Analysis by Storytelling
Connecting story, narratives, and fundamentals for ‘Adventure Companies’
The 1948 motion picture “The Naked City” concluded with a narrator intoning the iconic line: ‘There are eight million stories in the naked city. This has been one of them’. Just as each resident of New York City has a unique story, the financial markets are animated by stories of companies vying for the attention of investors.
A story can be an an account of incidents or events, a news article, or a statement regarding the facts pertinent to a situation. Alternatively rumors, lies, and falsehoods are also stories, as is a short fictional narrative or plot of a dramatic. It’s fair to say that stories are a composite of elements, where common sense and hard facts intermingle with half-truths and distortions.
The most powerful and enduring stories in the corporate world unite multitudes around a vision or idea. Apple (AAPL), with Steve Jobs as the hero, is the quintessential business odyssey of the century.
Even so, on Wall Street being called a ‘story stock’ is not always so flattering. It refers to a company’s shares whose value is based on overly optimistic expectations for outperformance, usually based on an unproven innovation and hyped-up media coverage. Investor sentiment drives the valuation far out of line with fundamentals since buyers will pay a premium to participate in the company’s growth prospects. The biotechnology industry is a fountainhead of story stocks, although investors gravitate wherever next-gen technologies flourish.
We find an abundance of story stocks among the 1,000+ emerging growth firms (<$1B market cap) tracked by Third Stream Research—encompassing Information Technology, Biotechnology, Healthcare/Life Science, Medical Devices, and Cleantech. ‘Adventure Companies’ is the all-inclusive moniker we use for the entire group.
Defining Moment
‘Adventure’ according to Merriam-Webster is an undertaking usually involving danger and unknown risks; an exciting or remarkable experience, and an enterprise involving financial risk. Technology-intensive companies—particularly those we track—embody all of the characteristics.
Third Stream Research was created to provide both independent research and sponsored research and advisory services to help Adventure Companies build recognition of intrinsic value in the Wall Street community. Our market intelligence is built on the data and information we accumulate on the 1,000+ companies in our scope, but the centrality of intangible factors and qualitative analysis defines our process.
Traditional sell-side research coverage of Adventure Companies resists acknowledging the inherent differences between smaller technology firms in the developmental stage and mature enterprises. It's confounding that equity analysts customarily evaluate Adventure Companies and their shares with the same mindset and tools for value discovery of mid-, large- and mega-cap stocks.
We saw a microcap report last week from a boutique investment bank. It was devoid of any reference to people. Period. It didn’t even contain the names/bios of the company’s management team, or a single sentence on culture, customer experience, or anything relating to the human dimension. For that matter, the analyst failed to write a word of original commentary or analysis, instead publishing what amounts to a fill in the blank template.
This is not as strange as you would think: most equity research coverage severely undervalues the connective tissue essential in shaping the qualities of a company. Without this it’s just a numbers game.
Adventure Companies in our stock universe are either in the development or emerging stage, with highly unpredictable financials and volatile share trading. A significant percentage have sketchy fundamentals. Accounting for the 915 companies (~56% biotechs) with market capitalizations of at least $20M, 399 reported revenue of less than $50M in the latest 12 months, 89% were unprofitable over the same period, while 29% had less than $20M in cash as of their latest quarter.
Why the study of corporate culture is virtually non-existent in sell-side research when it determines success as much as anything, is perplexing. Management guru Peter Drucker who said that “Culture eats strategy for breakfast” would undoubtedly agree. His point wasn’t that strategy was unimportant, rather that a strong and empowering culture was a surer route to organizational success.
Last year in Confluence, we recounted an exchange between Datadog (DDOG) CFO David Obstler and an unidentified analyst at Barclays Global Technology, Media and Telecommunications Conference, which contrasts the analyst’s condescending attitude towards culture (i.e., what cannot be quantified is of lesser value) and the vital role it actually plays for managers and their companies:
Analyst: “How do you maintain the culture? Sorry, that's a more fluffy question, like a consultant.”
Datadog CFO: “…It's hard to have a stylistic view of the company as you might have sitting in one of these seats….We're developing a culture where people want to come to work where the engagement is very high, and then retention is high…It's the people and we're only as good as scaling this on the people side.”
No one should be astonished. The analyst’s obliviousness is representative of the predominant mindset in equity research coverage of emerging growth companies.
Whole-Brain Investing
Right brain. Left brain. Whole brain. Scientific and medical research to date indicates that humans who haven’t suffered any head trauma or diseases of the brain use both hemispheres to think and function. We still have a lot to learn about the right-left brain distinctions, but it continues to be a useful metaphor for two ways people experience the world.
Right-brained people tend to be intuitive, creative, qualitative, ‘big-picture’ thinkers who experience the world in terms that are descriptive or subjective. Left-brainers are more quantitative and analytical, attentive to details and ruled by logic. According to Robert H. Shmerling, MD at Harvard Medical School, “this is often understood as an either/or situation where one side carries the load while the other is shut off.”
“Our talent for division, for seeing the parts, is of staggering importance – second only to our capacity to transcend it, in order to see the whole.” —Iain McGilchrist, The Matter with Things
Investors who have been successful over the long term perform like whole-brain thinkers. While their primary characteristics may be dominated by either the right- or left-brain, they demonstrate a keen ability to balance aspects of both sides. Two titans of investing—Benjamin Graham and Philip Fisher—serve as counterpoints.
Graham, an economist whose name is synonymous with value investing, advanced an investment philosophy that emphasized far more than fundamental analysis. Graham wrote at length on investor psychology, minimal debt, buy-and-hold investing, concentrated diversification, buying within the margin of safety, activist investing, and contrarian mindsets.
