Narratives, reflexivity, and markets
How narratives become reality in private and public markets
I was joking with some friends the other day that companies went from being valued on free cash flow multiples to revenue multiples to narrative multiples. The truth is narratives and stories have always been a big part of investing in both the earliest and the later stages of companies.
In this post, I’ll go deeper into how narratives can emerge and touch on:
reflexivity and self-fulfilling prophecies
how narratives play a role in private markets
how narratives play a role in public markets
Reflexivity
Reflexivity refers to the idea that in areas where a lot of subjectivity exists, perceptions of reality drive decisions, which can then go on and influence reality.
One of the more outspoken proponents of Reflexivity has been George Soros, who described it as such:
I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts.
There are two key things to keep in mind:
Areas where subjectivity is involved are ones where reflexivity plays a role. There are two kinds of realities: objective realities and subjective realities. Objective realities are things that are true regardless of what others think (i.e., is it raining right now at a specific set of coordinates? My saying it is not raining while it is will not make it stop raining). Subjective realities are things where there is some level of subjective judgment involved, such as markets.
When people base their decisions on their perception of reality, it can go on and influence actual reality. Once reality changes, people’s perceptions might change again, and that may go on and influence reality again.
Self-fulfilling prophecies are an example of reflexive processes at work, where a belief or a prophecy leads to changes in behavior which then cause the prophecy to become true, even had it not been the case otherwise.
Reflexivity often pops up in private and public markets, where certain narratives about companies often gain steam and everyone in the ecosystem behaves as if the narrative is true which then results in it becoming closer to true which then alters beliefs again. That’s what I’ll touch on in the rest of this piece.
Narratives in the private markets
At the earliest stages, certain companies end up attracting “hype” among the broader ecosystem of “insiders” (i.e., investors and tastemakers) which is in excess of their execution so far1.
Hype and Narratives
This hype might be generated for any number of reasons:
Founders are good at attracting attention (outspoken personalities, founders leveraging their brand or building in public, etc.)
The company sitting at the intersection of key themes and trends prevalent at the time
A unique or novel aspect about the companies product, GTM (e.g., the way it onboards customers) or culture (e.g., unique practices or processes which it is public about) that may be applicable broadly
The companies product is loved by insiders in the ecosystem (who are a target customer but by no means the only set of target customers for the company to become successful)
This hype leads to a lot of investor interest and a lot of press and earned media. Everyone wants to get an allocation in these companies, they become the Y in “Y for X” companies that start new trends and they show up in multiple think pieces and market maps. But it doesn’t lead to customers directly initially, because customers, with some exceptions (products targeted at the community of insiders or other startups), aren’t necessarily in the same circles and so don’t care about the hype.
In the insider circles however it almost seems like even at the early stages of Seed and Series A, these companies are being anointed as successful.
How Narratives become reality
In many cases, that narrative becomes the reality over time, through reflexive processes where the perception of this company is likely to win makes people behave in that way such that it becomes more likely that the company wins.
The way it plays out it as follows:
These companies garner a lot of investor interest which allows them to raise money at high valuations with lower dilution.
They also garner a lot of earned media (whether in tech think-pieces such as market maps or people discussing the “Y for X” trend where this company is Y, or in traditional media outlets which may not necessarily be positive but either way builds awareness)
This money and “brand value” enable these companies to attract talented people
These talented people with the resources the money enables allows them to develop and distribute innovative products and earns the company a reputation of being a “talent magnet” for its size.
The products and talent lead to investor interest for the next round and the cycle repeats.
One of the things I’ve changed my mind on is that hype as a strategy is actually not a bad option for many startups. It shouldn’t be taken to the extreme where the company is building for insiders rather than their actual customers, but it can be a really good way to get the momentum flywheel spinning, and start getting some awareness around the company.
The reality is that most startups are competing against “no one giving a shit” rather than other companies. While ideally, you want customers to be the ones giving a shit, sometimes starting with insiders/investors giving a shit is enough to get the momentum going towards customers giving a shit.
Narratives in the public markets
The typical way to value stocks is to discount their future cash flows to the present. But anyone who has made a DCF knows that you can get the models to basically spit out any number you want, depending on what assumptions you make.
The key is to come up with a narrative (or probability-weighted set of narratives) of how the company and the market play out which guides the assumptions that then guide the DCF which produces the numerical output tied to that narrative.
