Overview – Understanding the Unquantifiable
Imagine you’re currently looking to purchase a new house. This is a very big decision, so there are a lot of factors that must be weighed before you eventually decide which house to call your next home.
Some of the major factors are quantifiable, such as the market value of the house, how big the house is, the annual property tax, the annual utility bill, and the estimated cost of any repairs/upgrades that need to be made.
These are all important factors to consider, but chances are, there are other considerations you will also want to take into account.
What’s the neighbourhood like, is it safe and somewhere you’d feel comfortable walking around? Is the house near any major commercial establishments, such as a grocery store or a mall? Do you like the interior design of the house and its overall layout? Will this house be able to support your living needs now and in the future?
In addition to the numbers, there are several qualitative elements that will also impact your decision on whether or not you intend to buy a certain house you’re looking at. Approximately equal consideration must be given to both to ensure you make the best decision possible.
When making investment decisions, most investors focus on all sorts of quantitative variables, and rightfully so. However, quantitative factors paint only part of the picture. In the words of Benjamin Graham:
“An investment operation is one that can be justified on both qualitative and quantitative grounds.“
Security Analysis, Sixth Edition, page 107.
It’s possible for a potential investment’s numbers to look great yet still end up being a flop because the qualitative factors were not properly assessed. Understanding which qualitative investment factors to look at, and knowing the relative importance of each, can make all the difference.
Why Should Investors Care About Qualitative Investment Factors?
Given the fact that investing is a very quantitative activity, this naturally begs the question: why should investors worry about unquantifiable factors at all?
After all, investors pore over all sorts of quantitative data, and their ability to analyze the numbers and extract key insights from them directly influences the quality of their decisions. If that’s the case, then how can qualitative investment factors possibly affect their work and the subsequent decisions they make?
To show why qualitative investment factors deserve an investor’s attention, let’s go over a simple example.
Say you recently purchased some shares of a company you just finished analyzing. From a quantitative standpoint, everything looks great: your ratio analysis results were promising, earnings are up, debt levels are under control, and according to your valuation, the stock is slightly undervalued.
While things may appear excellent on paper, there are a number of unquantifiable, yet important, factors that you failed to consider.
Although things look good for now, the industry that this company is part of has, in recent years, started to decline. Other companies in the industry have either scaled down their operations or merged with others in an effort to stay afloat. Not only that, but the company recently had a class-action lawsuit filed against them alleging that they misstated earnings for the past five years.
Management is aware of these problems, but despite saying they will be addressed, so far no meaningful action has been taken. Because of this apathy, investor confidence in the company has declined, causing prospective investors to look elsewhere and current investors to dump their shares, all while the stock price steadily dips lower.
Can you still say that you made a good decision?
This may appear like a problem that’s exclusive only to equities, but that isn’t the case at all. Regardless of what investment instruments you wish to pursue, qualitative investment factors will always play a role in your decision-making.
Paying close attention to the numbers is an integral part of investment analysis, but focusing exclusively on the numbers won’t guarantee that your decisions will always be correct. That’s because, as we looked at earlier, not every variable that affects investment merit is quantifiable.
In fact, it’s entirely possible that an investment’s quantitative strength is the result of certain qualitative factors.
A company may constantly post impressive financial results and have a steadily increasing stock price because of the world-class management that’s leading it. A real estate investor’s properties may experience a meteoric increase in value because of increased commercial activity in their areas, coupled with the fact that they’re all situated in excellent neighbourhoods.
Many investors forget that evaluating investment merit is a holistic process, and part of this process includes looking at variables that can’t be directly measured or quantified, yet still have the potential to determine whether a given investment is worth pursuing or not.
Which Qualitative Investment Factors Are Worth Focusing On?
If qualitative investment factors play a key role in an investor’s analysis and subsequent decisions, what specific factors should an investor focus on? The answer is, frustratingly: it depends.
