IFB12: The Validity of Scuttlebutt Investing and Qualitative Analysis

scuttlebutt investing

In today’s session, we are going to talk about quantitative versus qualitative analysis of stocks, this should be an interesting go around. I know how I feel about this, but I am not sure how Andrew feels about this, but I have an idea, but I think this could be interesting. Phil Fisher was the creator of the term scuttlebutt investing, it was a method he used to gather qualitative information to help him in his investment process. He used it to great effect and it was integral to his success. This process is a little more difficult for the individual investor but some of the aspects of scuttlebutt investing can be added to anyone’s arsenal.

  • Definition of quantitative versus qualitative
  • What it means to be strongly quantitative
  • The pros of quantitative analysis
  • The advantage of utilizing both quantitative and qualitative analysis
  • How biases can affect your thinking and investing

Andrew: Yeah, the guy who formulated the Value Trap Indicator, a quant-based system, obviously I might lean one way or the other. The way that I kind of look at and I think it is a little bit contrarian to what a lot of value investor that there is a lot of belief that you have to have a balance of quantitative and qualitative.

If we define that real quickly, for the beginners. Qualitative is talking about the aspects of the business that are more intuitive things like how skilled is management, where you perceive a trend as far as supply and demand. It is things that you can’t put a hard number on, but it still can have an effect on the business. So that’s qualitative and quantitative is everything that is strictly about the numbers, tangible data like assets, earnings, cash flow stuff like that.

So, I kind of want to hear your take on it, Dave, because I am all about the quant, I know there are guys like Phil Fisher, who wrote “Common Stocks and Uncommon Profits”, which was one of the first books I read about the stock market. He talks about a thing called “scuttlebutt” which is his way of using and doing qualitative analysis. He would go and talk to different executives at different companies that he was interested in, and try to get some information based on those kinds of conversations.

I think that Buffett tries to do the same as well. And I know guys like Jae Jun at Old School Value, I’ve interviewed him before and he talks about how there’s an art to value investing and you need to balance qualitative and quantitative. I don’t think there is a right or wrong answer and that is why we are having this discussion and having this episode, it is going to be interesting to see what the positives and negatives are of both methods and which one is better. Or should you try to merge the two?

Dave: That is a very good point. My thoughts on the battle of quantitative versus qualitative. I am going to say that I am a little more like Jae Jun, where I think I don’t know that I could necessarily put hard and fast rule number wise, 75 to 25 or 50/50 anything in nature. I know that Ben Graham, who we both admire quite a bit was definitely a quant, he was definitely all about the numbers. Warren Buffett who is one of our idols, he started off as a quant and he has merged through his life into a little bit more of both. And I think I probably fall a little bit more into that as well.

You know the quantitative analysis is like Andrew said, is all about the numbers, the balance sheets, cash flow statements, income statements, and all the numbers. Looking at valuations, which I think are vital to being a good value investor and coming up with a great intrinsic value and finding a margin of safety are the bedrock of what I try to do when I find a company that I want to invest in.

But I also like to take into account the story of the company. I look at, not necessarily the scuttlebutt because I am a peon, I am not going to have access to the CEO and be able to talk to him about what’s going on with the company. But there are resources on the internet that can give you insight into things that are going on with the company. And think about the place that you work and you have scuttlebutt and your workplace as well.

I have said before I work at a bank and you are always hearing about different things that are going on with upper management and the bank, and how it affects the business. And you can sometimes see the correlation between the decision are made on our level and how they affect the business when we get directives from upper management about how things are going to be done.

I don’t know that I feel like that there is a hard and fast rule about this. I think that having numbers is very important to what I do, and I know that Andrew feels that way too. But I also feel like a having a bit of qualitative is going to be helpful as well. I think to go all qualitative as just basing it solely on rumors, scuttlebutt, the different information you may gather from the internet, or friends, from talking to people that are involved with the company.

I think that could be very dangerous because there is very much a bias that you can get from this kind of thing, where the numbers are not going to lie, when you are looking at the earnings, cash flow statement, or the balance sheet, it is really hard to fudge some of those numbers.

And when you talk about qualitative there’s a bias when you are talking to an employee who works for the company that they’ve drunk the Kool-Aid, and really like it there. Of course, they are not going to say anything bad about the company. They are not going to lead in a direction that is going to cause you to think negative of the company.

I’ll use an example of a book I read. One of the first books I read when I first started getting interested in the stock market. It was the “Education of a Value Investor” by Guy Spier. He talked a lot about merging from basically being very much a numbers guy, but also a qualitative guy as well. And his emerging to being a strictly quantitative guy now. He just started distancing himself from meeting with the CEOs of companies.