Aswath Damodoran, a professor at NYU has touched on the importance of stories to tie together an analysis:
While your final valuation may be composed of forecasts of revenue growth, profit margins and reinvestment, it is the story that binds together these numbers that represent the soul of the valuation.
Narrative Stocks
Given that markets have imperfect information, people have different perceptions about a stock’s outlook, and that stories play a key role in driving valuations (either directly or by driving the assumptions which drive the valuations), certain stocks are able to become “narrative stocks” where very optimistic narratives are painted about the company, which often leads to an increase in stock price ahead of what would be considered normal given its future outlook.
Typically, stocks that are ripe for narratives have most if not all of the following:
A large total addressable market or vision of expanding their total addressable market
A founder with a compelling and outspoken personality who is able to sell a grand vision
High topline growth (even if on a small scale)
Progress around a technology that is not very well understood but believed to be at least somewhat unique
Fitting with broader trends prevalent at the time2
One way to think about valuations at the simplest level is to consider the stock’s value as being the expected value of the base, bear, and bull case scenarios for the stock multiplied by the expected probability of those outcomes.
So narrative stocks are those which are able to:
Paint a picture of some grandiose outcomes in the bull cases, which big TAMs and fitting in with broader trends allows for.
Increase the market’s belief in the probability that such outcomes are possible, which is where a founder can sell a grand vision and high topline growth and some progress around a technology help.
These narrative stocks then tend to go up based on:
The narratives taking shape and getting more grand
More people buying into the narratives
The perception of the increased likelihood that these grand narratives play out
And lastly, of course, actual progress towards the narratives
How Narratives becomes Reality
Similar to private markets, the existence of these narratives can help make them a reality through reflexive processes which alter behavior. The process is similar to private markets and works as follows:
As more people believe the grand narratives and assign high probabilities to them, the stock appears cheap to them, and so there are more buyers relative to sellers, which pushes the stock prices up.
These companies are then able to issue equity at these higher prices, meaning they get capital with lower dilution.
In addition, at these higher stock prices, existing employees tend to stay to at least see out their initial grant and more importantly the higher stock prices become a valuable currency to use to attract talent (the grandiose narratives also help of course)
Now armed with even more money and more talented people, the company can push towards that narrative. It also has the ability to use its expensive equity to make acquisitions which can help them make progress towards the narrative.
The Tesla Case Study
Take Tesla as an example.
How much the stock should be worth depends on what you believe the long-term trajectory is with Tesla. There’s a lot of grand possibilities - autonomous taxi network, become the leading car manufacturer, etc and a lot of less optimistic ones - every manufacturer figures out EVs, and you end up competing on price, a history of delays which suggest a potential lack of ability to scale operations.
Going back to our “narrative stock” requirements:
Large TAM. Check.
A cult-like founder who is able to sell a grand vision. Check.
Fast growth and good tech. Check.
Fits in with the EV trend. Check.
Musk was able to draw people to his vision, such that the more people started to believe the more optimistic scenarios (either implicitly based on the prices they were willing to pay for the stock or explicitly)
In fact, consider this analysis by ARK of potential 2024 prices of Tesla given different probability-weighted scenarios or “narratives”. In an interview, Cathie Wood said that she expects Tesla’s stock price to be in the ~$4K range based on them launching an autonomous network in a super bull case which is 10X from where it was at the time.
Less than 15 months later, it hit that price, despite not having this autonomous network.
Now, the price might be driven in the short term by supply and demand, but essentially at the prices of $800/share (which correspond to $4000/share split-adjusted), the market is implicitly saying that they are buying into these grander narratives and believe there is a high probability of them playing out.
Tesla was a month away from bankruptcy in ~2018, per Musk, but it survived and as its share price surged in 2020 with more people buying into the Tesla and broader EV and autonomous narrative, it was able to issue equity three times, raising $12B. The realization of this narrative has not fully played out yet, but as people have bought into it, Tesla has been able to take advantage of that and its risks of bankruptcy are close to gone, and it has a lot more money in the bank to make these grand narratives a reality and justify its valuation.
Additional Reading and Viewing
George Soros on Reflexivity: FT article and Journal Essay
Aswath Damodaran’s speech on the value of stories in finance
Robert Shiller’s speech on Narrative Economics
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I consider attention and interest commensurate with execution and performance as not being hype
Narratives in specific verticals or areas and bubbles could be a topic for a whole other post
Great post, articulates some questions I've had really well. Thank you!
This got me wondering if all “growth” stocks are narrative stocks. I think it seems reasonable to say they are.