Before we look at the next investment style debate, I want to go through the two types of fundamental analysis.
You will encounter both quantitative and qualitative analysis (aka “Quants & Quals”) when researching potential investments. Both are important to understand, as well as knowing their strengths and weaknesses.
Quantitative Analysis
Quantitative analysis looks at hard data. That may be the economy, market, industry, company, etc. You may also see this called the “fundamentals”.
A company’s fundamentals are compared to historic results and expected future performance. A company is compared against fundamentals of its peers, the industry and sector in which it operates, and the stock market as a whole.
Common fundamentals include: price/earnings; price/book; dividend yields. We will look at each in separate posts.
It is relatively easy to perform quantitative analysis.
Find the correct data – not always a simple thing to do, especially for small companies -, plug it into the appropriate equation, and you have your result.
But if it were that easy we would all be very wealthy.
Qualitative Analysis
Investors tend to do a decent job on quantitative analysis. That is, most arrive at similar ratios and results.
What usually trips them up is the qualitative side.
I believe qualitative analysis is the key to any investing decisions. Whether they be stocks, buying a home, or lending money to a friend. So pay close attention to this side of analysis when researching any potential investment.
Based on quantitative data, terrible investments may look attractive. No one wants shares in bad companies. Weak demand and excess supply drive the share price of a junk company lower. Unfortunately, the fundamentals (being a function of the share price) tend to look very good, when instead they should be a warning to potential investors.
When we cover the common fundamentals later, we will go through some examples.
Qualitative analysis uses non-numeric data to assist in separating the wheat from the chaff. It provides context to the hard number quantitative analysis.
Qualitative analysis involves assessing a company’s nonsystematic risks (see Part I and Part II for greater detail), including: management; operations; competitors and the industry.
Management
Management is the number one driver when I consider companies.
Equally important when assessing mutual or exchange traded funds. Strong fund management is crucial.
Management makes the decisions that impact operating performance and ultimately the share price. As an investor, you want to invest in well-run companies. If you do, you will increase your probability of positive returns.
Who is on the management team?
Review their credentials and experience in the industry. What is their track record of success?
With key management, past performance is an indicator of future results. Both good and bad.
How long has the current management team been in place?
If a successful company has recently lost key management, it may be a sign of problems or changes in the approach to running the company.
If management is new, were they successful in their previous ventures?
These are some of the questions you should consider.
Operations
What does the company do? Does the business model make sense in today’s world?
A few years ago, manufacturers of floppy disks were profitable. Today, if they have not evolved into making flash drives or “in-the-cloud”, they are no longer in business.
What is your experience with the company’s product?
Consider something as simple as cola products. Let’s pretend that Coke, Pepsi, and RC Cola are all separate companies with only one product, cola.
When you are at the grocery store, in a restaurant, or at an event, what do you see? A lot of Coke and Pepsi for sale, but much less for RC. Intuitively, who do you think sells more cola?
When you plan to invest in a company, think about how its products are seen in the world.
The same is true for your personal likes and dislikes.
For the most part, you are the “average” consumer. Trust your judgement when investing.
Maybe you plan to buy a smartphone and options include iPhones, Blackberries, and Androids.
Which one is getting the best reviews? Which one did you purchase or would like to buy? What are your friends buying?
If you are a typical consumer, then there is a high probability that other consumers are making the same choices as you and your friends. This results in stronger sales than competitors, which should enhance profitability and the share price.
When assessing a particular company, always consider its products. If the product is junk, there is a good chance that the stock is also junk and not a good investment.
That said, a lower end company may be undervalued and a good buy. Or well regarded companies may be overpriced and not great investments. You want to invest in good companies. Just not at too big a premium.
Industry and Competitors
Just because your quantitative analysis indicates a stock has potential value does not mean it is a great investment.
If the industry is in a downturn, even good investments may suffer.
Consider the real estate market. Perhaps it is in a major slump in your region. If you intend to sell your home, you may have to accept less than you believe to be its true value. It is not the fault of the house, rather it is an industry wide issue.
Often you will find a well-managed company that sells quality products. But in their market segment, they cannot compete against even stronger competitors.
Apple came to dominate the MP3 player market with its iPod, then iPhone. Even competitors with good products suffered.
You may love a product, but always review it in light of the industry before investing.
This is obviously not an exhaustive list of things to analyze.
Legal issues are often key. Government policies – regulatory, tax, subsidies – may also need review. Depending on the industry or company, there may be other crucial items to review.
For example, solar companies may only be currently viable due to government subsidies and incentives. Or consider The Weinstein Company. Until recently, a well regarded film studio. After all its legal and related issues have come to light, its value has plummeted.
