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The "Little Black Book" will be a series of articles where I will explain several things about the market which you usually just learn with experience, as they're mostly not listed in academic literature. This is the second article in the series.

People Buy Stories Not Numbers

This is related to the first article on the series, "Little Black Book: A Stock Is Not Just A Stock". When stocks are promoted or bashed, what is usually at stake is not their valuation ("the numbers"), but some kind of thesis, be it long or short. It is thus very important to know which thesis is dominating the trading on a given stock, for several different reasons:

  • To know how far the stock might go, for instance to have an idea of what potential market the market is believing to be addressable, and what share of that market the market is believing the company will take;
  • To interpret the news, as new information that impacts the thesis is bound to have a much bigger impact on the stock quote, than information which doesn't;

Why do people buy stories?

People solve many problems by using heuristics, the world is an incredibly complex place and nobody can understand how every little relationship and fact will affect a given stock. So people simplify, using heuristics, rules of thumb. This drives many investors to believe one, or just a few, stories on each stock they consider. And to decide whether to invest or not just based on those simple stories. Although there are investors that are much more sophisticated, this kind of decision making affects even institutional investors, because they, too, are under a deluge of information that is simply impossible to digest in the available time. Many different things contribute to the formation of bubbles, but you cannot discount the institutional participation in those same bubbles.

Extreme examples from the past

The most extreme example you can get, is the pure "story stock": A stock where the numbers simply don't exist, yet commands a huge valuation. A clear example of this could be seen during the 2000 tech bubble. There was a stock, Corvis, which traded at a market capitalization as high as $30 billion, while having revenues of … $0 (zero). Why? Corvis was going to build "the all-optical network". That's all there was to it, "the all-optical network". Obviously it fell 99% afterwards.

But not all "story stocks" end up that badly. A few years ago Steve Wynn launched Wynn resorts (WYNN). WYNN was building a casino/hotel in Las Vegas and at some point got a license to do the same in Macau, but even before any of those resorts were open to the public, the stock already traded as being the 1st or 2nd largest casino operator in the world by market capitalization, all based on Steve Wynn's reputation. And guess what? The casinos were a success and WYNN deserved the valuation, even though it was so stretched that most of the gains to be had happened before the resorts opened.

Then again, not all "soon to open", "sure thing" resorts go the same way. Back in Europe, Euro Disney shares traded exactly the same way as Wynn resorts before Eurodisney actually opened. But they started falling at about the same time the resort opened, and bombed thereafter, with the resort being a disappointment for years.

Present example

One of the most impressive examples in the market today is Amazon.com (AMZN). Amazon.com is clearly not trading on the numbers, because it is both incredibly overvalued (at a forward 2012 P/E of 150), and the numbers have been deteriorating at a fast clip, with earnings now down to 2004 levels, down year-on-year, and with margins and estimates plunging.

So what's the story on Amazon? Before this fundamental deterioration occurred, it was simply that Amazon.com was a clear leader on online retailing, and online retailing was the future. But today it has changed a little; basically it morphed into "we're investing for the future".

It helps greatly to know this is the thesis the market is buying, especially if you're short. It explains why the numbers themselves haven't taken Amazon.com lower, and also gives you something to analyze. A look at Amazon.com's P&L quickly dispels this long thesis, since it becomes obvious that content (technology) costs and fulfillment costs - variable costs, not investment - are the real reason why Amazon's margins are imploding, so you can be reasonably safe shorting it, knowing you're going against a false thesis.

On the other hand, it also becomes obvious that for Amazon.com to fall, the numbers themselves might not be enough. Some kind of thesis, like Google (GOOG) eating Amazon's tablet lunch or a paradigm shift regarding digital sales will have to take over. But here shorts have a plethora of emerging theses, not only those two, but also the coming sales taxes, increasing competition, etc … one of these will, at some point, wrest control from the "we are investing" thesis, and then the numbers will mean that the downside is incredibly large. Amazon.com could easily trade below $100 and still not be cheap.

Another present example

I've written at length on how reduced residential construction spending in China - a near certainty - will inevitably hit several different stocks, namely the iron ore producers Rio Tinto (RIO), Vale (VALE) and BHP Billiton (BHP) as well as Australia's economy in general and the Australian Dollar in particular. This is the kind of story that will keep these stocks in a downtrend (as they are already in). We know this will have a fundamental impact; however there are so many moving parts to the steel market that's quite impossible to know exactly how deep the impact will be. Yet, the market will keep on trading on it, as the thesis itself is pretty clear.

This is an example on how you can trade a trend while knowing fully well what the thesis that's producing that trend is. It also helps avoid going long said stocks just because they seem "cheap", and getting stuck in a value trap where, subsequently, the fundamentals deteriorate even though presently the impact is still mostly invisible both in volumes and prices of the end product.

Conclusion

It does great wonders to your trading to know precisely what the thesis that's driving a stock is. No longer will you be buying into something just because it's cheap, or shorting something just because it's overvalued. You'll be more confident to enter trends knowing what's moving them, and will be more prone to leave them in time, given your knowledge of the basic story and how news affect it.

Source: Little Black Book: People Buy Stories Not Numbers