Stories Still Work for Stocks

07/10/2012 9:45 am EST

Focus: MARKETS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

The recent trend in analysis has been to cleave tightly to the numbers as a way to see the fortunes of businesses and eschew story-based analysis, but stories are still crucial to understanding growth stocks—and making money, writes Marc Gerstein of Forbes Low-Priced Stock Report.

Years ago, I was asked by some finance students for suggestions as to coursework that would best prepare them for careers in security analysis. Much to their surprise, I bypassed all the mathematically oriented offerings then (and still) in vogue, and suggested that besides accounting, they load up on as many “case” courses as they could take.

This refers to the instructional method that gained prominence at the Harvard Business School that eschewed traditional lectures and required students to read and analyze often-complex real-world business situations that did not pigeon-hole precisely into any specific academic topic. This is a very substantial approach. Professors can achieve full-fledged academic publish-or-perish brownie points by researching business situations and writing up these cases.

Often we’ve seen in this newsletter the virtues of case-based analysis (story-based analysis, special situations, and turnarounds are other labels that fall under this umbrella), and that’s particularly so this month.

Believe it or not, stories are actually essential even to academic formulations. Investing is about the future, and however many numbers we have and however sophisticated our crunching techniques may be, the information all comes from the past. Common-sense stories are needed to help us project facts into the future.

NYU’s Aswath Damodaran, author of The Dark Side of Valuation, is particularly effective at discussing this. He even recognizes he’ll often be wrong (as any of us must when we look into the future) but hoping to be just a bit less wrong than most others. Even I, a devotee of and advocate for stock screening and multifactor ranking, cherish stories.

The models I use are quite lenient compared to many others, and are designed to uncover worthwhile opportunities among companies whose financials don’t offer the sort of conventional metrics fundamental investors typically cherish. One example: To us, diminishing losses can be as good as rising profits. Stories pointed us to pretty much all of our winners.

Story-based analysis got a bad name after the dot-com boom imploded. But there was never anything wrong with the approach. It was just implemented badly. Stories need to make sense (many of the old ones didn’t) and however conceptual they may be, they still need to have some credible relationship to the numbers (the old ones didn’t).

In fact, story-based investing is so important, at least one of the major institutional data providers is now aggressively trumpeting its efforts to develop models that use “unstructured text” to “generate alpha.”

Frankly, I’m not convinced by the models they’re presently promoting. But these are early days for this sort of thing: Who knows what the future will bring? In any case, we can and have been doing fine using the human brain to process such text.

There may, however, a short-term catch. When macro events dominate investors' thoughts, as in much of 2011, the number-crunching machines tend to dominate as do more conventional numbers-oriented strategies. Stories, such as those that underpin many of our investment cases, tend to get buried.

As Europe works through its challenges and as investors assess the US election and stalemated Washington climate, we may see some more of that in the upcoming months.

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