You know Guy has quite a bit of money in his fund, the Aquamarine Fund. And I don’t know what his assets under management is  because I don’t have those numbers in front of me, but he has quite a bit of money and he has access to these CEOs if he wants them. He can pick up his phone and call them and they will take his call. But he chooses not to talk to these people because he feels like he gets a bias from talking to them. That they are going to give him information that may skew his thinking, along lines he really doesn’t want to go down those paths.

I thought that was a very interesting comment that he made when I was listening to the Audible version of his book. That really had a big impact on me, and I have also read the Phil Fisher book and I thought it was a really good book. And I tried really hard to think about different ways that I could utilize some of the more qualitative aspects of what he does.

And I know that Warren Buffett uses a lot of those, and I really haven’t been able to figure that out on my own yet. But I think what I do when I am thinking about some of this. When I think about the qualitative part of it, I think about the story of the company.

I’ll give you an example, GameStop (GME), which is a company that I invested in recently, they had a horrible, horrible earnings report come out just recently. And the stock market freaked out, everybody bailed ship. I think it lost 13% at one point of that particular day. I thought Uh-oh I am going to trigger one of my trailing stops and I just bought the company a couple of months ago.

But the reason why I bought the company was because they are a retail company and for those of you not familiar with the company, they’re a video game retailer and as a lot of people know, retail is dying a slow, horrible death and they’re in the video biz. And with the huge competition out there in the video biz, they have been struggling. But they’re smart and their working towards changing the product mix of the company and moving away from the video game part of their sales, and working more towards the hardware.

One of the things that a lot of people talk about on the websites that I read, was the results of GameStop’s holiday sales were horrible, and they were. But GameStop’s a little bit different of a beast than Walmart or Amazon for example. GameStop has a Christmas every time Sony or Microsoft or one of the big providers of consoles issues a new console. Because everybody and their brother are going to want that new console. And that to them is Christmas, whether that falls in July, August, or September. That is their Christmas, not the one that falls in December.

There is a bit of skewing with this company, I guess the point of all this is that I look at the story of their company and that they are transforming from what they were to what they’re going to be. Are they there yet? No, they are not there yet but I have confidence that they are going to get there. They have already started the process and they’ve made great improvements from over a year and a half. Changing their product mix of the company and I think it is going to pay them huge dividends going forward and I think that is why I invested in the company.

If I had looked solely at the numbers I would be reacting the way a lot of people with Seeking Alpha, where a lot of people have been very, very negative about the company. Comparing it to blockbuster and that they are going to declare bankruptcy. And that they are like the Titanic and they are bailing ship now. I don’t think that is the case, to me that is kind of where I come from with this.

Andrew: Kind of like an aside, it almost pisses me off but is more amusing and kind of hilarious is when they are making these comparisons of GameStop to Blockbuster. Did you even look at the financials of Blockbuster before they went bust? I’ll tell you it was several years, not just one year, but several if not four or five years of negative earnings. and you compare that to a company like GameStop where maybe growth has slowed buy they’re not anywhere near negative earnings and they’ve got a fantastic balance sheet and their ridiculously cheap, especially since they had that little hiccup that you talked about where you almost lost your lunch on the screen when you saw what happened

Dave: Yeah, but by the same token I was kind of excited because it dropped below the price I had originally bought it for, and I was able to buy some more.

Andrew: And any future dividends, let’s say worse case it either continues to flat line or maybe even goes lower, but future dividends will just accumulate more shares, assuming your dripping it.

Dave: Oh absolutely, and with the qualitative part I guess we both know you are a very staunch quant guy, tell me what your thoughts are on the qualitative part of it.

Scuttlebutt investing

Andrew: I did like what you said about the bias. I think biases are a huge part of investing and it’s such a big effect in such a greater way than we like to realize. I’ve like to talk about in previous episodes as even as human beings we don’t like to admit how just naturally primal we are and we like to think we are so sophisticated, evolved, and rational but really if you’ve got aliens looking in on us from another planet and seeing the way we act and the things we do subconsciously and without thinking and without talking about, they are going to think that we are just a little bit weird because there are just certain things we do, and it’s just the way that humans are.

One of those things is biases, and especially it’s not hard to think about what kind of a bias an executive would have. Executives are obviously very heavily financially incentivized to make their company look as great as they can. They’re going to be compensated, and a good chunk of the compensation is going to come from stock options.