Fisher, best known as the author of “Common Stocks and Uncommon Profits,” is one of the early proponents of the growth investing strategy. He pioneered the gathering of ‘scuttlebutt’ as a crucial part of sleuthing for information about a company. This kind of detective work enabled him to make more informed decisions due to a better basis for analysis and valuation.
Since the 1990s, when intangibles and the accounting of them were beginning to crystallize, Wall Street research initially had been slow to keep pace with the changes underway. In the years following the Tech Bubble, analysts, fund managers, institutional investors, and others accelerated efforts to understand how to value enterprises with a paucity of tangibles.
How do you establish the true market value of an asset in a world? Aswath Damodaran, a professor of finance at New York University's School of Business, is one of the best people to answer this question. His 2017 book “Narrative and Numbers: The Value of Stories in Business” is in part a personal journey for Damodaran as he evolved from a pure number cruncher to an advocate of a more holistic approach.
Numbers people (left brain) believe that stories are distractions that introduce irrationalities into investing, according to Damodaran. Narratives people (right brain) believe that valuation and investing is really about great stories and that it takes chutzpah to try to estimate numbers in the face of uncertainty.
Still, Damodaran asserts that “numbers are dangerous because they come with the illusions of control, precision, and objectivity and can be easily imitated.” Stories can reduce those problems, because they effectively serve as a check and balance on the reliability of numbers, accuracy of forecasts, and inherent biases.
“A whole [story] is what has a beginning and middle and end.” ―Aristotle, Poetics
“…storytelling in business comes with more constraints than storytelling in novels, since you are measured not just on creativity but on being able to deliver on your promises.” ― Aswath Damodaran, Narrative and Numbers
Jason Voss, an analyst with the CFA Institute at the time, gave a presentation in Mumbai at the India Investment Conference in 2015. He advocated a ‘whole-brain’ approach to seeking alpha, integrating the traditional left-brain investment skills (technical analysis, mathematical prowess, logical reasoning) with right-brain skills (intuition, creativity, nonlinear understanding).
“The right brain is important because there is no such thing as a future fact.” You’ll need intuition, creativity, and wisdom…to make the leap from historical facts to future predictions. In fact, modern alpha exists almost entirely in the space of right-brain skills because nobody’s using them, according to Voss.
Adventure Stocks are suitable for some investors, not all. But for anyone attracted to this wild terrain, it’s advantageous to be wired in a way that activates right-brain qualities.
Sphere of Influence
Stories matter more at the earlier stages of a business, while numbers speak more loudly as companies mature. Analysis for Third Stream Research’s universe of coverage is determined by story first—but it’s more complicated. A story in our view is invariably connected with all of the circumstances and imperatives that contribute to the emergence of a growth company.
Our valuation model for technology-intensive companies with market capitalizations up to $1 billion is illustrated below. Models are always abstract and simplifications of the real world, so the sphere conveys the three main concepts—Story, Narratives, and Fundamentals with their main elements—and alludes to the myriad relationships across all levels:
STORY: the essential qualities of a company
NARRATIVES: of or relating to the process and development of a company’s story
FUNDAMENTALS: metrics and methods of measuring a company's intrinsic value
Third Stream Research modifies the widely accepted definitions of Story and Narratives to help describe how we research and analyze Adventure Companies, which eschews financial models to predict the future.
Formalizing a methodology is a worthy effort that we continuously strive to attain. Progress comes in fits and starts, but each step moves us closer to understanding how the diverse, complex, and dynamic elements work together to form a clear picture of a company with insight into probabilities about future paths.
We have discussed only abstractions until now, so it’s constructive to introduce a real-world example.
In October we issued an independent report on ProPhase Labs (PRPH), writing that the company’s “agile management team balances aggressive strategies with pragmatic financial stewardship and a track record of execution—a combination we have rarely seen in a development-stage life science company.”
Third Stream Research covers the new generation of emerging growth companies that are successfully leveraging digital transformation.
ProPhase Labs, Inc. (Nasdaq: PRPH) – Initiation Report, October 18, 2022
Analyst Rating: BUY; long-term market outperformance.
From our Investment Thesis:
“ProPhase Labs is a relatively new entrant into the diagnostic laboratory business, having launched operations in late 2020. Accordingly, PRPH’s success with COVID-19 testing may be perceived as beginner’s luck. We see it differently.
ProPhase fits the classic definition of a disruptive innovator: a challenger entering the low end of a market (diagnostic labs) with an efficient business model. As the firm gains a toehold, it targets additional market segments (whole genome sequencing and biopharma). Rather than inventing breakthrough technologies to improve already good products, the company innovates to make products and services more accessible and affordable, thereby making them available to a larger population.
ProPhase at its core is a technology company. Its progressive management team wholeheartedly embraces digital transformation. This is most apparent when we recognize that information technology is an income generator for PRPH, not a cost center as too many C-level executives at large and small enterprises view it….”
Third Stream Research was created to provide both independent research and sponsored research and advisory services to help Adventure Companies build recognition of intrinsic value in the Wall Street community. Our market intelligence is built on the data and information we accumulate on the 1,000+ companies in our scope, but the centrality of intangible factors and qualitative analysis defines our process.
We share ideas on the emerging-growth universe and distribute articles, interviews, briefs and research coverage on Adventure Companies in the Confluence newsletter. It’s less than two months into the new strategy for Confluence and we’re excited that additional features—including a Prospects Watch List—will be introduced in the weeks ahead as we attempt to exercise the powers of our right hemisphere.
See you next week, and thank you for your support.
Josh
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Disclaimer
The content provided in this newsletter is intended to be used for informational purposes only. It is important to do your own analysis before making any investment based on your own personal circumstances. You should take independent financial advice from a professional in connection with, or independently research and verify, any information that you find on our website and wish to rely upon, whether for the purpose of making an investment decision or otherwise. I do not own shares of companies mentioned.