Our personality and experiences shape our investment philosophy. Similar to an artist molding a clump of clay into something desirable, investors mold and shape their investment philosophies over time into something more lasting and profitable. Since your investment philosophy is the cumulative effect of your past experiences, it also forms a focal point or lens on different investing topics. Market participant’s love to debate topics such as: Investing versus Swing Trading, Growth versus Value, Diversification versus Concentration, and finally Qualitative versus Quantitative Analysis.
Great descriptions of Quantitative Analysis and Qualitative Analysis can be found on @BaseHitInvestor’s blog [HERE]. Imitation is the best form of flattery, so I’ve asked for John’s permission to copy/paste his descriptions of the two schools of thought below:
- Analyzing income statements, balance sheets, cash flows
- Comparing current valuations with historical valuations
- Comparing valuations and company financials with other companies in the same industry
- Rarely talk to company management
- Studies the stock, but not the company (not overly concerned with the company’s products or services)
- Doesn’t rely on anything other than publicly available data
- Doesn’t put much weight on the industry or sector, nor the trends of those sectors
- Doesn’t rely on macro economic trends or overall top down analysis
- Usually run diversified portfolios since they don’t analyze each company in depth
- Talking to management
- Relies on “scuttlebutt”: i.e. talking with a company’s competitors, vendors and distributors to gain legal information that others might not have
- Analyzing in depth the company’s products or services
- Determining the capability of the company’s management
- Determining the competitive advantages a company has or doesn’t have
- Making judgments on the prospects for the industry or general line of business the company is in (sustainable, growing, etc…)
- Often concentrates the portfolio in a select few positions that have been thoroughly researched
You won’t find anyone that ever says Quantitative Analysis is useless, so the real debate has always been the importance of Qualitative Analysis. I would like to give my perspective, but keep in mind I’m looking at it through the lens of a quality focused microcap investor. I make my living exclusively investing in small public companies less than $100 million market cap. My #1 priority isn’t finding cheap companies, it’s finding great companies early.
Quantitative analysis is very important and it’s what brings to light most new opportunities. It is an important first step which I like to call surface due diligence. To really understand a company you need to look below the surface. Refusing to conduct qualitative analysis is like driving a car without being able to hear. You can still drive. You might even be able to drive pretty well, but most would agree the ability to hear would make you more comfortable and decisive behind the wheel. In the same way you must use all five senses when you conduct analysis into a company.
I hate to break it to you, but there is no such thing as an even playing field. Those investors that work the hardest and make the best decisions win. Period. The more informed you are the better decisions you will make. Going the extra mile to uncover exclusive public information is always a benefit. If I attend a conference where a company presents to a group of investors and the presentation is also broadcast live on the internet. Because I was sitting in the room I could pick up on body language. I could see the CFO roll his eyes when the CEO talked enthusiastically about an upcoming product. I also heard two questions/answers that didn’t make it on the internet broadcast. That is an edge and it’s why going the extra mile to meet management in person is always an advantage.
When Warren Buffett was just getting started and making his first $100,000, he was more of a quantitative analysis Ben Graham disciple. Even back then in 1950 he decided to do qualitative analysis and visited with GEICO’s Lorimer Davidson for hours before investing a bulk of his capital into the company.
“To achieve superior results, you have to have an edge in either information or analysis, or both.”In my experience the smaller the company the more you should focus on management and qualitative analysis. Microcap companies become microcaps two different ways. Either they were larger companies that became small (fallen angels), or they were always small. I tend to focus on the latter. This subset of microcap companies are normally more unknown and don’t have long operating histories. Greater emphasis needs to be placed on qualitative attributes to form a high conviction investment decision. In addition, you will find the smaller the business the greater the impact the CEO has on the company and its future. We have written about the importance of Talking to Management [HERE] and The Art of Interviewing Management [HERE].
“If you get an opportunity to get into a wonderful business that’s being run by an intelligent fanatic and if you don’t load up, it’s a big mistake”
Beyond talking to management to see if they are capable managers, you are really looking for these intelligent fanatics. Sanjay Bakshi (a must follow @Sanjay__Bakshi) wrote this excellent piece on Intelligent Fanatics. Intelligent fanatics are those CEO’s that have intense focus, integrity, energy, and intelligence. As Sanjay says, “(1) an intelligent fanatic has the ability to turn what looks like a poor business into a very good one; and (2) the force (I call it “fire in the belly”)” of an intelligent fanatic, when combined with a good business, has a tendency to produce what Charlie Munger calls a “lollapalooza” outcome.”
In this fascinating video interview, value investor Paul Lountzis talks about qualitative and scuttlebutt research. I would encourage everyone to view the entire interview. (@ 1 hour 10 min) Paul says:
“Companies today in many cases are becoming commoditized. Two examples are banking and insurance. They are inherently commodities; they’re not that complicated. What’s the difference? It’s the people. And the ability to find the young Phil Knight, a young Howard from Starbucks, a young John Mackey from Whole Foods, it is becoming ever more important and I don’t mean identifying one person. I mean maybe identifying that one person like a Phil Knight in 86′ that has a unique vision, drive, focus that consumes him. And as a result of him and how he thinks, he is creating a culture that is so different and unique and everlasting…. You need managements that are adaptive, flexible, creative, and innovative in a multitude of ways... This is becoming more important today because things are changing at a phenomenally rapid pace that if management isn’t like that, then you’ve got a problem.”
If you want to understand a company’s moat and staying power you should analyze a company’s product/service and talk to industry experts and competitors. Some of this you can do by reading annual reports and exploring the internet, but for the real value add information you’re going to have to get your hands dirty and do some physical stock research.
“Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.”So why don’t more people do qualitative analysis? The bottom line is because it is hard work. At first it is uncomfortable to visit companies, management teams, or cold call competitors, suppliers, and customers. Anyone can be taught quantitative analysis. Qualitative analysis is the real “edge” because so few do it, and it takes time and experience to do it well.
Fund manager Avner Mandelman wrote a great book on qualitative analysis called, “The Sleuth Investor”. When Avner conducts due diligence he approaches it like a detective. In the book he gives his sleuthing techniques to uncover information that can give him an edge.
“As an aside I occasionally give talks to MBA classes about Sleuth Investing (in Ivey’s business school in Canada, or in Columbia in the U.S.), and found it odd that very often, the smarter the students, the more difficult it is for them to grasp the idea of physical stock research. And even those who do, usually right away they want to computerize it, automate it, do it with databases, A.I. algorithms …What most instinctively resist is the hard work of person-to-person contact, and the use of all five senses, so as to generate an un-quantifiable, un-modellable gut feel.”Don’t let your entitlement handcuff your returns. Don’t be lazy. This is a competition. In a recent blog post by Ben Carlson, he talks about legendary hedge fund manager Michael Steinhardt. When Steinhardt was asked what the most important thing an average investor could learn from him, he replied, “I’m their competition.” If you are looking for great companies early, you want to find them before others.
Your “edge” is knowing your investments better than most. This is a must if you are going to be successful and quite frankly your fiduciary duty if you manage OPM (other peoples money). The only way to develop the Conviction To Hold is to know your positions better than most. Don’t bother finding the next multi-bagger if you aren’t going to develop the conviction to hold them. You can’t do this by quantitative analysis and surface due diligence alone. This can only be achieved by having a deeper understanding of your investments. The smaller the company the greater the impact that management has on the business. The smaller the company the more important qualitative analysis becomes. Qualitative analysis doesn’t just mean analyzing things that can’t be quantified. Qualitative analysis is looking for quality. Quality over Quantity in everything.
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