Tuesday, October 17, 2017

Cutting through the bullshit when assessing investing stories.

I certainly did not like Narrative and Numbers : The Value of Stories in Business by Aswath Damodaran because it takes a while for his framework to sink in and become monetizable for local investors. In fact, upon closer reading,  the book is actually solid evidence that narratives can be quite dangerous for investors as even experts don't have a clue and have to run with multiple assumptions. Nevertheless, Damodaran is open-minded to criticism and a master of his art and possibly the best guy to ask when assessing companies with no credible cash-flow.

Ok...About narratives... why do we read a financial blogger and decide to jump in and support his story?

I am usually quite trigger happy when a story involves dividends but I, too, exhibit a personal bias when I jump into the markets after reading about a good investment. A lot has to do with whether I see the blogger as a person of substance or a bag of hot air. Sometimes I jump in if I like the blogger and do a double-take if I "see him no up". It's not an objective process at all.

I think we can do better in this regard.

Damodaran has a framework that allows us to assess how good a story is. I have tried to create a very rough outline based on his book.

To have a credible investment story, we may need to consider the following elements :

  • Does the story address the total market size of the investment opportunity ?
  • Does the story talk about the market share of the company in question ?
  • Reality check - Revenue can be derived from an assessment of market size and market share. Is it realistic ?
  • Does the story talk about future trends in operating expenses ?
  • Does the story discuss trends in operating margin capital which can be obtained from operating income by revenue ? ( Operating income = Revenue - Operating expenses )
  • Does the story discuss future trends in taxes ? ( Might be less important for local stocks )
  • What are the reinvestment opportunities - Typically the story should have a credible sales to capital ratio which is how much revenue can be generated from $1 of reinvestment. But, accounting-wise,  this is complicated as it involves dividing (change in revenue) to ( capex + working capital ).
  • The entire story will need to be discounted based on the discount rate and probability of failure.
  • Reality check - Do these financial characteristics fit with a company in a particular phase of its growth cycle ?

I thought perhaps this list may be refined to form a checklist that can be used further to "audit" any investment recommendation and assist the investor to ask further questions of the blogger.

For example, a person who is very bullish about Banyan Tree over tourist arrivals may be focused on the market size over the next year. Series of good questions from an investor would be whether Banyan Tree can capture more tourists or market share over the upcoming year and whether the added arrivals would increase their operating expenses ? Otherwise the thesis that profits would increase may not be as strong as what the person claims.

If any financial blogger wants to volunteer to have an article "audited" in a friendly manner, do let me know !!!

Otherwise, I might just "volunteer" someone to test it out !

No comments: