a business. Everyone reading this post is probably familiar with the price/earnings ratio. Like all multiples, a “justified” version of the P/E can be constructed out of several fundamental data points.

In the case of the justified P/E, we have:

Justified P/E = Dividend Payout Ratio / (Cost of Equity – Dividend Growth Rate)

We can decompose other multiples in similar ways. Ultimately, the exercise boils down to a handful of key variables: margins; returns on capital; reinvestment needs and opportunities; a measure of opportunity cost to the investor (discount rate). Of course, a reasonably perceptive investor also realizes returns on capital are unlikely to remain static over time. You’ve got to account for the impact of competition and market saturation. How aggressively should you fade growth and profitability? The answer to that is probabilistic. It’s where qualitative judgments about a business and its management are made and then transformed into quantitative inputs.

Narrative exists at the intersection of subjective, qualitative judgments and “hard data.” Likewise, it’s at this intersection of subjective, qualitative judgments and hard data that reflexivity operates.  

Aswath Damodaran does a fantastic job of recognizing this whenever he values a stock. For an example, you can look at his Lyft valuation. You can agree or disagree with his view of Lyft. What I appreciate about his approach is that it’s explicit about incorporating Narrative, and tying his quantitative assumptions to his qualitative ones.

I’m using Narrative with a capital N here because I’m not talking about spin. I’m talking about meaning. It’s easy for a reasonably competent analyst or portfolio manager to see through spin. Scammy penny stock newsletters are full of spin. Sell-side research, taken at face value, is full of spin. Spin is straightforward to test with a research process. Spin is amenable to number crunching. Developing the vision to see through spin is table stakes in both trading and investing.

Meaning, on the other hand, is necessarily more nuanced. Meaning is reflexive. Because it’s reflexive, meaning isn’t straightforward to test with a research process. It’s Schroedinger’s Cat. The cat is both alive and dead until you look inside the box. A company is both a value play and a value trap until events run their course. A stock is both a buy and a sell until the price moves decisively in one direction or another. The trading action around every stock reflects a dynamic dialogue between buyers and sellers about meaning. Sometimes, in the case of an Herbalife or a Tesla, dialogue escalates into a shouting match. In markets as in real life, shouting matches exhibit different dynamics than measured dialogues. You trade a shouting match differently than you trade a dialogue. Particularly if you’re short.

As far as your P&L is concerned, price is the arbiter of truth. Price is the only truth that matters. For all its faults, technical analysis is spot-on in emphasizing this.

“Dead money” stocks lack meaning. They lack strong, directional Narrative. They’re neither longs nor shorts. They’re empty vessels, drifting listlessly in the markets. To “work” in either direction, a stock requires a Narrative. To borrow the language of a technician, a stock without a clear directional Narrative is a stock that’s “consolidating” or “range-bound” between strong levels of support and resistance. Of course, you can still make money off these stocks. The trick is to see them as trades rather than investments–to see your position as a bet for or against the emergence of a strong directional Narrative.

This also helps explain why well-covered, large cap stocks still exhibit significant price volatility. It’s precisely because they’re well-covered. They’re perfect vessels for Narrative. Prices don’t swing on data so much as changes in the meaning of the data.

The following conditions must be present for strong directional Narratives to emerge:

• A coherent and compelling qualitative story
• Quantitative data supportive of the story
• A missionary (or missionaries) with credibility and reach telling the story

Together, these conditions are reflexive. They can exhibit both positive and negative feedback loops. Investment manias (dot-coms, cryptocurrency) are special cases involving especially powerful feedback loops. I am thinking of writing up a “case study” or two in the next couple of weeks to flesh this out in more concrete terms.