Weekend Reading #21

This is the twenty first edition of our weekly newsletter, Weekend Reading, sent out on Saturday 15th June 2019. Sign up here and receive a copy each week direct to your inbox.

* * * * *

The neverending story of markets.

Stories are everywhere.

They’re how we make sense of the world. As film director Jean-Luc Godard puts it, “Sometimes reality is too complex. Stories give it form.” The stories we tell ourselves help us to derive order from chaos, taming the random indifference of the natural world that would otherwise destroy us. “Twere the mirror up to nature”, as a procrastinating (but nonetheless eloquent) Danish prince once observed.

You might associate stories with books, movies, or even podcasts, but they predate all of these things. The earliest forms of storytelling in ancient cultures combined many different formats and styles of delivery. Australian aboriginal people decorated the walls of caves with symbols, delivering stories via a mixture of oral narration, music, art and dance. They performed their stories, like the modern, mass manufactured pop-star performs their identity on stage.

These days we don't spend much time in caves. Our fathers replaced their ancestors’ rock art with rock and roll. We commercialise stories into “content” and pipe them to the masses via monthly Netflix subscriptions, Kindles and freemium podcasting platforms. We’ve invented new ways to relate to the world, and new ways to relate to each other.

The power to make us rich.

We believe this development is important, but not for the reasons you might imagine. It’s easy to judge other people for staring at their phones in meetings and assume that our rich and varied storytelling culture is being homogenised by lazy three-act structures and UX loops dreamt up by product designers in Silicon Valley.

But the fact remains we are more connected to stories than ever before in our history. This is an inescapable truth, hammered home by the ubiquity of streaming content and boxset bingeing. Stories are all around us, informing, inspiring and terrifying us in equal measure. They are ambivalent – only as good or bad as those who tell them and those who consume them. Yes, stories can overwhelm and impoverish us through information overload. But that simply means we’re listening to the wrong stories, at the wrong time, in the wrong context. The stories we consume can make us poorer, smaller, less engaged with the real world. But they also have the power to make us rich.

The story of storytelling.

Storytelling is the most powerful cultural, political and economic force in the world today. It always has been. But for many years, the best storytellers – who also tend to be the world's wealthiest and most powerful people – have kept this secret to themselves, like a wish that when shared, ceases to come true.

In the 20th Century, the ad-men of Madison Avenue elevated storytelling to a kind of commercial alchemy, selling their skills to the highest bidder. In the process, they created the eponymous household “brand” and made money pour out of telephones, televisions and finally, smartphones. Now we have social media.

So if storytelling has been an obvious value generator for a hundred years, why haven’t financial markets caught up?

A short history of markets.

Markets are governed by stories. To be precise, they are governed by stories within stories. In our experience, the companies that know this and position themselves accordingly consistently outperform those that don’t.

This has been true since the dawn of capital. The markets of the mid 19th Century were governed by sophisticated forms of information arbitrage. The story of the American railroad is perhaps the greatest story ever told, one of bold exploration, irresistible progress and rampant commerce that transformed a frontier market into the world’s largest economy. Fortunes were made and lost depending on how that story was interpreted. Many years later, Warren Buffett famously said, “It’s never paid to bet against America”, and whilst this is certainly a simplification, in the heyday of the great railroad boom it really was the case.

In the late 20th Century, Asian markets benefited from the same grand narrative, with the “rise of the middle classes” driving wealth creation on a level hitherto unseen in economic history. That narrative, too, is now dissipating, leaving many long-only managers in emerging markets scratching their heads and scrambling for the next promotional hook to sell to their investors.

Too many stories, not enough time.

Today, markets still revolve around stories, but with a twist. The technological prowess of our species means we have unparalleled access to information. There are too many stories, and too many people telling them. The market has responded, transmuting the investment discipline from an artform into a science.

Investing has always been a multidisciplinary phenomenon, one that demands elements of economics, politics, psychology and philosophy. Experienced investors know it’s a game of mental manipulation, a battle of the mind and of minds. It demands the ability to read people, since the market is composed of other investors.

The father of value investing, Benjamin Graham, observed that in the short run, the market is a voting machine, but in the long run, it’s a weighing machine. The rise of value investing was perhaps the first salvo in the scientification of markets that’s been ongoing for the past hundred years, driven in part by the hegemony of the Efficient Markets Hypothesis as the dominant prevailing mental model. Trading started out as the domain of bandits, scoundrels and entrepreneurs. So how did it end up being the preserve of economists, MBAs and CFAs?

The next episode.

The prevailing wisdom is that the next chapter will be written by the proponents of quant investing, which takes things a step further by removing human beings from the equation altogether. Order will be mined from chaos. Markets will be automated. AIs will trade with each other. Portfolio Managers will be forced to retrain as software developers or moonlight as Uber drivers to fund their overleveraged mortgages.

That is already happening to a degree, but the nirvana will go unrealised. When Fama and French looked to historical returns to create their “Three-factor model”, adding Market Capitalisation and Book Value to the traditional Capital Asset Pricing Model, financial academia believed it had cracked the mystery of the market and distilled it into a handful of simple factors, spawning the subsequent decades of “factor” and “style” investing as their model and forming the basis of financial orthodoxy.

On ice cream and drowning.

They missed the point: the story changed once they became part of the story. Statisticians call this endogeneity, whereby the error term is correlated with one of the factors in the model thanks to reasons including reverse causation. Add that to misspecified models, oversimplified assumptions and spurious regressions, and it becomes clear how markets have gone more awry even as analytical frameworks have become more sophisticated.