Different investment instruments require different analytical methodologies, and this includes the qualitative investment factors to focus on. Some overlap may exist, but for the most part, the specifics vary. The qualitative factors that an equities investor will want to pay attention to will be different from the ones a real estate or fixed-income investor will choose to look at.
That being said, not every qualitative factor different investors should focus on will not be listed here – the point of this article isn’t to create an exhaustive list.
Instead, we will look at some qualitative investment factors that equities investors may wish to consider. This is by no means all the factors that equities investors will want to look at, but rather, the goal here is to demonstrate how a few qualitative factors can materially impact a publicly traded company’s financial/business performance, and subsequently, its investment merit too.
Management Competence
Although there are many elements that determine the success of a publicly traded company, there’s no denying that the decisions made at the very top significantly contribute to that.
A company can be comprised of a world-class workforce and currently enjoy the status of being labelled an industry leader, but all it may take is for management to make some questionable decisions and employ ineffective strategies for things to go south very quickly. Conversely, a company may currently find itself in the doldrums, but all it may take to turn its fortunes around is a management shakeup.
Microsoft is an example of a company that, though already a titan in its industry, was made even better after a change at the top.
In February 2014, Satya Nadella was appointed as the new CEO. The outgoing CEO, Steve Balmer, received mixed reviews during his tenure, and the company was in the midst of dealing with the less-than-favourable reception of Windows 8, as well as the underwhelming performance of the Windows phone.
For several years, Microsoft’s stock price largely remained flat, despite Balmer improving Microsoft’s profitability and bottom line.
Faced with a plethora of challenges, Nadella brought all sorts of changes to Microsoft’s management team, its overall business direction, and its brand image.
Now, when looking back on these changes, it’s clear they worked. He’s largely been credited with completely transforming Microsoft, bringing it back from the brink of obscurity and back into the mainstream. The most visible demonstration of his success was the eye-watering rise in Microsoft’s stock price between 2014 and 2019, which, at the time of this writing, shows virtually no signs of slowing down.
This fundamental reimagining of Microsoft didn’t show up as a reported figure in any financial statement, but in hindsight, the gradual but drastic increase in stock price demonstrated that the change in tone at the top directly impacted Microsoft’s investment appeal and merit.
Although management competence has the potential to greatly affect a company, and subsequently, its investors, for the better (or for worse), the consequences of their actions and decisions take time to produce any noticeable results.
Not only that, but it’s very hard to objectively assess management competence. What seems like a great decision in the eyes of one investor may seem like a horrible one in the eyes of another. There’s really no straightforward way to determine whose assessment is correct and whose isn’t.
Business Prospects
At its core, investing is the act of putting down money today with the anticipation of receiving more in the future. Investment analysis is the act of determining whether this anticipated future increase is warranted, and if so, to what extent.
Although a certain company may look very enticing today, how long can it continue to enjoy that success? Even if a specific company is performing well, how long can it continue to stay relevant in the future?
Investors turn to a company’s financial data to guide their investment decisions because, for the most part, the past is a rough indicator of what can be reasonably expected in the future. A company that has performed very well in the past, and has all the pieces in place needed to ensure that continued success, will most likely perform similarly, if not better, in the future.
However, the implicit assumption being made is that the prospects of this company (or, more broadly, the industry that it’s part of) continue to look promising. After all, why commit your capital to a company that doesn’t have a reasonably bright future down the road?
If those prospects were to suddenly take a turn for the worse, or disappear entirely, then the entire premise of “past performance roughly predicts future performance” falls apart.
Now, just because a company has strong prospects doesn’t automatically mean that it’s guaranteed to succeed in the future, let alone improve its investment merit. Things may look promising right now, but there are so many potential variables, both controllable and uncontrollable, that can prevent those bright prospects from producing any sort of tangible results.
That being said, this doesn’t mean that prospects can be ignored either. An investor who commits their capital to a company without any consideration of its prospects is akin to boarding a ship without checking to see if there are any leaks. Any sensible investor will take the time to ensure that the companies they choose to park their money with will offer some assurance that the future will be bright.
