07 Dec 2 Approaches to Value Investing – Qualitative vs Quantitative
Not many people are aware of the existence of the two approaches to Value Investing. Most investors understood the qualitative method, but fewer have heard about the quantitative method. I think it isn’t the fault of investors but rather, the success of Warren Buffett puts the qualitative approach to the fore. I first wrote about investing in assets versus investing in earnings, and this article extends the discussion on the differences.
Benjamin Graham coined the terms “Qualitative” and “Quantitative” approach to investing in his book, “The Intelligent Investor”. I quote,
“Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations. Corresponding with these two kinds of value elements are two basically different approaches to security analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.
Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years – in particular whether earnings will show pronounced and persistent growth. These conclusions may be based on a very careful study of such factors as supply and demand in the industry – or volume, price, and costs – or else they may be derived from a rather naive projection of the line of past growth into the future. If these authorities are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling…
By contrast, those who emphasize protection are always especially concerned with the price of the issue at the time of study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price – which margin could absorb unfavorable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company’s long-run prospects as it is to be reasonably confident that the enterprise will get along.
The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth.”
Qualitative Value Investing
As Graham mentioned, qualitative approach entails assessment of nonmeasurable factors such as management integrity and ability, competitive advantage, brand equity, etc. Warren Buffett adopts such qualitative approach and in particular, he wrote about the qualitative factors he considers in one of his essays:
- The certainty with which the long-term economic characteristics of the business can be evaluated;
- The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
- The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself;
- The purchase price of the business;
- The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
Such evaluations definitely require more guesswork and most people will fail terribly at it. Warren Buffett has a knack of getting it right in the business he understands. But most retail investors are not Warren Buffett. We do not have his skills and insights to project the future with a certain degree of certainty.
Even our highly intelligent and knowledgeable financial analysts aren’t able to do it well enough. Without a doubt, the future returns are high with the qualitative approach. However, there is no point of fantasizing about mouth-watering returns when we cannot do it accurately enough. It will often backfire with disappointing returns, even worse than the stock index returns.
Quantitative Value Investing
Quantitative approach entails the analysis of the current state of the business. While qualitative approach buys a business less than what it is worth in the future, quantitative approach pays less than what the business is worth today. This requires the use of financial ratios such as Price-to-Book and Price-to-Earnings to evaluate the strength of the company.
Quantitaive approach’s risk management centralises on margin of safety as well as diversification. First, buy as low as possible below the value of the company. Second, diversify into many undervalued stocks. Below is a list of rules Walter Schloss advocated (not exhaustive, he has more rules than these):
- Diversify into many stocks
- Stocks trading below book value
- Stocks with little to no debt
- Stocks trading at new price lows
Most of these rules are quantifiable. They are less subjective as the qualitative approach. It also doesn’t require the investor to know a company deeply to ascertain her future prospects. The analysis of a company can be completed within minutes just by the numbers. Hence, the quantitative approach suits the investor with a full-time job, and he is unable to intimately keep up with in depth company research and developments.
Qualitative or Quantitative approach?
This article is biased towards the quantitative approach because I opined it is more suited to investors who have not much time and experience, and yet it can yield decent returns of 12-15% per annum. Of course, there is nothing wrong if an investor wish to pursue the qualitative approach and aim for a higher return than a quantitative approach could. However, the success rate of the former isn’t high.