Storytelling is for bedtime: How we produce evidence-based research

August 14, 2019 | Mark Rutherford Print

We believe that clear communication of ideas and analysis contributes to sound decision-making. As such, the contents of a research report and how it is presented can make the difference between putting the investment odds in our clients’ favour and impairing capital. That’s why we strive to produce thoughtful, evidence-based research. And, after collectively writing thousands of reports over the years, we have identified some common pitfalls and opportunities for improvement.

Leave the storytelling for fiction writers

There is an abundance of storytelling in the markets. Why? Stories are easy, memorable, and they help simplify complex dynamics. However, stories are also incredibly dangerous because they can mislead us. In our experience, storytelling is one of the most common sins of equity research—particularly the failure to distinguish between fact and story.

Simply put, facts are supported by evidence—either qualitative or quantitative—while stories are thoughts and opinions surrounding the facts.

For example, we currently observe several technology companies (e.g., Amazon and Shopify) are experiencing rapid revenue growth, and trade at high multiples relative to the market.

Most can agree those are the observable facts but the stories around why notable technology companies have such high valuations differ substantially.

One story is that investors are overpaying for revenue growth as the businesses have inherently low margins and will stay that way.

Another story is that these companies are spending aggressively to expand their service offering and acquire new customers. And, after the “growth spending” slows, we should see much higher margins, which would justify the high valuation multiples. Or so the story goes.

We find that differentiating facts from stories helps to clarify what we know and what we don’t know. This elevated awareness helps us hold stories lightly relative to facts. As a result, our research and internal discussions become far more constructive—they become truth-seeking exercises.

While having a “story” or opinion is unavoidable, distinguishing fact from story leads us to think more probabilistically and remain open to a range of potential outcomes.

From a behavioural standpoint, we find making the distinction helps guard ourselves against certain biases, such as overconfidence or the tendency to staunchly defend a position. And doing so ensures we focus our efforts on assembling all the evidence to provide as complete as possible investment case.

Verify, verify, verify

One of the critical steps for the research team is the verification of important facts.

Before we can begin to draw insights from observable facts, we must look critically at the gathered evidence. One quality control framework we use that’s a favourite of our deputy CIO, Christian Deckart, is to ask ourselves: “would this stand up in a court of law?”

The legal mental model is helpful. As we’ve written before, our duty as analysts is to gather evidence to provide a complete (as possible) investment case that can withstand close scrutiny.

For the evidence to withstand scrutiny, we want to see that it has been verified by multiple sources. This process of verification can differentiate signal from noise as it helps determine if a piece of evidence is an outlier. Failing to verify important facts increases the risk of placing too much weight on a misleading piece of information.

We also recognize that verification is hard. It’s time consuming and often leads to contradictory data. The great news is the quest to verify evidence is one of the most exciting parts of the job! It takes us into the real world to see assets, speak with customers, sell-side analysts, attend industry conferences, tour production facilities, and meet with management teams. It’s performing scuttlebutt and sharing and debating our findings with the rest of the team.

The act of verifying and corroborating important facts provides us with more confidence that the picture being painted—or, the “story”—is in touch with our best estimate of reality. It can help us narrow in on what is truly going on or lead us to a wider range of outcomes—and both are equally valuable insights.

Provide context

Informed investing decisions require that we not only have good, verified facts, but that we put them into context. 40% market share may sound great, but if the company had 50% market share three years ago, that’s a red flag to investigate.

In 2015, our team reviewed Sika AG, which produces and distributes specialty chemicals and materials. It was noted at the time that Sika had around 8% market share in a highly fragmented market where the top five players held roughly 25% share. In addition, the top players had not changed over the past ten years—a period where Sika generated very attractive returns on invested capital.

8% market share alone doesn’t mean a lot, but with the added context of industry fragmentation, we can deduce there is no 800-pound gorilla that dominates the industry. The additional context that market shares move slowly over time leads us to a critical question: what has prevented companies from entering this industry and driving down returns?

Additional research indicated Sika has an excellent sales network and sells products that are a very low percentage of the customer’s total cost. As a result, customers receive great service and there is minimal incentive to switch suppliers. This helped explain why the top players had not changed and why their respective market shares moved very slowly over time.

Without context for important facts, we would be left with blind spots, and most importantly, critical questions would not come to light. In our experience, investigating those questions often leads to meaningful insights.

Ultimately, because our team shares the same research framework, the above processes help to ensure decision-making is consistent and repeatable. We all have a story, but by doggedly verifying facts, and providing context, we can reduce human bias and avoid unsupportive narratives.


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