What Drives Narrative Changes, Part 1
This is the first Insight in a two-part series in which we will discuss the reasons why narrative changes happen, positively and negatively, in public equities. In the second part, we will discuss why one specific sector (cruise companies) deserves a positive narrative change.
Investors feel safest owning stocks whose estimates are rising. They are willing to pay up for companies which grow revenues and earnings with relatively low variance and are not very cyclical. However, there are times when narratives change, when stocks that have been favored become unfavored—not just for cyclical reasons—and when stocks that have been unfavored become favored. This post will outline some of the major reasons why narratives change, driving large changes in valuations.
Background
Investors want to invest in companies with rising revenues, rising margins, and rising earnings and/or free cash flow per share. Who wouldn’t, right? When consensus estimates are rising and a company is beating those expectations most of the time, investors want to get in on the action. Often this creates a snowballing effect because positive price momentum attracts attention and creates FOMO. Conversely, when a company’s fundamental performance disappoints, investors may fear the good times are over and rush to exit. Again, it snowballs when momentum turns negative and fast-money speculators sell at the same time. Stocks often overshoot in both directions before settling into their valuations, and then they tend to trade in ranges that approximate intrinsic value per share…until a narrative change occurs.
Let’s take a small detour to explain what happens academically through the lens of a DCF analysis. While ultimately a company’s value should match its DCF, we are hesitant to attribute too much value to these analyses because of their sensitivity to a few key assumptions. That said, understanding the inputs and outputs is helpful in describing why narrative changes can cause huge swings in stock prices, particularly regarding Terminal Value.
Terminal Value
Most of a company’s value is contained in the market’s view of Terminal Value. A company that can grow its free cash flow 4% forever with a 15% discount rate would have Terminal Value worth 65% of its DCF value. A company that can grow 10% for 10 years and then 7% thereafter would have Terminal Value worth nearly 80% of its DCF value. It’s the biggest swing factor when determining valuation.
The three variables that drive Terminal Value are (a) final year free cash flow, (b) terminal growth rate, and (c) discount rate. The formula is:
Terminal Value = [Final Year FCF x (1 + Terminal Growth Rate)] / (Discount Rate – Terminal Growth Rate)
Growth is the single biggest driver of value – higher growth will translate into higher final year FCF and a bigger multiplier on that value (dividing by a smaller fraction) via the formula above. This is important to understand when discussing narrative changes.
Most of the companies blessed with the “quality” tag, observable in high valuation multiples, have proven themselves through steady and predictable execution. Rising numbers, regularly exceeding consensus expectations, etc., along with qualitative attributes that amount to competitive differentiation and moats. These companies tend to garner high multiples because (a) they have superior growth and/or (b) due to steady performance, investors have high confidence in the future and require a lower discount rate (said another way, lower variance and higher probability). Conversely, companies trading at low multiples tend to be ones that (a) have poor prospects for growth and profitability and/or (b) have unsteady execution which raises doubts about the future and pushes investors to require a higher discount rate. Raising and lowering discount rates has massive impacts on enterprise value, and the discount rate is inversely proportional to the market’s view of the weighted-average probability of outcomes. The more likely the outcome, the lower the discount rate, and vice versa. Let’s walk through some quick examples:
If Company A has Final Year FCF of $100 million, 3% terminal growth, and the market assigns a 10% discount rate, its Terminal Value would be $1,471 million.
If Company B has Final Year FCF of $100 million, 3% terminal growth, and a 6% discount rate (“bond-like” in its variance), its Terminal Value would be $3,433 million, over 100% greater than Company A’s Terminal Value. The market’s confidence in outcomes, expressed through different discount rates, has significant implications on equity values.
These effects help explain why consumer staples companies with modest growth prospects trade at high valuations, while cyclical companies tend to trade at much lower valuations. Clorox (NYSE: CLX) trades at about 30x current year earnings, while GM (NYSE: GM) trades at about 4.5x current year earnings. There is a significant difference in the cyclical sensitivity of these companies’ earnings, their long-term growth prospects, and in the market’s assessment of the appropriate discount rate to use for each company’s valuation.
Let’s imagine some scenarios and think through what might happen. What if Amazon Basics expanded to overlap completely with Clorox’s most important and highest margin products, and Amazon’s grocery efforts started working at much bigger scale to push those products online and in store? Could it put a chink in Clorox’s “low discount rate” armor? Would the market reduce its free cash flow expectations AND attribute a higher discount rate to accept the risk of Amazon taking market share and/or reducing prices and margins? This is the type of double-whammy narrative change that can cause significant drawdowns very quickly. Where would the dust settle? Which investors would be willing to bet against the disruption case, and at what prices?