If their stock price can go up they are going to see that value go up as well and they’ll be able to cash out and take an extra-long vacation or buy that second boat they always wanted. They may talk to a guy like Guy Spier or Warren Buffet, some investor that is looking to employ a lot of capital. They are going to get in a conversation with them and it’s not going to be some honest one to one this is the reality of the business. They are going to prop it up, primp it up, make it look as appealing as possible because there is a financial incentive towards doing so.

And the second token there is something of another bias, but I am not sure exactly what the word is, it has something to do with the way that people talking about the law of attraction. It seems like whenever you’re, for example, if you have a trend of going to the gym a lot. And the law of attraction says that other things will appear in your life that will help you towards your path, or whatever that maybe. It may be true or not, but what our brain does with the bias it makes us more aware of things that are we are thinking.

If I’m thinking about knives or an I pick up a passion about cutting things with knives. All of sudden in my day today I’m going to see things I never noticed before as they apply to knives or you can apply it to fitness, money, relationships, or whatever it may be. It is really just our brain basically biasing itself towards something that we are more aware of. That can happen in the stock market as well where if you’re qualitatively trying to talk to different executives in this hypothetical world where we have access like Fisher did.

First off, your only one person and you have a limited amount of time and there are only so many people you can really talk to and give adequate time or research a company or try to understand what the complete picture of it is. If you want to be qualitative it is very inefficient from that sense. There is no way you can flip over enough rocks to really understand where the most natural opportunity is. Not that we can do that from a quant way as well. But you try to do it as best as you can with the limited resources and time that we all have.

Secondly, if you’re talking to a group of ten executives of various companies you’re going to see other pieces of information that kind of biases you and the way it’s biased Guy Spier. And we talked before in the efficient market hypothesis episode about how two investors can look at the same piece of information and perceive it differently just solely because of their bias and the way that they personally analyze a stock.

Now if you’re trying to perceive information from what somebody a small group of people is telling you. You might see a report somewhere else, maybe some macro, some industry report, and because you are more plugged into a certain company that you have a bias for, you might actually look at that new piece of information as more favorable as it really is. It is almost like you have these rose-colored glasses.

And just like you can fall in love with a person, you can fall in love with a stock. I have personally had this happen to myself and it happens actually to me all the time where as soon as you see a couple of things that you really like it’s really easy to get excited and pretty much anytime I am picking a stock I think that I am that I have the best stock pick that I have ever had. Every single month that seems to happen and what I’ve found is even thought a stock might look great.

For example, we like to look at numbers right? If you look at a company like GameStop for example and I am going to take. Ok, let’s take a look at company B and they have a dividend of 4% and they have a PE like 10. If I am really excited about low PEs and high dividend yields I might kind of gloss over the fact that they have a higher debt to equity or a higher price to sales that I’m usually comfortable with. Especially if there is one other valuation that is really nice or if they have really explosive short-term growth. I’ve had that happen to myself too where I see some sort of growth scenario or even a qualitative thing like you talked about with GameStop.

There’s other qualitative things, countless for any stock, and it’s really easy for me to get super excited about those little things and it naturally causes me to kind of blur the other things. If there is anything I can really hone down and kind of solidify for people is that when you’re analyzing a stock you need to take a holistic and a complete picture approach and it needs to be something that not laser focused but on the contrary it’s something where you can scan from left to right and look and see that everything looks good.

I’ve been in scenarios where number one either I get really seduced by the stock and then I run it through the Value Trap Indicator and actually it would have been a really bad thing because I might have overlooked something in my excitement or haste. I overlooked one single metric and when I ran it through the Value Trap Indicator I was like whoa, that’s actually a pretty big red flag, what’s far more common for me where it’s a second scenario where I will get really excited about a stock and then run it through the Value Trap Indicator and it’s just barely higher than where I want it. So, what that forces me to do is to again shed my biases away if I have something that is constant every single month and that’s the Value Trap Indicator.

I am making sure that it’s going to hit underneath there and as the markets change, as situations change, as the economy changes and as market valuations change I am still staying consistent towards buying stocks with the right Value Trap Indicator value. From that and my own personal experience, I’ve seen where excitement just begets more excitement and you start to go down this path where a stock becomes increasingly more attractive to you and even little things that you wouldn’t even notice. If you look from a third person perspective or you look at a rational, non-emotional perspective things that don’t even matter start to matter.

For example, I will look at a stock and be like, hey that stock makes food, like a chicken and think everyone is going to eat chicken, for a very long time, ten, twenty or thirty years from now I like it even more. It doesn’t make any logical sense because the numbers or the business model didn’t change at all but suddenly I’m finding myself liking it even more because of some random qualitative measure.

