Every stock carries a narrative. Hopefully this narrative has been borne from numbers. But, two people can look at the same set of facts and come to opposing conclusions—this is the basis of the narrative fallacy.
Narratives are intrinsically powerful to us mere mortals because we all want to make sense of the world. Seeing logical causes and effects makes us feel safe, more shielded from the randomness of reality.
But prevailing narratives, particularly those embedded in the stock market, can be detrimental especially to the average investor when they do not reflect reality but rather the opinion of the crowd.
Though behavioral biases have come into vogue more recently, ideas like the narrative fallacy have been around for as long as the stock market has been around.
Even back in the 1950’s, great investors like Philip Fisher have noted how easily the crowd can come to conclusions and dismiss facts based on preconceived beliefs. Fisher wrote about it in his bestselling classic Common Stocks and Uncommon Profits, telling a great story about the narrative of analysts in his day:
Our interest should be in why this normally able investment man would take this set of facts and derive from it a quite different conclusion as to the intrinsic value of the stock than he would have derived from the same facts in some other year.
Fisher knew then what we should know now—that the narrative fallacy can cripple our chances of outstanding success especially in a place so easily influenced by group think as the stock market.
How the Crowd is Always Wrong
I love the examples that Fisher provides in his book because we can see how much history rhymes.
Seeing the fads and narratives back in his day helps us to identify those kinds of fallacies in the stocks and industries we follow today, and make sense of why certain stocks always seem like a great deal in hindsight, when it turns out that the prevailing narrative was the wrong one.
Take the example Fisher shares about why investors didn’t respect the explosion of earnings emanating from the Dow company in the post World War II period.
With one simple example, we get a combination of narrative fallacy and recency bias all packaged nicely in one lesson.
Fisher talks about how he was talking to a man who was very well connected with the financial community at the time, who served as the president of the “New York Society of Security Analysts”.
Again, the Dow company had just enjoyed extremely high levels of earnings and from a numbers perspective screamed a great value and buy.
But at the time, Wall Street was not properly appreciating the postwar boom in profits from Dow and other similar companies precisely because they were occurring in the postwar period, and that there were major depressions which followed both of the previous two postwar periods—the Civil War and World War I.
Since earnings fell shortly after those two major wars, Wall Street assumed (perhaps not illogically) that earnings and the economy would also compress soon, making the most recent year’s earnings not representative of the true long term value of these companies.
Of course, the problem with the narrative fallacy is that oftentimes narratives can be completely wrong, as was the case with Dow and many other companies to follow.
Investors who bought into that narrative fallacy would’ve seen the same set of facts, explosive and growing earnings, and assigned different valuations to those facts only to see their assumptions proven wrong in the years to come.
But rather than being the exception, you’ll start to recognize this common behavioral bias as the norm in the stock market—which is why it’s so critical to learn how to defeat it.
Narrative Fallacy and Industry Evaluations
While narratives are most easily identified by the macroeconomic and stock market forecasts which are uselessly pontificated on by financial media day-in and day-out, you’ll also see the narrative fallacy creep into the way that particular industries are analyzed and valued.
Again the same set of facts can lead to different prevailing conclusions, borne out by how the valuation of industries come to be, only to be proven wrong as an industry embarks on substantial (out or) underperformance.
There were countless instances of this playing out over the years of Fisher’s time.
1—Fisher talks about the armament industry which relies on government contracts for its revenue.
Sometimes, the Street puts greater weight on the negatives of government contracts—its low profit margins, necessity for lowest price bidding, and the risk of world peace. At other times, investors flock to an industry like this because they aren’t subject to the normal cyclical effects and provide a safe haven when the economy goes into a recession or depression (or is even perceived to be going into).
2—There is the narrative around pharmaceutical companies, sometimes being valued highly and sometimes poorly regardless of where the overall market stood.
Sometimes the prevailing narrative of that day was that the possibilities for the industry were endless, with new innovation and R&D paving the way for vast new sources of revenues and profits combined with its benefit form an overall growing economy. But the high valuations of these companies did not last too long when the volatility of the industry came to light, as today’s top players were quickly unseated by tomorrow’s innovators.
It took just one widely public failure of a leading company in the pharmaceutical industry for valuations to fall precipitously for all of the stocks involved. As Fisher explains later in the chapter:
The financial community is usually slow to recognize a fundamentally changed condition, unless a big name or a colorful single event is publicly associated with that change.
Brilliantly observant of how stubborn crowd think can be, and it is prominently put on display with each year that passes in the stock market.
Interestingly in the case of pharmaceuticals, both sentiment and profitability swung in the opposite direction again, causing this industry to prosper in 1958 while the rest of the business world struggled.
