Investors think of Warren Buffett’s mentor, Benjamin Graham, as a numbers guy who only considered financial data, or the quantitative side of fundamental analysis.
They haven’t read his books carefully enough.
Ben Graham dedicated most of a chapter in his seminal Security Analysis to the qualitative factors of fundamental analysis. It is well worth examining.
Graham lived through multiple decades and observed much about Wall Street. His lessons have proven timeless, over and over again.
His acknowledgments of the common qualitative factors in fundamental analysis come with warnings and caution in the book. Graham recognized how some of these can cause Wall Street to disregard the quantitative, leading to high prices and eventual disaster.
Let’s learn about these factors.
1—Nature and Prospects of the Business. Industry Analysis
It’s obvious to investors holding stocks for the long term.
Great businesses produce great results.
However, Graham argued there was great danger embedded in this idea, especially when people assume that the past is indicative of the future. It often is not.
And even when great success for a business or industry continues, it is often already reflected in the stock price.
Graham found in his time that industries were prone to great reversals in fortune. He said it was “surprisingly frequent.”
Looking at historical earnings on invested capital, Graham showed 10 industries which reverted to the mean. In other words, past success or failure led to future reversals, from one decade to the next.
Obviously, it’s not true for every industry.
We can look at the horse and buggy or “dumbphone” industries to see those which never recover.
But if a surprisingly number of industries do revert, we should use that as a caution when looking at businesses which have had great historical performance and returns on capital.
Also interesting was Graham’s warnings about double counting the quantitative and qualitative. When a company has strong financials because of its dominance of an industry, analysts tend to count those as two favorable factors. Really, the great earnings are because of the dominance, not separate from them.
In other words, does the dog wag the tail or does the tail wag the dog?
Being careful not to overweight too many qualitative factors can be a way for investors to fight biases from creeping into their fundamental analysis of a company.
2—The Factor of Management
Along with the nature of the business, Graham called management’s character as the two qualitative factors most relied on by Wall Street. As he wrote,
Graham went back to the double counting problem discussed in factor one.
Investors tend to assume that great financial performance is proof of a management with character, especially when they outperform peers.
Yet Graham called it “counting the same trick twice”; he saw it over and over again in overvalued companies.
He also warned about the lack of good, tangible information about management. Much of it is objective and far from scientific.
That said, investors absolutely need to assess management.
Graham called it exceedingly important.
This is where it can pay to have a skeptical opinion, and a different way of evaluating management than the popular rituals performed on Wall Street.
Soft skills come into play here. I really like Dave’s checklist for evaluating management—looking for the company’s mission statement, their strategy, and their compensation and incentives.
Today’s investors have a wealth of tools they can use to evaluate CEOs which were not available in Graham’s time.
Use any advantage you can get.
Reading the books of founders and former CEOs, listening to leaders like Elon Musk and Mark Zuckerberg on podcasts like Joe Rogan’s, and listening intently to earnings calls and public investor presentations can all help with this.
But again, take it with a grain of salt too, and constantly try to leave your emotions and biases at the door.
3—The Trend of Future Earnings
This factor may discomfort the “quants” of the room. Graham found that relying on past growth rates and extrapolating them into the future to be a popular and dangerous way to do fundamental analysis.
He said investors mistake it as “mathematically sound.”
We have to remember that future earnings are simply an assumption.
In an extremely nuanced distinction, Graham stated that it is just as logical for past (earnings) trends to continue as it is logical for past averages to be repeated.
The way I interpret it, and have tried to apply it, is to rely more on base rates than past growth when estimating future growth rates for a company. Or at least just as much as I can.
Let’s take two examples of this.
Estimating a growth rate based on a past earnings trend, and past averages.
Example: Target ($TGT)
When analyzing a matured business like Target, it was obvious to me that the company did not have much avenue for future growth and investor returns other than same store sales growth, and dividends and buybacks.
This is because there is pretty much already a Target store in every major metropolitan area that the company should “target.” They had already tried moving internationally (Canada) and failed.
It would be foolish to take their recent 19.8% revenue growth in 2021 and 13.3% growth in 2022 to extrapolate it over the next 10 years. Same store sales growth of that nature is not sustainable.
What’s more reasonable is to take a past average, like GDP growth.
If you know Target’s typical clientele, you know they shop at Target not to necessarily buy at the absolute lowest price, but because they can get trendy products at a more reasonable price.
Since it’s typically a more relatively affluent consumer (vs Walmart for example), it’s not crazy to think the company can at least grow its same store sales alongside U.S. GDP growth. By having pricing power due to their strongest “on-trend” inventory niches, the company should successfully sell to that consumer as their incomes rise along with the economy too.
