Overview – Paving the Way for Qualitative Analysis
In the preceding article, we looked at how to come up with investment ideas, and by following the procedure outlined in that article we should now have a list of prospects that will be subject to further analysis.
This article marks the start of our in-depth investment analysis, starting first with qualitative analysis, and then quantitative analysis right after. The reason why this is the order we will follow will be explained shortly.
So, let’s get into it.
Why Perform Qualitative Analysis at This Stage?
Before starting any investment analysis, it’s crucial to remember that an investment must be justified on both quantitative and qualitative grounds. Most investors have no problem understanding the importance of performing quantitative analysis, but the same can’t always be said when it comes to qualitative analysis.
Some investors may believe that the numbers provide enough insight when trying to ascertain investment merit, while others may think that qualitative traits don’t affect investment merit in any meaningful way.
However, the argument can be made that a rough idea of a prospect’s investment merit can be understood without having to look at a single piece of numerical data. Qualitative factors alone may not be enough to justify an investment decision, but it would be unwise to underestimate the weight they truly hold.
Whenever you decide to buy something, chances are the dominant factor you keep in mind is its cost. However, it’s likely that you also take the time to assess its quality. If you feel the quality is lacking, then you may ultimately decide not to buy it, even if it’s selling at an attractive price: the same idea applies when pursuing investments.
In the context of our present discussion, we perform qualitative analysis at this stage because it helps us accomplish two things: further narrow our list of prospects, and as a result, save us time when performing quantitative analysis by reducing the likelihood of performing quantitative analysis on prospects we decide not to pursue.
If a prospect does not satisfy our qualitative criteria, then according to our logic there’s no need to perform any quantitative analysis on it because it’s no longer a justifiable investment.
Asking the Right Questions When Performing Qualitative Analysis
Because qualitative factors cannot be directly measured, we must take another approach when trying to study them. A relatively simple way to do that is to take an investigative approach, that is, asking specific questions with the hopes of uncovering specific bits of information.
Of course, the types of questions we can ask are seemingly infinite, so it’s only natural that the types of questions we’ll want to ask depend on the specific prospect currently being studied.
To help generate some inspiration, we will look at a few sample questions that can be applied to most prospective investments, namely equities.
What Are the Prospects of This Industry?
When trying to generate investment ideas in our previous article, one of the steps we went over was to ask ourselves which industries/sectors we already had a good understanding of, or at least which ones we could understand without much difficulty.
By having a good understanding of a given industry, the hope was that we could use this knowledge to perform our high-level search of individual companies and find potential investments among them.
At this point in our analytical framework, we once again turn to our understanding of certain industries, but not to find potential investments. This time, we use it to try and anticipate what the prospects of this industry will be.
No investor wants to commit a sizeable portion of their capital to a declining industry, which is why an important aspect of qualitative analysis is trying to determine what an industry will look like in the future, and if it will still be worth having their capital tied up in it.
Now, it’s impossible to flawlessly predict what the future holds for a given industry. Governmental, economic, and social changes are already difficult enough to predict, and it’s even harder to anticipate how these changes can impact a given industry.
However, this doesn’t mean investors cannot make educated assumptions. One of the ways to do that is to understand what sort of headwinds or opportunities an industry currently faces, and based on this knowledge try and envision potential outcomes down the road.
Take for example the oil and gas industry. As concerns regarding climate change started to pick up in the mid-2010s and have continued to intensify in the 2020s, this industry finds itself dealing with all sorts of headwinds.
Challenging regulatory environments, an increasing number of investors withdrawing their capital from the industry, constant pressure to intensify energy transition initiatives, and seemingly endless attacks from activists and governments alike have all weighed the industry down.
Based on this knowledge, it can be reasonably assumed that the industry faces an increasingly difficult future, and may prove to be unattractive to investors with a very long-term investment timeline.
What Is Management Like?
A company can have the best product/service, the most skilled employees, the most robust supply chain, and be an undisputed leader in their industry, but their success (or failure) largely depends on the decisions made at the top.
It’s not unheard of for companies to experience a dramatic turnaround, for better or for worse, based on the direction that management has decided to take the company.
Now, this doesn’t mean excellent management automatically means strong investment merit. A company that is inherently flawed due to years of complacency and poor culture cannot be changed instantly by a new management team.
