“Not everything that counts can be counted, and not everything that can be counted counts.”
Editor’s notes: Value investing is often seen as a science of carefully balancing various fundamental ratios, judging probabilities and running some arcane discount models. Ben Graham was certainly an advocate of looking at a business through the lens of hard numbers. However, as Buffett and many other value investors have discovered, it pays to consider the softer aspects of a potential investment. Mike Mask writes about contrarian investing and argues in this article below that the ideal investment style is a blend of quantitative and qualitative research. No arguments from me there – this is certainly what I employ in my practice.
Fundamental analysis, which is the evaluation of a stock based on its business characteristics, can be broadly broken down into two key categories: quantitative analysis and qualitative analysis.
Quantitative analysis involves looking at the hard numbers: anything from comp sheets (comparable companies) and financial ratio analysis to complex discounted cash flow models and more. You’re looking at profits, margins, sales trends, present and future values and such to gain insight into the meat and potatoes of the company’s business operations.
Qualitative analysis, on the other hand, requires digging beneath the hard numbers to discover the qualities of the business because those qualities are ultimately what produce the quantitative results.
Qualitative analysis involves asking yourself questions like “Do I understand the business and its competitive environment?” “Does management have a lot of integrity and talent?” “Are management’s interests aligned with my own?” “Am I under the influence of any psychological biases?” “Why are these numbers the way they are?” “What is the company’s competitive advantage and how durable is it?”
Most investors rely primarily on quantitative analysis. Indeed a whole new breed of stock market guru has swept Wall Street who takes quantitative analysis to an entirely new level. They’re called quants.
Referred to as “the alchemists of Wall Street”, quants mix high finance with high level mathematics and computer programming to profit off of (typically, though not always) short-term price fluctuations in the stock market.
The problem with strictly relying on quantitative data to invest is that data points are not representative of true understanding. A complete understanding of how a business works requires a keen awareness of the intricacies of the company that cause those data points to be the way they are. Qualitative analysis can help an investor figure out which data points they should focus on for specific companies and industries, and can help generate good contrarian investing opportunities when a good company is temporarily clouded by poor financial ratios and performance.
It’s not enough to know that a company has returned 15% on equity compounded over the last 5 years. An investor must figure out exactly what elements caused those returns and how likely it is that they can be sustained.
But there are a good number of investors out there who (wisely I think) look to the intersection between qualitative and quantitative analysis to find the real story of what is going on with the business.
One classic example of such an investment was Berkshire Hathaway’s large investment in Coca Cola (KO) back in the late 1980’s.
Coca Cola checked off all the quantitative boxes such as: stable sales growth, low debt, and consistent and above average returns on invested capital.
But the real genius of Buffett’s Coca Cola investment was the simplicity of the business and the power and durability of its brand. Bruce Greenwald put it best: “If you go to Mexico you might drink a Mexican beer, but you would never drink a Mexican Coke.”
Buffett recognized that technology was changing at an ever-increasing rate, but he also realized that the extremely simple business of selling glorified sugar water wasn’t going to be radically altered by emerging technologies any time soon. As Buffett later said about the chewing gum business “the internet isn’t going to change the way we chew gum.”
And finally, Buffett used his principle of being greedy when others are fearful by purchasing Coca Cola shares at a time when the company was experiencing some short-term problems and a mob mentality had formed against the stock that led to a significantly reduced share price as a result.
Buffett saw the great quantitative data, but countless companies possessed similarly great numbers. The key is that through qualitative analysis, Buffett was able to determine that Coca Cola’s attractive quantitative numbers, unlike those of numerous other businesses, were highly likely to be sustained for an extended period of time. And that is what made all the difference.
Follow Mike on twitter @ContrarianVille