Market Frame – The Company as Story
But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side.
It is common for value investors to make comments along the lines of, “Remember that a share of stock represents a part of a business and is not just a piece of paper.”¹ The implication being that if you understand the company, you will understand the share price.
Such statements represent a classic example of what Nassim Taleb, in his book Antifragile, refers to as the Green Lumber Fallacy. The fallacy refers to the story of a trader who was highly successful trading in the market for “Green Lumber” despite believing the lumber was literally painted green rather than fresh cut. The important message was that the knowledge to understand the lumber industry and the knowledge required to trade lumber were distinctly different.
Traditional equity analysis recognises this distinction by reference to “fundamental” and “non-fundamental” analysis. Fundamental analysis is focused on understanding the “real world” of the company and its industry. In contrast non-fundamental analysis focusses on understanding the stock market where people buy and sell pieces of paper. Fundamental analysis links these two worlds by determining a real world value for the company that is expected to be reflected in the notionally more fictional traded shares. When fiction and reality diverge, fundamental investors can profit by arbitraging the difference.
There are two problems with this model of analysis. Firstly, is the idea that the paper shares are a true representation of the company. As Taleb² notes,
“That is how I learned the lesson that price and reality as seen by economists are not the same thing. One may be a function of the other but the function is too complex to map mathematically.”
The share price might be a function of the performance of the company that it represents, but this function is complex. A particular cause of this complexity is that causality runs both ways – not only is the share price a function of company performance, but company performance is also often a function of the share price. Any analytical approach based on “fundamentals” therefore needs to acknowledge both the nature of this function and our limited understanding of it.
The second and probably more profound problem with a distinction between a “real” fundamental world and a somehow more fictional “paper” world is that its all fiction!
In his book Sapiens, Yuval Harari notes that the key advance of the cognitive revolution was the ability of humans to create “imagined realities”,
“something that everyone believes in, and as long as this communal belief persists, the imagined reality exerts force in the world.”
Harari uses the limited liability company as an example of such a collective fiction. He notes³:
“How exactly did Armand Peugeot, the man, create Peugeot, the company? In much the same way that priests and sorcerers have created gods and demons throughout history, and in which thousands of French curés were still creating Christ’s body every Sunday in the parish churches. It all revolved around telling stories, and convincing people to believe them….
Telling effective stories is not easy. The difficulty lies not in telling the story, but in convincing everyone else to believe it. Much of history revolves around this question: how does one convince millions of people to believe particular stories about gods, or nations, or limited liability companies?”
In this view of the world, there is no such thing as a fundamental economic reality. The company is as much a fiction as the share price and there is no distinction between fundamental and non-fundamental analysis. Rather, in a world where everything is a story, the important distinction is between types of stories. Is the story about the company or the share price? Is it a story that has strong collective belief and is therefore durable, or is it more ephemeral?
Recognising that all investing relies on story telling does not exclude the role of fundamental analysis. Fundamental stories are potentially both more durable than other stories and more capable of long term understanding. However, recognising that we are dealing in narrative rather than physics potentially makes us more humble in our interpretation of such stories and provides a better platform for incorporating both behavioural and systems tools into our understanding.
For the purposes of this discussion, we have grouped our stories into three baskets:
- Value Stories – These are the most common stories investors use to explain “fundamental” reasons for share price changes
- Other Stories – Momentum trading, indexing, regulatory change are just a few of the non-fundamental stories that drive share prices.
- Market behaviour – Rather than trying to understand the individual stories, we can adopt a top down approach and look at how the various stories have interacted over time.