Likewise, what if GM’s Cruise division became the first to solve fully autonomous driving, thereby supersizing demand for GM’s cars? What if the company could raise prices, volumes, and margins, increasing final year FCF materially and the discount rate investors would use? Another double-whammy of rapid value accretion.
These are the types of developments that constitute narrative changes, but they don’t have to be that earth-shattering to cause significant changes in valuations.
Narrative Changes
Companies going through normal cyclical slowdowns or accelerations may experience bouts of volatility that do not correspond to narrative changes. It is normal for there to be relatively large trading ranges, and a stock bouncing around its trading range does not constitute a narrative change. We want to focus on events that change the market’s assessment of terminal value in a more meaningful way.
In our experience, there are some specific triggers that tend to force investors to reassess their views on a company. These “narrative changes” are more than numbers moving around at the margins– they cause a reassessment of growth and of the discount rate – both huge factors when calculating terminal value, catalyzing a “double-whammy” impact on valuation.
There are a number of developments that can cause narrative changes:
A change in revenue growth
A change in margin outlook
A change in balance sheet health and/or capital allocation
A change in predictability of revenues (more or less cyclical)
A change in competitive intensity
Strategic M&A
Serendipitous “ah ha” by the market, i.e. fantasy land (this never happens)
If big enough, any of these could drive a narrative change. While it’s easy to think that investors watching a company closely will detect important changes immediately, this process usually takes time. As we discussed in our Insight about Charter, the residential broadband market became more competitive when 5G wireless operators entered the broadband market with compelling prices and low friction installations. However, Charter’s investors and management team shrugged off increasing competitive intensity for several quarters before recognizing that fixed wireless 5G broadband services were winning subscribers from cable operators. The narrative shift happened slowly, then accelerated when Charter’s subscriber woes worsened.
Many mature “quality” companies like Charter are in a long-term fight against disruptive forces. Investors hope that the moats these companies have built over time can endure forever. Even if most investors don’t own stocks forever, if the 10-year view becomes murkier, Terminal Values will adjust within many investors’ holding periods.
Meta Platforms (NASDAQ: META) suffered one of the quickest narrative change “round trips” in the market over the last two years. It dropped -70% while suffering from a double-whammy of (a) margin compression and pressure on free cash flow from seemingly boundless capital intensity to compete in the platform wars, and (b) powerful new competition from TikTok. These led to reduced free cash flow expectations and a higher discount rate to accommodate for greater execution and competitive risks. Subsequently, Mark Zuckerberg announced the year of efficiency, internal performance started to improve, and Reels successfully fought back against TikTok, all of which turned around revenue, margins, and free cash flow. To top it off, Meta announced its first regular dividend which opened a new class of investors to the company (capital allocation change). It lived through a big negative narrative change, followed by a massive positive narrative change.
Closing
We invest in Builder Companies because they are the disruptors that continue to invest, add value to customers, and push to gain more share over time – even though they already have the strongest brands in their markets. We prefer to own companies that continue to attack competitors, armed with faster/better/cheaper products and services, rather than those defending an already-built fortress position. Our Builder Companies generate annual growth in free cash flow per share of at least 15% per year on a normalized basis. While focusing our quantitative analyses on this metric, we evaluate all the drivers of narrative changes as part of our normal workflow, particularly as we build confidence in competitive dynamics, growth, margins, capital allocation, and more.
It is difficult to change investors’ minds about a company or an industry. It is often psychologically and emotionally easier to assume the future will continue to look like the recent past rather than to bet on a change in trend. While it’s fun and exciting for some investors to bet on a narrative change, they often take much longer than most participants would like. We don’t look explicitly for Builder Companies that we believe should benefit from a significant narrative change, but all our companies should benefit from strong revenue growth, expanding margins, and attractive growth in free cash flow per share, powered by sustained share gains in healthy end markets. Some of our companies are appreciated by the market, while others may benefit from narrative changes over time, and we believe it’s healthy to own companies in both categories. We expect our companies’ returns to approximate their long-term growth in free cash flow per share, but it is likely that our highest returning investments also will benefit from positive narrative changes which adds extra gains from improving valuations.
In Part two of this mini-series, we will talk about an industry which we believe deserves a narrative change: Cruise companies.
