A Story Goes With It

A Story Goes With It

Jeffrey P. Ryan, CFA, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research

November 23, 2010

Key points

• There's often much fanfare over "story" stocks—ones where news is expected to impact the stock's price.
• Investing successfully in story stocks can be difficult, but certain steps may improve your odds.
• Designed for stock investors.

A story stock is one where news, whether from a publication or an internet chat room, is expected to impact the stock's price. This is different than thematic investing—a belief that a long-term trend, like renewable energy or rising commodity prices, will affect a group of stocks over a longer period.

My personal "story" moment occurred a number of years ago, after addressing my wife's investment club on the topic of value versus growth investing. I concluded by saying, "Be careful when investing in story stocks—I'll bet you a steak dinner you're not the first person to hear the story." As I prepared to leave, the first words I heard (thankfully, not from my wife) were, "Let me tell you the story of this great stock I heard about …"

It's understandable that investors pay attention to stories. There are limits to the amount of information investors can process.¹ Focusing on recent news is one way of limiting the number of alternatives we need to consider in order to make a choice.

But not every stock with recent news will end up a winner. Can anything make this approach more successful? We decided to find out.

What makes a successful story stock?

In order for a story stock to become a success, three elements have to fall into place:

• The story must be a surprise. If many investors already know about it, the story's impact will already be factored into the stock's price.
• The story must be meaningful. In other words, it must be significant in terms of the company's earnings. For example, a new version of a product that represents less than 1% of a company's profits isn't going to have much of an effect on the company's overall performance. On the other hand, the announcement by a semiconductor manufacturer that it is building a new chip-fabrication plant costing more than $5 billion—equivalent to two years' profits—would be much more significant.
• The story must come true, at least eventually. Many dot-com and biotech stock stories went astray because the stories never turned into actual cash flows. Professor Stewart Myers of MIT once noted that top venture capitalists don't succeed by picking successful companies, but by ruthlessly weeding out companies in their portfolios that don't meet specified development plans and target dates (a characteristic of stories that don't come true).

Where do the stories come from?

A stock's story doesn't have to be delivered via chat rooms or Twitter. Wall Street stock analysts often base their recommendations on stories (also known as "investment rationales" or "investment theses"—much more dignified terms). Clients can look at any analyst report on a stock, such as those found on the Reports tab after you enter a ticker symbol, and you'll see what the analyst had in mind when developing the recommendation (sales are rising faster than expected, strong balance sheet, and so on).

An analyst's recommendation can also be "news," particularly when it deviates from the consensus and could potentially help investors focus their attention on a smaller set of potential buy candidates. But our research indicates that the stocks that analysts rate best, presumably those with the best or most powerful stories, tend to underperform the market in general.

Stocks With the Best Analyst Ratings Tend to Lag the Market

Click to enlarge
Source: Schwab Center for Financial Research from December 31, 1993, to December 31, 2008. We divided the largest 2,000 stocks (in terms of market capitalization) into five groups, based on the average of Wall Street analyst recommendations. The first set of five groups was formed on December 31, 1993. We tracked the average performance of the stocks in each group over the subsequent year. The five groups were then reconstructed on December 31 of each subsequent year until December 31, 2008, and performance was tracked over that year. The percentages shown are the gains of each group, averaged over the 16 years of our simulations.

Take a look at the chart above. It shows that on average the stocks that analysts liked best—those with the most compelling investment theses—underperformed every other group. This should serve as a warning that if Wall Street analysts' stories are so often wrong, the average investor may find "story" investing difficult.

How do you find a story stock that may work?

If you are undeterred by the odds of finding a successful story stock, here are some steps to help keep your research on track.

First, check the stock's Schwab Equity Rating for an objective view of the stock's prospects, based on factors like the company's fundamentals and valuation. We believe a Schwab Equity Rating of A or B will improve your chances of determining whether the company has a reasonable chance of turning a story into actual returns for investors. Clients can find out the Ratings of their stocks on the Stocks Overview page.

A common concern about this step is that the stock's Rating doesn't reflect the stock's potential, as embodied in its story. That might be true. But the Ratings tend to favor stocks for which the three elements noted above have occurred fairly recently, before the market in general has caught on. That's the basis for the concept of "surprise anticipation" on which Schwab Equity Ratings are built.

Second, if the stock has a Schwab Equity Rating of A or B, go through these steps as described in Managing a Stock Portfolio Using Schwab Equity Ratings:

• Check the market's sentiment about the stock, as reflected in its performance relative to a broadly defined market index and the stock's sector over the past year. If the stock's price history indicates a stock in a long-term downtrend, you've already reached the end of the story. And if the stock's sector has underperformed relative to the broader market, then the stock and its story may be fighting an uphill battle against a negative trend for the sector in general.
• Check the volume that accompanied recent performance, not just price. A stock that's already had recent upward moves in both price and volume is probably one where the news has already been embedded in the price.
• Check the news. Most stories will only work if the news is generally unknown. If the story is already in the news, it's unlikely that a "surprise" is still available.
• Check other third-party research. One of the best signs for a story stock is when institutional investors start to take positions. And generally, institutions won't do so unless they have some research-based reason. Clients can find the number of shares held by institutional investors by going to the Reports tab after entering a ticker symbol (see Schwab Equity Ratings Report or several of the third-party research reports).

If by this point you've encountered nothing that makes you doubt the story or the stock, go to the company's website and look for any investor-relations materials that might be available. If you can see how the story represents a positive addition to the narrative presented the company's investor-relations documents—prospectuses, annual reports and SEC filings—then you've made a good start at doing your "due diligence" on the story.

1. Barber and Odean. "All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors," Review of Financial Studies, Vol. 21, Nr. 2 (2008).

Important Disclosures
Schwab Equity Ratings use a scale of A, B, C, D and F and are assigned to approximately 3,000 stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months. Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.

The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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