In that case, it makes more sense to estimate a revenue growth rate based on historical GDP growth averages (such as 4.5% per year), versus any other way.
Example: Domino’s ($DPZ)
Domino’s is in a different situation from Target because management estimates that there is still room for 5,000+ more restaurants openings, much of that internationally.
In other words, Domino’s is not matured like Target. They can grow faster than GDP growth simply by opening new restaurants, rather than just relying on same store (restaurant) sales.
In this case it makes more sense to take Domino’s past historical revenue growth as a reasonable estimate, because the company has a proven system for expanding into new markets through new restaurant openings.
For as long as that growth potential is in place, an estimate based on past earnings trends may be better than a historical average.
4—Trend Essentially a Qualitative Factor
This factor is a reinforcement of #3, but with another thought. At what point, or how long, should a trend be projected into the future?
In theory, there’s no limit to how long a trend projection can be utilized. Wall Street has proven that time and again, and as it adjusts those projections, the valuations compress.
It has dangerous implications because it can cause errors through undervaluation or overvaluation.
5—Qualitative Factors Resist Even Reasonably Accurate Appraisal
Part of the danger of relying on qualitative factors is how it can spiral into extreme opinions.
For example, did Qualcomm really deserve its forward P/E of above 80 in the months before the dot com bust of 2000/2001?
Investors at the time all believed in a “new economy.” They saw the internet as revolutionizing business forever, and bid up the equipment companies laying the infrastructure of the internet to astronomical heights. Stocks like Qualcomm’s faced huge crashes in the months to follow.
Extreme valuations and crashes like these happen all the time in the stock market, and it can only be explained by an overreliance on qualitative factors.
Graham warned about it through multiple editions of Security Analysis—1934, 1940, and 1951.
Yet investors remain determined to learn this lesson the hard way.
6—Importance of Qualitative Factors in Current Analytical Thinking
There is more nuance to this discussion of qualitative and quantitative factors as described by Graham here.
On one hand, Graham bemoaned the popular opinion of analysts of his day, which was to “make sure of the right quality and the price will take care of itself.” This mindset has proven to be more dangerous over history than many of the analysts themselves realize.
On the other, Graham warned that untrained security buyers are “easily led astray by an apparently attractive price or yield to buy low-grade securities,” leading to “grief.”
Graham’s prescription for the “untrained” (beginner) investor was to take his framework for becoming a Defensive Investor. By having a guidebook with a few simple rules, an investor can avoid many pitfalls and value traps that plague beginners who don’t respect the qualitative nature of business.
7—Security Analysis and the Future
Here, Graham took a sledgehammer to his observations about qualitative fundamental analysis, effectively calling those who don’t rely on facts as speculators.
So I don’t mince his words:
Those focused on expectations are speculating.
To learn from this, Graham recommended that investors guard against the natural tendencies to predict future changes in the markets and economy.
By taking the right mindset, and using key Graham and Dodd principles such as investing with a margin of safety, an investor can put up a shield against some of the great uncertainty that is inherent in all investing.
8—Inherent Stability a Qualitative Factor
In a final statement which may be shocking to even his biggest fanboys, Graham stated that stability was a qualitative and not quantitative factor.
Investors typically use a historical track record of earnings to define a business as more or less stable.
Graham went deeper and more logically than that.
He used the example of a business, The Bon Ami Company, with a single trademarked product. This was a very well known product and it produced stable earnings for the company for 18 years!
Yet as technological change made the company’s product irrelevant, Bon Ami saw its earnings steeply decline in 1947—leading to a drawdown in the stock price of over 70% through 1950.
Though an unpopular opinion, Graham stressed that quantitative factors are more important than qualitative, in general.
Qualitative was the “prevailing school of thought” in his time, and seems to still be today.
Maybe that is why there are opportunities in the stock market.
Graham stressed that much of qualitative analysis is based on opinions rather than facts. So, they can be easily manipulated or misunderstood.
He also bemoaned that there was an endless supply of data that an investor can find when doing qualitative analysis. It’s up to the investor to sift through the data and use only what’s truly important.
That said, guys like Warren Buffett have made much use of qualitative factors, to great success.
As long as your qualitative analysis is grounded on verifiable facts, you might find that this kind of thinking can give you a great edge on Wall Street. But it must be done with a great respect for the dangers in relying only on qualitative analysis.
My favorite qualitative factor is competitive advantage. I highly recommend mastering that next.
Disclaimer: The author has recommended TGT and DPZ in his newsletter The Sather Research eLetter, and is currently long both stocks at the time of writing.