When it comes to investing in stock market, the power of “the story” is very strong. But unlike the fairy tales, most stories here have an ugly ending.
Remember the story of Cinderella? And how she seemed plain and peasantly? With the help of her fairy godmother, Cinderella was able to turn her pumpkin, mice, rat, and lizards into her coach, horses, coachman, and footmen.
I can relate this story of Cinderella to the stock market. To find a stock worth investing in, you’ve got to search for your own Cinderella – a story worth believing in, but which is ignored or looked down upon by most other people.
The problem is, most investors end up stumbling onto story stocks that have ugly endings. A large part of this is because the hottest selling stories in the stock market are often those where the storytellers are looking for bigger fools to offload their own junk before the stories turn sour. And they often manage to find a lot of such believers (often small, gullible investors) for their stories You see, as investors, we all are on the receiving end of sales pitches from brokers, friends, investment advisors, fellow investors, and bloggers in media, stock forums, and social media about stocks that they claim will deliver spectacular returns. These stories not only sound persuasive and reasonable but are also backed up by evidence – anecdotal, in some cases, and statistical, in others – that the strategies work. I am sure you have often read stuff like these in media –
• Small-cap stock backed by famous investors like ABC and XYZ has “tremendous potential”
• 5 multibagger stocks picked by ABC are set to soar
• XYZ multibagger stock is set to multiply 10x in next 3 years
• 5 Indian stocks Warren Buffett would buy and why
These are nothing but stories that are hyped under the pretext of “what has worked in the past will surely work in the future.”
The irony is that when you try to implement such stories for your investments, you seldom can match their success on paper. All too often, you end up with buyer’s remorse, poorer for the experience and promising yourselves that you will not fall for the allure of these stories again. All too often, you forget the lessons of past mistakes and are easy prey for the next big stock story.
Now, while there are literally hundreds of schemes and stories to beat the market in circulation, they are all variants of about a few basic themes that have been around for as long as there have been stocks to buy and sell.
These broad themes are modified, given new names and marketed as new and different investment strategies by salespeople to a new generation of investors. There must be something in these stories that appeals to investor instincts and to human weaknesses – greed, fear and hubris, to name but three – to give them the staying power that they do.
Of course, with each story, there is a kernel of truth that makes it believable and a base in financial theory that allows proponents to claim to have a solid rationale.
Power of a Story
Aswath Damodaran wrote this in his book Investment Fables…
Investing is full of stories that sound good when they are told but don’t hold up under close scrutiny. Consider a few: Buy stock in good companies and the returns will surely follow. Buy after bad news. Buy after good news. Stocks always win in the long term. Follow the insiders. Buy stocks with big dividends. Buy stocks that have gone down the most. Go with stocks that have gone up the most.
We humans are much more likely to be swayed by good stories than they are by graphs and numbers. The most effective sales pitches to investors tell a compelling story, backed up by anecdotal evidence. But what makes a story compelling in the first place? I find two big reasons for the same –
1. Most good investment stories appeal to a fundamental component of human nature, whether it be greed, hope, fear, or envy. In fact, what often sets apart successful investment salespeople from unsuccessful ones is their uncanny ability to gauge an investor’s weak spots and create a story to take advantage of them.
2. Good investment stories are also backed up by the evidence, at least as presented by the storyteller. Though, the evidence may only tell part of the story and much of what is presented as irrefutable proof of the effectiveness of an investment strategy falls apart on closer examination.
Types of Investment Stories
Like fairy tales and children’s toys that come in all forms, even investment stories have a great amount of variety. Some are designed to appeal to conservative investors, and those talk about low-risk ways to play the stock market. Such stories include –
• Buy stocks with low price-to-earnings (P/E) or price-to-book value (P/BV) – Such stocks are traditionally considered cheap and, in fact, a lot of investors confuse value investing with buying such stocks. The story part is when these low P/E or P/BV stocks are sold as safe stocks, irrespective of the underlying business’s fundamentals. Some things are cheap for a reason, but this fact is hidden from the storyteller’s (broker, analyst etc.) script. Even a lot of investors fool themselves while buying bad businesses just because they are trading at cheap price multiples. Think what people did with stocks like Suzlon and Kingfisher when these were trading at rock-bottom P/BVs. And then, the bottom fell off!
• Buy stocks with stable earnings – Thus is surely a foundation of simple, sensible, long term investing – buy businesses that show stable earnings growth and performance. But it’s easy to get blinded when any level of valuations is justified for such businesses as the analyst predicts the stability to continue in the future. Investors bend over their backs to purchase such stocks, as “nothing could go wrong.” And then a Hawkins happens.
The second category of investment stories are oriented toward risk seekers who want to get rich quickly; these stories emphasize the potential upside and hardly ever talk about the downside risk. These are stories like –
• Buy great companies – Well, “greatness” has been replaced with “moat” these days…and any business that is doing good, financially or in the stock market, is called as having a ‘moat’.