However, a strong enterprise continues to remain strong if the management team continues to guide the company in the right direction and can successfully execute its strategic initiatives.
Fortunately, assessing management competence isn’t an overly complex affair, and one way to do that is to view publicly available documents such as the annual report.
Virtually all annual reports contain a section where they provide details on every notable member of the management/executive team, namely their job title and how long they’ve been working at the company.
A company that constantly shuffles its executive team every few years may be a red flag. This is because this can signal a few things:
- The Board of Directors is unhappy with the company’s direction.
- Past executives have repeatedly tried, and failed, to affect any positive change within the company.
- The Board of Directors feels that the company’s vision and strategies are not being properly carried out.
On the contrary, a company whose management team is comprised of people who have been at their post for several years may be a sign that investors and the Board of Directors have confidence in their ability to continue providing value – though this is by no means a guarantee.
Sometimes, discontent about management’s performance may come directly from a company’s investors, namely its institutional investors. If an institutional investor feels a company’s management isn’t going in the right direction, they will usually make their feelings known, an example being Elliott Investment Management’s discontent with Suncor’s operations.
If a company’s management truly is competent, then this will be reflected in quantitative measures, such as their financial performance and stock price.
Again, this is why we’ve decided to perform qualitative analysis first. If an investor jumps straight into the financials and notices a trend in the data, they may be left wondering why because they lack an understanding of what the management team is attempting to do.
Has This Company Been Involved in High-Profile Events?
Successful companies don’t live in the limelight, they exist to provide value to their customers and investors. Most companies simply want to do what they do best, provide value, and generate revenue, without involving themselves with unnecessary external headaches.
If a company has a relatively quiet history, that is, it didn’t get involved in some major corporate scandal or some high-profile litigation, then this can, in most cases, be interpreted as a positive sign.
Virtually every major company has some sort of ongoing litigation. These cases are reported under a company’s “legal proceedings” section of their annual reports. This is normal, especially for large corporations, and most legal proceedings are either dismissed or dealt with without any major issues.
Red flags should immediately be raised, however, if a company has been involved in a major historical event (or several major historical events), and has suffered material losses as a result (i.e., the business has negatively been impacted because of those past events).
An infamous example of this is Boeing. In 2019, Boeing made international headlines after their fleet of 737 MAX aircraft was largely grounded worldwide following the deadly crashes of Lion Air Flight 610 and Ethiopian Airlines Flight 302, both of which killed all passengers on board.
In 2024, Boeing once again made international headlines after another 737 MAX, this time flown by Alaska Airlines, had one of its doors completely detach mid-flight. The focus quickly intensified on Boeing’s seemingly lax stance on quality control and safety, especially after the discovery of ‘many’ loose bolts on Alaska Airlines’ fleet of 737 MAXs.
With so much negative press, an increasingly deteriorating reputation, and a barrage of lawsuits targeted at them, Boeing faces a lot of headwinds when trying to convince potential investors to park their capital with them.
Getting caught up in high-profile events can deal major damage to a company’s image and reputation, and if damages need to be paid, will have a material impact on financial health as well. What sort of investor would want to commit their capital to a company that’s busy paying for damages instead of using it to maximize investor value?
Preparing for Quantitative Analysis
Earlier, we talked about the reasoning behind performing qualitative analysis before looking at the numbers, and those reasons were to further whittle down our list of prospects, and in doing so, save us as much time as possible when performing quantitative analysis.
Qualitative analysis takes comparatively less time to perform while simultaneously disqualifying prospects that appear questionable from a qualitative point of view, which is why we’ve opted to do it first.
Make no mistake: even after performing quantitative analysis, it’s still possible for a prospect to be rejected. The idea is to avoid performing extensive quantitative analysis on several prospects, only to end up rejecting them one after the other.
Wrapping Up
After looking at the qualitative traits of our list of potential investments, the hope is that the remaining prospects we have are the ones that have a high probability of ending up in our portfolios.
Because an investment must be justifiable on both qualitative and quantitative grounds, as well as the fact that quantitative analysis takes considerably more time to perform, we have opted to perform our qualitative analysis first.
With this qualitative analysis now completed, we now have additional information in mind when looking at the numbers. Numerical data on its own may at times appear to be odd, but after performing our qualitative analysis the hope is that they make more sense in light of this additional information.
