There has always been an ongoing debate about the pros and cons of quantitative and qualitative methods for picking stocks. Which way works better? Is one better than the other? Should an investor use both “quant” and “qual” factors when making investment decisions? I’m not sure… but I’ll give you my opinion.
Two of the investors that I’ve learned the most from had completely different viewpoints on these two schools of thought. Ben Graham was a quantitative analyst, choosing only to make investment decisions based on the numbers that were publicly available to everyone (standard income, balance sheet, cash flow statements, annual reports, etc…). On the other hand, Warren Buffett, although one of Graham’s students, thought that qualitative analysis was what “really made the cash register sing”. Now, Buffett started his career as much more of a “numbers guy”, paging through Moody’s manuals one stock at a time and looking for bargains. He became more qualitative over time as his skills developed.
To briefly summarize the basics from the two schools of thought:
- 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
So quants basically just invest by using the numbers. It doesn’t mean quants can’t take a look at the company or management and factor some of those things into their decision, but true quants really just look at the numbers and decide if the stock is a good value or not. In fact, Ben Graham and Walter Schloss both agreed that talking to management can actually be counterproductive, as management is always overly optimistic about their company’s prospects.
- 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
Qualitative analysts look at the business itself and tries to make decisions based on the above qualitative factors. Phil Fisher, who was a great qualitative investor, wrote the best book on qualitative analysis (in my opinion). I strongly recommend it: Common Stocks and Uncommon Profits.
So Which Method Is Better?
I use both to an extent, but I’m much more comfortable, at least at this stage in my career, using primarily quantitative analysis. The skillsets for each method are very different, and require different methods of operation. Much of it has to do with your personality. Do you want to spend time talking with people, visiting companies, reading all kinds of trade journals, or would you prefer analyzing numbers, reading company annual reports, and poring over SEC filings?
For me, it’s also a matter of time, and how I can feasibly run my business…. Walter Schloss discusses how he thought that Peter Lynch (a great qualitative investor) burned himself out because he worked so hard and had endless amounts of information to cover on each company. He only ran the Magellan Fund for 13 years before retiring. Schloss on the other hand ran his fund with very little stress for 47 years. Buffett also talked about how he envied Schloss at times for being able to (paraphrasing) “come in at 9, leave at 4:30, read company reports all day, buy cheap stocks, make 20% per year, and sleep well at night.” Longevity is a very important factor when considering an investment strategy.
Buffett talks about how the “sure money” is made by analyzing the numbers. Buffett started his career as a numbers guy, and made huge returns in the early years of his partnership thanks to this method. He slowly evolved as an investor and later developed (thanks in large part to the influence from Charlie Munger) into a much more qualitative investor.
Ben Graham stayed a quant for his entire career. In fact, later in Graham’s career, he felt that even elaborate quantitative analysis was not necessarily better than using just simple valuation metrics like P/E, Price to Book, Dividends, and a few others. In this interview in 1976: A Conversation with Ben Graham he gives an overview of this method. The method was basically buying stocks with low P/E ratios with debt to equity ratios under .5, and current ratios over 2. Can’t get much simpler… He actually backtested his new simple method and found that it made 15% per year from 1926-1976 (relative to the Dow’s 7% per year).
Walter Schloss was a big believer in using simple numbers from Value Line and reading company annual reports. He didn’t even have a computer, and rarely used the phone. He bought cheap stocks relative to their assets (he loved price/tangible book value), and did that day after day, year after year. He wrote this great piece: Why We Invest the Way We Do, which discusses more of the reasons why he prefers to use simple numbers over elaborate analysis.
Joel Greenblatt developed his famous Magic Formula, which was not only quantitative, but also systematic. The system has simple rules for buying and selling stocks each year, and it’s very easy to follow. And it relies on just two simple metrics: Enterprise Value/EBIT and Return on Invested Capital (ROIC). The system averaged around 30% per year from 1988-2004 (per Greenblatt’s book).
To Summarize My Thoughts:
I think that these two methods both are an important part of an investment strategy, but I prefer to give more weight to the quant side. I find that it suits my personality and my current set of skills. I intend to improve my analytical skills over time, and maybe my thoughts on this topic will evolve. But for now, I choose to study and learn from Buffett and other great qualitative investors, but to manage my portfolio using basic quantitative value principles and investment methods that have been proven to be successful and predictable over time.