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Why NOT to Use Qualitative Analysis

The theories behind how to analyze a stock can vary greatly depending on who you are talking to. There’s guys who like to focus on the growth of a stock, and those who focus on finding value. There’s those who like to examine the business, and those who like to look at the chart.

In this same regard, there are investors who focus on the qualitative features of a business, and those who focus on the quantitative. Now of course there are upsides and downsides to each one. Let’s talk about qualitative analysis and form an opinion on the matter.

qualitative analysis

Google’s dictionary defines the word qualitative as “measuring the quality of something rather than its quantity”. The term qualitative analysis is defined by Investopedia as security analysis that uses subjective judgment based on unquantifiable information.

The characteristics that investors who rely on qualitative analysis usually focus on usually revolve around the perception of management, the perception of the market or industry, the perception of a company’s future prospects due to perceived demand or strong R&D, or other such intangibles.

Examining this further, the top comment on businessdictionary.com defined solid qualitiative analysis as when “you can just tell it has good value to your company”. As you dig more and more into the central thesis of qualitative analysis, you’ll see it centers on the investor’s emotions about a company.

If you’ve been following my blog for any amount of time, you’ll know I argue profusely against letting your emotions dictate your investment decisions. We know the stock market runs off of the collective emotions of all investors involved, constantly varying in degrees of fear or greed.

Many investors’ shortcomings come from being swept up in these emotions. 

For example, being greedy near the top of a bull market and paying too high of a premium for stocks that subsequently crash lower. Or… avoiding stocks at the bottom of a bear market until most of the recovery gains are already missed.

But surely there must be some good to qualitative analysis, especially because some famous and successful investors such as Philip Fisher relied on it. Right?

In his investing classic Common Stocks and Uncommon Profits, Philip Fisher called his qualitative analysis scuttlebutt, wherein he would glean information through conversations with top executives in those prospective companies he wanted to invest in.

I hope that you can see that the more I explain qualitative analysis, the less useful it is to the common investor. For one, we don’t have access to top executives. Last I checked, none of us have the credentials or capital that a Warren Buffett would have to make scuttlebutt easy.

Even still, how many executives do you think that are out there that wouldn’t talk favorably about their company? Any information gleaned from scuttlebutt would undoubtedly be colored with rose colored lenses, with any shortcomings glossed over or purposely hidden.

After all, it’s in the best interest of management to have as much investment capital into their company as possible. I hope I don’t have to remind you of the vast amount of stock options compensated to top executives which make up a big portion of their net worth.

Qualitative Analysis: The Big Issue

My biggest beef with qualitative analysis is that it relies on gut feeling. Feelings always are accompanied with strong biases that can be easily swayed. It’s so easy to get swept into the feel good narrative of a company and completely disregard the inherent risk involved.

If you don’t believe me, look no further than investors during the dot com bubble. By any measure of feel good narrative, this was one of the best stories of all time. The internet was such a revolutionary new technology that it was bound to change every aspect of our lives. And it did.

But the basic principles of the stock market never change. And investors swept up in the emotion and story behind dot com companies didn’t understand that fundamentals and stock market valuations are vastly more important than qualitative aspects of an investment.

Yes, the internet created fortunes and spurred our economy like never before. Yes, the internet spurned countless new products and ways of commerce.

But… much of this wealth has been a result of companies who have slowly built their bottom line as they capitalized on the advantages of the internet. The high flyers, bubble stocks whose prices soared during the mania, dissipated as they rose to valuations that were ultimately unsustainable.

By all measures of qualitative analysis, these bubble stocks with exciting narratives were primed to make a killing for quite a long time. After all, the internet had brought a new age.

But in the stock market, there is no such thing as a new age. Fear overtakes greed after greed defeats fear, only to continue and cycle once again. Investors become too fearful and too greedy as the overall economy naturally contracts and expands over time.

Credit drives economic growth only to evolve into eventual over-leverage, causing unavoidable collapse and retraction of credit: the cleansing of bad debt and balance sheets, until prudent businesses rise once again and the cycle repeats.

Some wanna be clever investors claim that the dot com crash was foreseeable under qualitative measures. Yet they fall into the biggest qualitative trap of them all, the confirmation bias.

Confirmation bias takes a result after the fact and weaves a new narrative behind it. New stories are constantly fabricated until each unexpected black swan seems like a predictable event. The business media feasts on this bias.

In the end, stories are just that. Stories. While they might have a place in explaining stock market events and concepts, they have no place in making investment decisions.

Leave that to the the things that aren’t subject to human error, the cold hard facts. That’s where quantitative analysis comes in. Since U.S. stocks are mandated by the SEC to provide accurate financial statements, investors are able to depict a picture of how a company is doing.

That’s the kind of narrative we want to depend on: using numbers to reveal how strong a business is performing. I don’t care how you feel about it, the numbers never lie.