Reputation
When deciding where to spend your money, such as which barber shop to get a haircut from, which brand of electronics to buy, or which car you want to drive, there are several variables that you probably take into consideration. Amidst all this juggling, there’s one factor that, although most people may not always consciously think about, is probably in the back of their minds: reputation.
Many companies and individuals go to great lengths to maintain and improve their reputations because they know how serious the consequences of a poor reputation are. They could offer the best product/service, at the best price, with the best customer support, in the most convenient way possible, but none of that will matter if people view them in a negative light.
A similar observation can be made for publicly-traded companies trying to attract or retain investors: sometimes all it takes is for their reputation/public image to be tarnished for their investment merit to take a hit, or at least for investors to lose confidence in them.
In 2012, the cruise ship Costa Concordia entered very shallow water and struck underwater rocks, leaving a huge gash on the vessel. Long story short, the damage was so severe that the ship partially sank, resulting in the deaths of 32 people. Various lawsuits were launched following the incident, as passengers and grieving loved ones demanded justice and compensation.
In the aftermath of this incident, the parent company that owned the ship, Carnival Cruise Line, experienced a 16.5% drop in their stock price.
Photo credit: Italian Guardia di Finanza
Now, a temporary hit to a company’s reputation doesn’t automatically mean they’re doomed. If they take steps to show improvement and are earnest in doing so, then their reputation and public perception will most likely recover.
However, if a company’s reputation has been chronically poor, or has slowly been deteriorating over time, all while no effort is being spent to try and repair it, then this could be a major problem, especially if this is reflected in the company’s financial performance and stock price. Why would potential investors want to commit their capital to a company that’s infamous for its apathy toward its problems, and why should current investors continue to put up with this?
A company may appear to have lots of investment merit on paper, but that won’t matter if they’re viewed in a negative light, especially by investors.
Competitive Advantages
When comparing different investment options, one of many things that investors look for is some sort of competitive edge that sets a prospect apart from the competition.
A strong competitive advantage can mean the difference between a company that successfully maintains its investment merit well into the future, and one that finds itself quickly overtaken by increasingly fierce competition.
Competitive advantages come in a variety of forms, some of which are relatively easy to pick up. For example, Enbridge’s competitive advantage lies in the fact that it controls the largest hydrocarbon pipeline network in North America. Competitors would need to commit prodigious amounts of time and money in order to match or exceed this pipeline network.
However, some competitive advantages take a bit more time to fully piece together because it’s comprised of more than one component. Many people think Amazon’s competitive advantage lies in the size of its e-commerce operations. While their e-commerce platform is certainly one of the largest in the world, many people overlook the fact that their other source of strength is their cloud computing operations, Amazon Web Services, which is one of the largest cloud computing platforms on the planet.
A company with a sizeable competitive advantage can successfully keep competitors at bay, meaning they don’t have to worry about competitors taking a bite from the financial performance they’re currently enjoying.
This subsequently means they can continue to benefit current investors by way of dividend increases or steady capital appreciation and will also have an easier time attracting future investors down the road because they’ve successfully demonstrated how they set themselves apart from the rest of the crowd.
Dealing With Vanity Metrics
Although there are many qualitative investment factors that investors will want to focus on, there are some factors that, although widely touted and proudly shared, may be of little use to investors, if at all. In other words, these are nothing more than just vanity metrics.
Again, based on the specific type of investments you wish to pursue, these potential vanity metrics may vary, so for the sake of consistency, we’ll limit this discussion solely to equities.
Something many publicly traded companies proudly report, whether it’s on their website or the highlights page of their annual report, are their community/social initiatives. Whether it’s the volunteer hours they’ve racked up, all the trees that they’ve planted, or all the money they’ve given to charity, many companies are proud to share these things.
Now, there’s nothing wrong with a company wanting to pursue such activities to improve its public image, but from an investor’s point of view, such activities probably won’t lead to improved financial performance or an increase in stock price.
