A few weeks ago, I discussed why you shouldn’t rely on qualitative analysis for your stock market decisions. On the other side of the coin is the option of quantitative analysis. I’ll explain the philosophy behind it and provide the reasoning behind my support of it.
A quick Google search of quantitative analysis returns the definition as “analysis of a situation or event, especially a financial market, by means of complex mathematical and statistical modeling”.
Investopedia extends this definition as “measurement, performance evaluation or valuation of a financial instrument.”
It is the analysis of a financial instrument, not a situation or event that we are most concerned with. A financial instrument is simply an asset that can be traded like a stock or bond.
So what’s the point of being able to find the valuation of a stock? Will quantitative analysis really assist in finding stocks that will increase in value on average more than they decrease?
To answer that question, we must look at the basics behind a security (or stock).
A stock simply represents part equity in a business. Equity means an ownership stake. So, to understand the basics of a stock, we must understand the basics of the business behind it.
The primary goal of a business is to turn a profit. All of the complicated moving parts surrounding the business world and the corporations inside eventually circle back to this chief point.
There are many strategies behind doing this, and some companies delay turning a profit in the present to expand the business quickly, but the final end goal resides with turning a healthy profit.
Other elements of the business, such as assets on the balance sheet (property, buildings, equipment, etc.), are acquired to assist in creating revenue.. Which turns into profit.
I hope you can understand my point. There’s plenty of complicated jargon, industry specific metrics, and accounting details that could possibly involve quantitative analysis. But it always comes back to the most important question, if the company is making a profit.
Last key point that I must share. Yes, the word profit is nice, but what does it mean? Well for owners, a profit means that the business makes more money than it costs to run. But of course, the business world isn’t around for charity work. There must be a strong incentive for business owners to risk much of their time and capital towards turning a profit.
The most beneficial part about profit is that the business owners can take it and pay themselves with it. In the stock market, this is known as a dividend. A business owner can choose to defer much of the profit and use it to fuel more growth, but the end goal of this is to create more profit in the future, which can then be paid to the owner.
Add the complexity of the stock market with this basic model of business. In this case, more profit usually leads to a higher stock price, which raises the value of the equity held by shareholders (owners). Owners of the business have a double incentive for higher profit, as it should raise the value of their equity and provide more income in the form of dividends.
Since it is common for part of compensation to comprise of company equity, workers in the business are highly incentivized to work hard for the owners. It’s actually a very intelligent system that essentially makes the world go round.
Can You Predict Net Income Growth?
Now that we’ve established the importance of profit, called net income in a company’s financial statement, we must determine whether quantitative analysis can help investors find companies that consistently increase their net income. Investors desire this for obvious reasons explained already: to raise their investment’s value and the potential income from it.
From a purely observational standpoint, there isn’t much in the real world that can tell us whether a company is truly raising its net income. I mean sure, we could look inside stores and notice which ones are filled with customers, but this doesn’t tell us much.
For example, a store could be affected by regional demand, where it is wildly popular in one region but not so in others. Or a company could be supporting a vast number of customers, but spending an equally proportionate amount of capital to do just that.
From an outside perspective, there’s no way for the average investor to accurately determine how efficient a company is with their capital, or how much capital a company is bringing in.. Thus making quantitative analysis useless in this case.
Fortunately, all corporations that trade on the major markets in the United States are required by law to submit audited financial statements to the SEC. The SEC has in turn made this highly valuable information accessible to the general public.
Investors can look through the financial statements and determine whether an ownership stake would be a prudent decision, much like a prospective buyer would analyze a small business and its financials to determine if he’d like to buy the business.
In both cases, much of the decision lies in not only whether the business is sound and a dependable profit machine, but also at what price must be paid for ownership. In the stock market, this is measured through valuation, bringing us back to the original definition of quantitative analysis: “valuation of a financial instrument”.
Evaluating the Effectiveness of Quantitative Analysis
Having the information is nice, but if the information isn’t able to tell us much about the business, it really is utterly useless. That’s where literature already written can help us deduce meaningful analysis from the numbers available.
There’s whole libraries worth of books written to decode the meaning behind financial statements. While there’s no exact science behind accurately predicting which businesses will increase their net income (the world is unpredictable after all), there are trends and generalizations that tend to lead to favorable outcomes.
Much of this quantitative analysis work has been done in the value investing space, and I’ve included many of those important books in my 8 Top Investing Books post. I’ve also personally researched the implications of financial data when they foreshadow company bankruptcies in my Value Trap Indicator post.
Quantitative analysis is extremely effective, and there’s a body of work done over many generations that proves it.
But it makes sense in simple terms too, if you comprehend what I explained here. A business will either turn a profit, or it won’t. There’s no mystery behind whether this is accomplished or not, since the stocks we are able to buy have to reveal this fact.
They also have to disclose what cash is going where (i.e. how much is going towards day to day operations, how much goes towards financing the business, how much is invested in R&D for the future of the business), how expenses are paid, how revenue is coming in, and which assets they hold which enable these profits. Each of these sections are highly detailed in line-by-line fashion. The stock market also reveals the valuation of these securities, with prices that are updated by the second.
So an investor has everything he needs to make a prudent decision. The problem is that most investors aren’t adequately educated about these facts.
We see greedy investors pile money into bubble-like stocks with absurd valuations, completely ignoring the most basic premise of quantitative analysis. This continues to happen, even in the age of information with the internet.
Which makes quantitative analysis work. If everybody used it, there would be little value to it.
Conditions like this make the case for quantitative analysis a very strong one. One that should continue for as long as business are concerned with profit and people are greedy and foolish.