A famous example of a spurious regression is the increased occurrence of swimming pool drownings at the same time as increased ice-cream sales. To suggest that ice-cream causes drowning, or worse, that drowning causes ice cream parties, is ludicrous (a heat wave could have caused both). The message is clear – using data without context is precarious ground for investors.

Relying on history to forecast the future, no matter how far back it goes, is always dangerous. The assumptions made for simplification purposes have massive ramifications once taken to a different scale. A classic example is the assumption of normality in the Black-Scholes Option Pricing Model – most things follow a normal distribution in nature, but not asset prices, and certainly not asset prices that are built upon reliance of artificial, simplistic assumptions. The implosion of Long Term Capital Management with the Asian and Russian Crises in 1997 and 1998 respectively is a case in point. On its board was none other than Myron Scholes, after whom the option pricing model was named.

Markets are coming full circle at an accelerating pace. Stories matter more than ever. It turns out that the common platitude that “numbers don’t lie” is misleading in itself, since the numbers are as much the result of the story, as they are part of the story itself.

With managers’ strategies converging on “more of the same”, the institutionalisation of information arbitrage is rendered increasingly impotent. The advent of MiFID2 and MAR regulations in Europe, and increasing adoption of their principles in the US and Asia, is making information more and more available to everyone at reasonable prices. No longer can brokers have “preferred” clients to which they give an unfair informational edge for free. On a practical level, this means the quantitative models that underpin the automation of markets – the DCFs and CAPMs of this world – don’t work anymore in generating outperformance, particularly in emerging markets where the idiosyncrasies of local markets and lack of liquidity get in the way of financial analysis.

If everyone tries to outperform everyone else with the same strategy for outperformance, no one performs.

We believe in the power of stories.

Here at Three Body Capital, we think that underlying fundamentals are important. They are, if you like, the details of the story, the content that decides whether a stock is investable or not. But this content needs to exist within a context that is relevant, durable and timely. And that context is the story of a stock, a market, a global economy that modulates the relationship between capital and opportunity. This is the force that drives the disconnect between book value/fundamentals and price.

If you’re still sceptical about the power of storytelling in markets, look at the recent buying frenzy for recently listed "fake meat" producer, Beyond Meat. Its share price is soaring because it's telling the right story at the right time. Current valuations obviously defy belief, but as we know, stocks overshoot all the time.

Stories exist within stories. A stock exists within a sector, within a local market, within a global economy. All of these contexts relate to each other. Fundamentals help us decide whether or not a company is investable – the story helps us decide if we should actually invest. But we also need to factor in the thinking and behaviour of other investors. How do they interpret the story? How do they interpret our interpretation of the story? As Keynes observed with his infamous beauty contest, investors shouldn’t price shares based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is. Or, more precisely, what everybody else would predict the average assessment of value to be.

Why are we writing this here, in the presence of an audience that’s interested in emerging markets, broad-based transformation and alpha generation in a world dominated by passive flows? Because we believe that storytelling is key to all of these things.

The writer, Kenneth Burke, said that “Story is equipment for living.” It’s also equipment for investing. People who trade markets don’t think in predictable ways. We are not the same and it’s okay to be different. In fact, as an active manager it’s necessary to be different. That’s what we believe. It’s a story we tell ourselves – and one we truly believe.

What we're doing.

This week, after much planning and thought, we mandated software developers on building our online private investment network. This is a big step for us and one that underlines our commitment to increasing access to private markets for emerging market investors and companies. Please get in touch if you’d like to find out more. We also spent some time catching up in London with our partners from Turkey and Nigeria and further cementing ways to work together.

What we're reading.

We have been monitoring the large-scale protests in Hong Kong. And reading this piece in the Asia Times about "Hong Kong’s existential moment". On Sunday, roughly one million people marched through the city in protest against China's extradition play, the biggest demonstration since 1997. The piece concludes that “Hong Kong’s economy is already becoming collateral damage in Donald Trump’s trade war [...] and the likely winner here will be Singapore." This is a complex issue and we can’t do it justice in brief blog post, but it certainly got us thinking about the fierce competition for global capital and how one city’s loss can be another's gain. A final thought we’ve been discussing is what the read across could be for Taiwan. Hong Kong could be but a preview of what may unfold there. China has been clear on its ultimate intention, yet the Taiwanese story is less straightforward. Jawad Mian has written an excellent piece about this in the June edition of his must-read publication, Stray Reflections. We're happy to connect anyone to him and his team.

What we're watching.

This week we watched an incredible trailer. But it wasn't for a movie. It was for a video game. As regular readers of this newsletter will know, we are huge fans of Polish gaming company, CD Projekt. The company has developed a cult following after the success of its Witcher gaming series, which has sold over 33 million copies in 10 years. We've been waiting patiently for the release date of Cyberpunk 2077, an open-world role-playing game with a look and feel reminiscent of heavyweight sci-fi movies like Bladerunner and The Matrix. Keanu Reeves was on hand to present their plans to the world at E3 in Los Angeles earlier this week! The star plays Johnny Silverhand in the game, which is due for release in April 2020. This is significant – when top Hollywood actors are starring in games, it’s time for everyone, everywhere to take gaming seriously.

Weekend ReadingEdward PlayfairJune 18, 2019