3—Machine tool manufacturers suffered from the long held narrative that these companies were extremely reliant on the economic cycle, and were the “epitome of a feast or famine industry”.
Recent earnings had very little bearing on overall valuation, because investors were assuming that they were temporary. However, a new school of thought (written about in Fisher’s original version of his book) was starting to gain momentum that customers were now moving towards long term capital expenditure planning instead of primarily short-term, meaning that excess profits were here to stay.
In this example, following the new school of thought would’ve been painful for the investor rather than sticking to the “old school”. By 1957, another recession gripped the country and the businesses in this industry reverted back to their same historical trend of feast or famine, causing temporarily high historical valuations to revert back to historical norms.
It’s not an easy task, but combatting the narrative fallacy inherent in all stocks can be very profitable over the long term, and requires investors to think for themselves rather than rely on the current mood of the day.
How Narrative Creeps Into Valuation
You may wonder how the narrative fallacy can be so pervasive in the market, particularly if so much of the market is driven by earnings and these are relatively indisputable facts.
It all goes back to how stocks are widely valued in markets.
This idea is an entirely different subject on its own, and if you are interested in learning about valuation then I’d highly recommend our post about the Discounted Cash Flow Valuation model and what that formula entails.
That said, I’ll tell you that the primary inputs for a DCF are:
- Free Cash Flows
- Discount Rate
Free cash flow and growth are often derived from earnings, which is why the earnings part is so heavily focused on and can move stock prices so much.
The discount rate is the other half of the equation, and is primarily influenced by two things: (1) interest rates and (2) the perception of risk.
Since risk and volatility have been inescapably tied in the financial community, it’s the perception of volatility in the future which causes analysts to “discount” cash flows and earnings more heavily than others.
In other words, if analysts see a company’s earnings as more volatile in the future, then current or recent earnings won’t be respected as highly as those which seem more secure.
Since many valuation models use “beta” as the primary input to evaluate risk for a discount rate, it’s this measure of beta which has a wide bearing on whether a stock or industry might have a higher (or lower) P/E ratio than the market average.
Of course growth also plays its role, but this is why cyclical industries tend to be more heavily discounted, and why the consensus on an industry’s perceived cyclicality has consistently played a major role in valuation… and continues to this day.
But as we can see in these prominent examples of narrative fallacy, the future prospects of a company or industry are highly subjective rather than objective, and lead to both opportunities and potential landmines for investors.
Questions to Ask About Today’s Narratives
As I write this in 2021, I see many narratives which have caused industries to trade at much lower valuations than they historically have.
One of the most obvious examples is bank stocks.
Bank stocks have traded at high single digit or low double digit P/E ratios for most of the last decade, and it has been widely accepted that this is because the industry is matured and has little in the way of growth prospects moving forward.
Yet at the same time, you have the dichotomy of “fintech”, wherein the sky appears to be the limit for these companies as their technologies seem to disrupt all of the old ways of banking and finance.
While some of this is bound to take place, as the new replaces the old in very many industries, you have to wonder whether the lofty valuations being placed today are accurately representing the true growth prospects of these companies, both on the banking side and the fintech side.
Another example which is less obvious is the homebuilding industry.
Marred from the housing boom and crash of 2006/2007, these stocks are traded like highly cyclical feast and famine businesses.
While it seems obvious that these companies are subject to the real estate market, and that real estate has cyclical properties just like any market, it’s interesting to observe how much of a shift in sentiment has occurred in just over a decade.
Where before real estate imploded people thought that real estate never went down, today it seems that everybody believes another real estate crash is imminent, even though many macroeconomic and demographic statistics seem to imply that this can’t be further from the case.
In both the banking and homebuilding industry, the scars of the recent past are still affecting the narratives around these stocks, and causing their valuations to remain discounted both to stock market averages and their own historical averages.
Whether these are examples of recency bias and the narrative fallacy or accurate representations of the riskiness of these investments, it’s discerning this difference which subconsciously enters into the decisions of an investor in whether to buy or sell these stocks at their historically low P/E ratios.
While this might seem extremely difficult, I don’t see this as impossible for the average investor as long as you are able to interpret facts for yourself rather than rely on others to do that for you.
The only weapon against falling victim to the narrative fallacy is an honest evaluation of yourself and your opinions and biases that you hold.
Investing takes self-awareness and humility, both of which are constantly needed especially as you become successful.
It’s what can make investing so difficult, and why you see the rockstars rise and fall so quickly.
But if you constantly remain curious, constantly look to learn and grow, and find enjoyment in the process—you should be able to overcome biases like the narrative fallacy and others, and find it pays you many dividends over the rest of your life.
What a great thing.