Strong narratives: A source of competitive advantage?
One of the best things about investing is that you will draw on virtually all of your skills, knowledge, and experience at one point or another.
I studied narratives at school, formally, as an academic pursuit. It sounds dry, and it kinda was, but it’s proven to be valuable in highly unusual ways. Try deconstructing a modern political narrative and see what core themes you come up with, you’ll be surprised (or maybe not…). Anyway, the human brain continually strives to explain and grant significance to its experience and I believe my understanding of narrative has, by extension, made me a better investor.
Typically, the vast majority of investors have equal access to the facts (excluding the minority with the most in-depth research and/or best access to management). Each investor is presented with a series of facts and essentially strings them together into an investment thesis that says ‘Buy’ or ‘Sell’. You can draw entirely opposite conclusions depending on what narrative you actually use to tie them all together.
I suppose a classic (simplified) example of narrative would be something like Fisher & Paykel Healthcare (ASX/NZX: FPH). Obesity and lung cancer; two big killers and a huge driver of demand for FPH’s oxygen masks and related devices. People are getting fatter, living longer (especially Americans, FPH’s biggest market), and finding it harder to breathe, and they’ll need more of Fisher & Paykel’s devices in the future. The company is switching manufacturing from New Zealand to Mexico and along the way it’s expected to generate big increases in its profit margins. It already has great ROE and ROIC and it is a world class company on these metrics.
The flip side of this is that a meaningful % of profit is going to lawsuits defending its patents as FPH has been accused of patent infringement by ResMed (ASX: RMD), a major player in the space. Fisher Paykel is well and truly going up against the incumbent here, it is priced to the moon, and it potentially stands to lose the ability to sell its primary products (worst case scenario; it might also have to pay restitution) in the USA. Depending on the outcome, shares could conceivably either be worth double in 5 years or fall 70% in the same time. Virtually nothing will change in terms of its expertise and the appeal of its products, however. Depending on which narrative you choose – and both appear equally consistent at first glance – you come up with diametrically opposed outcomes. This is a case where the numbers alone will not save you – you also need to create, investigate, and follow a coherent narrative.
(‘Meta’ strategies around position sizing, through-the-cycle view, avoiding potential for loss/binary outcomes etc can also be quite valuable here.)
How to read a narrative
I recently stumbled across this post about cracking the narrative from a random blogger which, in my opinion, hits the nail on the head. It’s great to read a narrative for entertainment or excitement. I love hearing about how a company is going to change the world. But the real investing work starts when you use the narrative as a jumping point for asking questions and seeking inconsistencies.
Why does Jason Bourne in The Bourne Identity (30yo) look like he’s about 12, despite his life being filled with brutalization and violence?
Why is Marie, despite the wastrel’s idle life that she lived, suddenly so adaptable to a life on the run?
Every narrative has its own internal logic, and I’m not just talking about the ‘introduction, problem, resolution, conclusion’ story structure that you learned in primary school. Even unconventional narratives (narratives with no coherent story structure) are conventional, because they make sense to somebody. I’ve heard it said that life without meaning (action without purpose) is the definition of insanity. I prefer to believe that people who are insane have an unusual view of reality and the things that they do make sense to them. Whichever way you cut it, a coherent narrative is key to almost all of life’s ventures and the absence of one is always a warning.
I suppose I’m not exactly delivering earth-shattering insight here, but if the narrative in an investment changes, that’s an instant sign to be wary. Narratives change all the time. But the fact that they have changed is a sign that you must look to either positively vet and/or attempt to falsify the new narrative.
And if you can’t find a narrative, then you either have a bad business (it is unfocused) OR if you can generate your own narrative from the company’s actions (perhaps the execs are poor communicators or the market misunderstands the company), then you have a source of potential competitive advantage.
Note that the narrative is never ‘we have an awesome product that is going to change the world.’ That’s garbage – that’s not a story. A real narrative is something like Greencross Limited (ASX: GXL), which also fills in the empty space:
In the course of growing by acquiring new vet clinics, we realised that pet retail is a perfect complement. So we entered a new market by acquiring pet retailers, then we realised that we could add a substantial kicker by installing vets in our retail stores. This would let us establish new vets for a lower cost, letting us grow the vet biz faster, while also allowing us to cross-sell products, boosting our retail sales. Because of our big initial foray into pet retail, we incurred a lot of debt. Our expansion is now at a point where we are funding ourselves from our own cash flow, and as we pay down debt and roll out our in-store clinics and grooming salons, growth could remain strong for several years. (this is just a summary in my own words)
I don’t hold Greencross. I’m pretty bearish on it. I think if you look at its Western Australian sales recently you get a real good taste of what happens to the company in a downturn – but it’s got a very well-defined narrative. In my opinion, very few ASX companies have a narrative that is this well defined.
(The speccy small caps like to kid themselves that they have a narrative, but typically the story is light on detail and heavy on fluff and optimism.)
Anyway like all good stories, Greencross’ narrative writes its own questions in the mind of the reader. If you come across a story like the above, you can generate your own questions (you must be skeptical), answer them all, and the investment thesis practically writes itself. Brief sample:
- How much better is this co-located vet thing? What do the numbers say, how much faster could the company grow compared to acquiring externally?
- How is this a source of competitive advantage?
- What’s the possible market size on vet clinics and pet retailers?
- Why would vets, skilled medical professionals, want to work in a retail store and be expected to cross-sell dog food? (actually, I dunno why, but I suspect incentives are the answer)
Importantly, you also now have a number of checkpoints to follow over the course of your investment. What’s the maximum possible # of in-store clinics and how far from that goal are they? You can literally follow the narrative over a few years and watch if each of the events in your ‘story’ comes true. And you will get a very clear idea of whether your investment is kicking goals or not.
Narratives. I’m tellin’ ya. You gotta use em. There are also situations in which a narrative doesn’t work, such as if an investment is attractive on a risk-reward basis but the result clearly depends on a binary outcome (e.g. a successful lawsuit or clinical trial). Narratives are not binary, and typically investing is not binary either, which is why narratives are useful most of the time.
Sometimes, you can find investments that are likely to be winners almost regardless of the narrative and its coherency or lack of – Forager Funds is a good example, but they follow a ‘meta narrative’ – no less valid – around the flow of capital and the business cycle.
Bashing the narrative
It has become favourable in recent times to bash companies that emphasise their story, and rightfully so, because many companies are in the business of selling a story, not a business. Yet I think that a strong narrative can equally be a signal of a focused and driven business. Those that understand how to compare reality to the narrative, find narratives quite useful.
A preference for narratives
Anyone that follows a narrative alone is a sucker – but the same can be said for those who use numbers (e.g. valuation) alone. Even the investors that think they are purely probability or valuation-focused, what they’re really doing is testing hypotheses (a.k.a narratives) and evaluating likely outcomes. An investing narrative (jointly the ‘why’ and the ‘how’) is at least as important as the numbers (the ‘what’ and the ‘how’).
If I have an edge as an investor, I’d say it’s 100% my understanding of narrative.
Edit: After writing this post, I stumbled across another great blog post on narratives, and ironically, it references the same ‘cracking the narrative’ blog post I linked earlier! Clearly my competitive edge is under threat.
I don’t have any financial interest in any of the companies mentioned. This is a disclosure and not a recommendation.