Another thing many companies like to do is to brag about their workforce, such as proudly stating how diverse it is, how talented and driven their employees are, or how committed each employee is to achieving excellence: the list of praise can go on endlessly. While this is nice to know, this supposed superstar workforce is only as good as the tangible results they can produce, and how those results ultimately affect investment merit.
Knowing the difference between important qualitative investment factors and vanity metrics is certainly important, however, there is a problem: sometimes the line between “important qualitative factors” and “vanity metrics” isn’t always clear-cut. To make matters worse, some factors may fall somewhere in between, leaving investors to decide whether they’re worth looking further into or not.
In that case, how can investors hope to distinguish the two?
The key lies in remembering what a vanity metric is: a qualitative or quantitative piece of information that has no clear influence on a company’s investment merit.
For the most part, knowing what to focus on, and knowing how much attention to give it, will be a matter of personal judgment and experience. Some investors will know right away which qualitative factors are worth considering, and which ones are nothing more than fluff – of course, this is something that takes time to develop. That being said, what if you lack the experience needed to make that judgment call?
In lieu of having a vast repository of experience to turn to, an alternative would be to research what qualitative investment factors are worth looking at, whether by performing a series of internet searches or by asking others. The major risk associated with this is that you may get different answers based on where your searches take you or who you ask, but the answers should more or less be the same, and as you steadily gain experience, knowing who’s right and who’s wrong becomes easier to do.
Can Qualitative Investment Factors Be Compared?
Comparisons are the backbone of investment analysis – that’s because data studied in isolation will seldom lead to any meaningful conclusions. There are a plethora of investment ratios and quantitative metrics that investors use in their work, and the whole point behind using them is to compare different data points to one another to extract some kind of insight.
If quantitative data is routinely compared to help investors form their decisions, can the same be done for qualitative factors too? To an extent, yes, albeit a very limited one. That’s because qualitative factors are very difficult to compare on an objective basis.
For example, comparing the P/E ratios of several companies is relatively straightforward, you simply find or calculate that figure for each company, put these figures side-by-side, then begin your analysis. Companies with a P/E greater than the average may be overpriced, and those under the average may be selling at a discount – the numbers are clear, so there’s really no room for debate or ambiguity.
What if, instead of comparing P/E ratios, you wanted to compare the reputations of these different companies? Unfortunately, there isn’t some number you can calculate that will tell you which companies are held in higher regard than the others.
It’s possible to get a rough idea of each company’s reputation by taking some creative measures, such as looking at how they’re perceived in the different news articles they’re in, as well as looking at any public discussions surrounding them. However, given the countless variables that affect reputation, and the fact that it’s ultimately unquantifiable, objectively comparing them between companies is very difficult.
That being said, this doesn’t mean qualitative investment factors have no chance of being compared. Investors with an abundance of experience and with a refined investment intuition can approximately gauge whether certain qualitative factors are satisfactory or not, but this is an approximation at best, and not all investors have the experience and intuition needed to make such judgment calls.
Wrapping Up
Investors focus on all sorts of quantitative variables when performing their analyses, and rightfully so. Knowing how to work with the relevant numbers and extracting insights from them directly impacts the type of decisions that investors ultimately make. However, the numbers alone don’t tell the entire story.
Any important decision should always be justified on both quantitative and qualitative grounds – investment decisions are no different. An investment that looks very promising when looking solely at the numbers may still end up being a flop due to underperforming qualitative factors.
Naturally, the type of qualitative investment factors to focus on will vary based on the specific investments you wish to pursue. However, there’s also the risk of paying attention to vanity metrics, that is, qualitative factors that have no real bearing on investment merit. As an investor gains more experience and refines their intuition, knowing which qualitative factors to focus on and which to ignore starts to become easier.
Just like numerical data, qualitative investment factors can also be compared, but only to a certain extent because of a lack of objectivity. This doesn’t mean that qualitative factors have no chance of being compared whatsoever, but the process isn’t straightforward and will rely on an investor’s experience and judgment.
