The pros and cons of building an investment story

So you’ve crunched the numbers on a particular company, and they’re looking good.  It has a long history of profitable dividend growth, and that growth has been faster and more consistent than average.  It doesn’t have much debt, and the current yield is significantly better than the market average.

Does that mean your job as an analyst is now done?  That you’ve found your next investment, and you should just go ahead and buy it?

Perhaps, but then again, perhaps not.

Numbers and ratios can only take you so far

If you stopped at this point and just went ahead and bought the shares, you’d be doing something called “mechanical” investing, which is where you have a fixed set of rules that you follow, like a machine, with no exceptions.

This sort of thing is ideal work for computers, and there are a million and one computer-powered stock screens based on all sorts of mechanical rules.

Various research studies over the years have found that portfolios that mechanically follow a set of sensible rules generally do better than portfolios where a human applies the same set of rules.

That’s because humans tend to ignore or bend the rules when they want.  That would be fine, except that humans generally bend the rules to buy what’s already going up and sell what’s going down.  The result is that they buy high and sell low, which is rarely a winning strategy.

Computers, on the other hand, are decidedly lacking in the emotional department.  They have no problem following rules to the letter, even in the height of a bubble or the depths of an economic depression.

But there’s a problem.

Even if a mechanical approach tends to win in the long run, that’s an irrelevant fact if you still control the actual buy or sell decision.  You – the human – are ultimately in charge, and the human cog is where most mechanical systems break down.

I have first-hand experience of this.  Back in the 1990s, I was a passive investor, primarily tracking the FTSE All-Share.  The FTSE indices are a good example of a purely mechanical investment system (although most people don’t think of it like that), where stocks enter and leave the index based purely on their market cap.

I, like most people, had zero knowledge of the 600 or so companies in that index.  I didn’t know what they did, where they operated or even what their names were.  I also didn’t understand valuations, so I didn’t realise – like most people – that by 1999 the stock market had become ludicrously overvalued and that a significant decline was virtually inevitable.

When the UK stock market collapsed by around 50% in little more than a year, I – like most people – had no idea what was going on, and so – again, like a lot of people – my response was to panic and sell on the way down.  That, of course, was a mistake and simply locked in my losses and kept me out of the subsequent market rebound.

Stories, emotions and the need to believe

I could have avoided those losses if I’d had some understanding of what the index is and how it actually makes money.  I should have built a story in my mind around the idea that the FTSE All-Share is a collection of 600 or so multi-million and multi-billion pound companies that, in the aggregate, produce a fairly reliable and growing stream of profits and dividends.

By building an investment story – a narrative – around an investment, you can build the sense of understanding, faith and belief that you’ll need when the going gets tough, as it invariably will at some point.

If a company’s share price drops by 20% and you know nothing else about the company other than its PE, it’s easy to sell in a panic.  But if you know that the company is a huge multinational, selling millions of toothbrushes or tins of beans every day, just as it has for the past 50 years, you’ll probably be less inclined to panic.

Of course, qualitative research isn’t only about generating faith and belief, as important as they are.  It’s also about finding out the things that numbers and ratios can’t tell you.

It can help you understand where a company’s growth has come from, how it coped with competitors and other challenges in the past, whether it’s reliant on a small number of key staff or whether it has a sustainable competitive advantage.

Financial numbers are not good at answering those and many other ‘soft’ questions.

Don’t let belief in your story turn into certainty

Although you’ll need faith and belief in your investment story before you invest, be careful.  Belief can very easily turn into fantasy or its darker cousin – certainty.

You must remember that your investment story is just a story.  You need an investment story because that’s how human brains cope with an uncertain and unpredictable world, but don’t believe your story to the exclusion of everything else.

You shouldn’t chop and change your story every five minutes; otherwise, it has no value.  But on the other hand, you shouldn’t hang onto it long after it has become obviously false.

Don’t emotionally tie yourself to your story being ‘true’ or ‘right’.

Personally, I’m quite happy for any of my investment stories to be proven ‘wrong’.  I realise that the story is a tool to help me commit and stick with an investment through the short-term ups and downs of the stock market and business news cycles.

If your story turns out to be wrong, learn from it.  Find out why it was wrong and if it was even possible to see the true story in advance.  In many cases, it wouldn’t have been, and there was no way to know that the investment would have turned out badly.  That’s why it’s a good idea to hold a diversified portfolio; so that no single ‘failure’ drags you down either emotionally or financially.

A story is just one tool among many

Don’t make the story your central focus, either.  Investing, like engineering, is still primarily a numbers game.  At the end of the day, even after I’ve spent hours researching a company to build an investment story, my investment decisions are based primarily on numbers, not stories.

I would say that perhaps 80% of my defensive value investing approach is quantitative, with just 20% being driven by qualitative analysis, stories and “gut feel”.

I think that’s a reasonable balance, which allows room for stories, opinions and judgement, but only within the confines of a rigorous and methodical framework.