Stock prices are driven by 2 factors – Narrative and Numbers
What is Narrative?
Narrative is story created around company’s product or services or management execution ability. Let’s see few examples
- Due to USA and China war, part of manufacturing will shift to India which will boost manufacturing sector leading to higher job creation and higher income. Manufacturing companies like Dixon, Amber etc. will benefit.
- Shift from Unorganized sector to organized (Unbranded vs. Branded) e.g. Industries like Footwear, Jewelry, Diagnostic etc. will benefit from this shift
- China’s closure of many chemical facilities on environmental concerns and US-China war will benefit Indian specialty chemical companies. Indian chemical companies like e.g. Navin Fluorine international, Vinati Organic, Nocil etc.
- Electric vehicles is the future. (Market Cap of Tesla – $400 Billion is greater than traditional auto manufacturer Toyota ($216 Billion), VW ($75 Billion)
Narrative part is usually reflected in expansion of price to earnings ratio (PE Ratio)
What is numbers?
Numbers part is mainly comprises of profit growth and dividend yield.
Which part plays dominant role over long term?
Below is the return from Sensex, S&P BSE 100 and S&P BSE 200 index over last 21 years.
As can be seen from above table Numbers part (contribute 69% to 73%% to the total return in all three index) plays dominant role in long term return from stock price.
Scientific method to play narrative and numbers game.
In a lecture at Cornell University in 1964, the physicist Richard Feynman defined the scientific method. First, you guess, he said, to a ripple of laughter. Then you compute the consequences of your guess. Then you compare those consequences with the evidence from observations or experiments. “If [your guess] disagrees with experiment, it’s wrong.”
I believe investor can apply this scientific method while investing. How?
- First investor will generate investment theme (narrative).
- Investor will calculate the size of opportunity (Market Share, Profit growth, expansion in profit margin etc.)
- Investor will test his/her thesis with actual profit generated by the company (numbers)
- If it doesn’t match, he should sell the stock and if his thesis proves right, he can ride that idea
- When Narrative part played for short term:
Companies – HEG and Graphite.
Company Business – Both the companies are manufacturers of graphite electrodes which are key components of electric arc furnaces that turn scrap into steel.
Narrative – China is one of largest producer of steel. Most of companies were producing steel using old method Blast furnace which is generating higher pollution. China started taking pollution control measures in 2016. To curb pollution china started producing steel using new method – Electric Arc Furnace Technology for which electrodes was the raw material. Marketing started factoring in higher demand for electrodes from China. Also government of India had imposed anti-dumping duties on graphite electrodes imported from China.
Numbers – This boosted profits of these companies for 2 years. The same is reflected in the below chart
But after 2 years of splendid performance, both these companies were not able to sustain profit growth mainly due to abolition of anti-dumping duty by government of India on imported electrodes and subdued demand and share price collapsed. Investor should keep watch on how long the narrative will play out
2. Narrative is going hand in hand with Numbers
Company: Bajaj Finance Limited (BFL)
Narrative: BFL brought in Mr. Rajeev Jain in 2008-09. He transformed the BFL from near bankruptcy to one of most profitable NBFC in India. He is known for his great execution capabilities.
Numbers: Profit has grown at CAGR of 42% from 2015 to 2020.
Current Market Environment
Investor should apply this scientific method to the sectors which are currently in limelight
As we can see, narrative part is playing dominant role in all of the above sectors. Investors are expecting that these sector will be beneficiaries of current crisis and will report higher profit growth in the future. Investor who have got this narrative right, should keep his eyes open and should test the same with the upcoming results to be declared by the companies.
If narrative is translating into numbers he should ride the wave and if not he should get of the stock even if means taking loses. To paraphrase Richard Feynman,
“If [your narrative] disagrees with numbers, it’s wrong. It does not make a difference how beautiful the guess is, how smart you are, who made the guess or what his name is…it’s wrong.”