To top it, there is a new category of investors who are searching for “emerging moats” or companies that will become great in the future, which sounds nothing more than a delusion.
The biggest problem with such stocks is that a quarter of two of lower than expected earnings can hurt investors big time. Of course, there is a great merit in buying businesses that are great or that have proven themselves in the past. But it’s important for you to separate the story from the stock and then answer – “Can something go wrong?” and “Do I have adequate margin of safety?”
• Buy growth stocks – This story is sold to people who are fine buying stocks primarily for their price appreciation, downside risk be damned. The idea is that high earnings multiples that such stocks command will only translate into even higher prices as the earnings grow over time.
So there are two big assumptions at play here – one, earnings will continue to rise and two, the price multiples will remain high or rise even further. Such stocks often provide no margin of safety, but investors often realize this when their expectations of high earnings growth and price appreciation are dashed.
The third category of investment stories are structured for those who believe that you can get something for nothing if you are smarter or better prepared than others in the market. Such stories often take the following forms –
• Buy companies growing faster than faster – Such stories are for those who want to move beyond high growth in quick time. These are sold to impatient investors who want their payoff now, as the wait can seem endless. And these often include buying stocks of companies that are accelerating their growth process by acquiring other companies. The lure for such companies is often great during bull markets because the investment bankers also join the storytellers list. Thinks stocks like 3i Infotech and Opto Circuits.
• Buy momentum stocks – To some investors, a low-risk and high-return strategy is to buy stocks that are
going up and to go along for the ride. Implicit in this strategy is the assumption that there is significant momentum in stock prices – stocks that go up will continue to go up and stocks that go down will continue to go down. Here, the chartists and technical analysts also add to the noise. The issue is that people who buy such stories fail to realize that the momentum that may have worked for them or others in the past, can turn as quickly against them.
Finally, there are investment stories for the optimists who believe that you always win in the long term. These are stories like –
Stocks always do well in the long term – This story is often told to new investors in the stock market. In fact, it has almost become conventional wisdom that the stock market may have a bad year or even a string of bad years but that stocks always win in the long term. Take any 10-year period in market history, you will be told, and stocks have done better than bonds.
The big problem with such a story is that gullible investors buy any and every stock that comes their way just because things will definitely be good in the long run. Then, this is exactly the story people who average stocks on the down tell themselves – “Let me average my costs down because this stock will surely do well in the long run.”
Consider here stocks from the real estate and infrastructure sectors that are still down 90%+ from their peak levels of 2008. If you own any of them, I am sure you have told this story to yourself several times over the past few years.
The Tragedy with Story Stocks
Remember that humans have a tragic tendency: The more we know about a stock’s story, the more likely we are to believe in it having a happy ending, even though our accuracy in picking winners doesn’t go up at all.
That’s why you need to stay away from most story stocks, they usually have bad endings.
The true happy endings are to be found through sensible analysis and after considering adequate margin of safety, however rosy the story might sound.
Isolating the Truth from the Story
Now, each story type I have profiled above has the potential for success if you are able to find the real truth behind it and then use it. But still –
• Even if you think that you have discovered the ultimate investment story that has a high probability of a happy ending, you should be curious about what would make the story work in your favour. This will allow you to modify and adjust the storyline as the world changes around you and you change your mind accordingly. For instance, before you start to believe that all stocks with low price-to-earnings (P/E) become great investments, know whether this has been true in the past or not. Of course, this sound logical because you are buying stocks at low valuations, but then there have been numerous cases where stocks selling at 5x P/E have fallen to 1x P/E.
• Remember that not all stories, however beautiful they may sound, will have happy endings. Take the case of moat stocks, which have been accorded super-normal valuations because investors consider their underlying businesses to be too great to fail or suffer. But if you were to ask me if many stocks from the sector are safe or defensives now, at P/Es of 60-90x, my answer will be ‘No!’ In short, what was defensive earlier might be dangerous now.
• Know that every story also has its villain – the weak spot. For instance, when you look at low P/E stocks, there might be two primary concerns that you may encounter – one, these stocks might not have much growth in earnings to offer, and two, they may be very risky (and that’s why the P/E could be so low).
Overall, most stock market stories that we read and hear in the media across bull and bear markets are for the optimists who believe that one will always win in the long term.
In good times, they tell you the story, “This time it’s different! This market will continue to scale new peaks because the Indian economy is going great guns, China is booming, US and Europe are consuming big time, etc. etc. You should expect to see your stocks double in six months.”
You believe them…and double your investment in stocks.
In bad times, they say, “Don’t worry! Given the law of averages, we will be back to great times very soon! So hold on to your stocks. Be a long term investor.” You again believe them….and average your dud stocks.
So, when it comes to investing in stock market, the power of “the story” is very strong. But your job must not be to just be a silent listener. Your job must be to bring the story into scrutiny and see if that really holds true.
In other words, you need to get past the story-telling because it’s easy to fall into it saying, “Hey, this company is worth a lot!” or “If this is on Safal Niveshak, there must be a great story behind it!”