To counter that I run it through the Value Trap Indicator and make sure that these qualitative things that could hurt or help, and in the long run it doesn’t matter because I am looking from strictly a business model perspective, strictly from a price and valuation perspective. And as long as those things pass then I know that I am consistently using the same system month after month. I am negating any sort of bias or emotions that can get up with this kind of decisions.

Dave: Those were excellent points. So in essence what you are doing is using your VTI as you’re a stop on your checklist to verify that you’re not having any biases because you using that system that you created to help you eliminate a possible bias that could hurt you in the long run.

Andrew: Exactly, and I’ve seen it already where I really, really want to buy this stock but it was barely over and then I come back a couple months later and it wasn’t as undervalued as I thought. Because either the stock dropped further or it didn’t go anywhere. So, maybe it was not a good idea that I buy this stock.

Dave: Yeah, exactly. You know one of the things I was reading about today as I was studying up for our conversation tonight. Peter Lynch, who is I know is one of your favorites and I enjoy his writing as well, he was very much a qualitative investor. There is a lot of speculation that the reason that he only ran the Magellan fund for 13 years was that he burned himself out because he had to work so hard because he had so much information he had to cover for each company, whereas when you do the quant style of investing, yes you have numbers and there are a lot of numbers to crunch but you have formulas and you have different ratios that you can use to help you filter through all those companies.

But if you have 150 companies you’re trying to look and you’re trying to look at all the qualitative information that’s the just mind-blowingly gigantic amount of information. And I am sure that contributed quite a bit to his retiring early.

Andrew: Burnout is real. But I do think all these negatives against qualitative aside I do think you need maybe you need some sort of past quant knowledge. For example, we’ve talked about on previous episodes where five oil stocks are all a buy on the VTI indicator doesn’t mean that you want to buy 5 oil stocks.

There are just some common sense things and some intuitive things that I personally I use in my own approach, but on the whole, I am 99.9% quant.

Dave: Let’s take a little step further. Using the news and something that happened a few days ago. The unfortunate situation that happened on the United flight a couple days ago. The stock tanked the next day, predictably, and I know there were probably a lot of people that were gobbling it up, but that’s more of a qualitative effect than a quantitative effect because you are buying it based on the bad news not necessarily on buying it based on the actual value of the company is.

That to me is where having a foundation of having the numbers and if it was something that you thought was maybe borderline fair value and this caused it to fall under that fair value and you wanted to take a shot at it, then by all means. But if you just bought it because, hey it just dropped in price because of all the negative stuff, not taking into account anything else about the company then that is just a mistake waiting to happen.

Andrew: So did it drop? I know it dropped and did it spike back up when all these people tried to buy in.

Dave: I’ll be honest and I didn’t look into that. It’s not anything that is on my radar so I am not sure of the price or any action on it. I saw something on Bloomberg in passing about the stock price falling like I knew it would. As soon as I saw the news that morning, I thought United is going to drop today and sure enough it did. There are some things that you can predict about the stock market and that’s one of them.

Andrew: Investors trying to be too cute. How does that change their business model at all? Maybe they lose a little bit of demand, at the end of the day I think most people that fly are price shoppers and obviously, they are not having any problems filling the seats from that incident you can see they have plenty of customers.

Its funny how you talked about the news wanted to talk about United being such a big drop. I think it’s funny because I saw a headline that said the market cap dropped by 900 million. I saw people on my Facebook who is obviously not really into the investing very much posting on there with those headlines and it’s funny because it sounds like a huge amount of loss but really it ended up being a three percent loss.

It’s funny how this news thing, we’ve talked about this before, they skew really badly and it’s really easy to feel emotional but look at the numbers, look at the quant behind it. It’s not that big of a drop and it wasn’t and it’s not that big of an event, but the news needs to make their headlines.

Dave: I am a big believer in the last market crash I think the news had a fair amount to do with the effect of it. Every time you turned on the news the stock market is down, death, doom, and despair and it just feeds into and it makes you emotional. You run out and think all of my stocks are losing money, my 401k is dying and I’ve got to sell, I’ve got to sell.

Sometimes yes you need to sell, but the flip side of that is if your reacting on emotion, your thinking about just the qualitative part of it as opposed to the quantitative part of it and you’ve done your research and you know the value of the business, this event is not affecting the value of the business then why in the world would you sell?

Andrew: To be fair, it was kind of scary when you have Lehman, Bear Stearns, and Fanny, Freddy and that is like Wall Street. People who worked in the news media companies during that time probably had a super easy job. They just opened the window and then “oops there’s my headline”.

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