Quantitative versus Qualitative Value Investing

Quantitative or qualitative value investing?

Which method is the most effective?

Quantitative investing based on mathematical finance. Generally speaking quantitative analysis is simply a way of measuring things. Examples of quantitative analysis can include everything from simple financial ratios such as earnings per share or price to book, to something more complicated as discounted cash flow or option pricing.

A quantitative approach concentrates on the income statements, balance sheets, cash flows and analyzes them. Quantitative approach entails the analysis of the current state of the business. Using these  methods you try to identify stocks trading below their intrinsic value.

Very important point is that quantitative process is a tool to protect us from our own behavioral errors and to exploit the behavioral errors of others.

The qualitative approach concentrates on the quality of the company. Emphasis is put on the company’s management, products and services – know what a company does and how it makes money – and industry and competitors. Special attention is given to finding companies with “moat” or sustainable competitive advantages.

Qualitative investing requires assumptions about the future, that are made on the basis of quality. You have to make judgements on the prospects of the stock based on the qualitative attributes of the company.

 

Roots of value investing

 It is difficult to ignore farther of value investing and fundamental analysis, Benjamin Graham when you begin to speak about quantitative value investing. Graham took it upon himself to form a rigorous analytical framework for the scrutiny of securities. Graham recommended that investors spend time and effort to analyze the financial state of companies to determine a conservative valuation for the security. When a company is available on the market at a price which is at a sufficient discount to its rough valuation of intrinsic value, to provide a “margin of safety”, the security could be purchased. This was true value investing although Graham never used the phrase “value investing”.

Ben Graham explained his methods best in his books Security Analysis, which was first well-reasoned and comprehensive approach to analyzing securities, and later in The Intelligent Investor. During his life long career Graham always tried to form quantitative methods to find undervalued stocks with varying success.

Instead Graham’s most famous student, Warren Buffett, moved during his career from quantitative value investing to more qualitative approach. Latterly Buffett focus on long-term sustainable growth rather than on simply the valuation of current cash flows or assets. However Buffett achieved his best results during his first years (Buffett Partnership) using mainly Graham’s methods: deep value / net-nets, special  situations and increasingly controlling investing. Presumably the main reason for Buffett’s change of investing style was his ever-increasing amount of money and assets. It was no longer possible to invest in smaller unknown and less followed companies.

 

Formulas

Different investing formulas are common ways to bring theoretical quantitative knowledge into practice.

One of Graham’s earliest formula was liquidation value. In the 1934 edition of Security Analysis Graham argued that stock selling persistently below its liquidation value was fundamentally illogical and it meant that the stock price is too cheap.

So net-net working capital method, buying companies at a price below net-net working capital (current assets less all the liabilities), was fundamentally a pure quantitative method.

Another quantitative method of Graham is “Simple Strategy”. Based on his stock research over a 50-year period and about 40 years after the publication of Security Analysis.

Investor should create a portfolio of a minimum of 30 stocks, P/E ratio below 10 and debt-to-equity ratio below 0,50. Finally investor should hold those stocks until they had returned 50 %, or if a stock hadn’t met that return objective by the end of the second calendar year from the time of purchase, sell it regardless of price.

Maybe the most famous Graham formula is his “Intrinsic Value formula”. This formula as described original by Graham in the 1962 edition of Security Analysis, is as follow:

V = EPS x (8,5 + 2g)

Where

V = Intrinsic Value,

EPS = Trailing Twelve Months Earnings Per Share,

8.5 = P/E base for a no-growth company and

g = reasonably expected 7 to 10 year growth rate.

 

Graham revised and updated his formula in 1974 included a required rate of return.

Intrinsic Value = EPS x (8,5 + 2g) x 4,4 / Y

Where

4,4 = minimum required rate of return and

Y = current yield on AAA corporate bond.

 

Joel Greenblatt and his “Magic Formula” is maybe the most famous current quantitative value investing formula. Greenblatt describes this method in his popular book The Little Book that Beats the Market (and later The Little Book that Still Beats the Market) . Greenblatt got the idea for his “Magic Formula” from Warren Buffet’s investing strategy to buy wonderful business at a fair price. Greenblatt’s challenge was quantitatively define “good business” and “bargain price”.

Greenblatt uses a high return on equity capital as a definition of a wonderful business.

Greenblatt ROC = EBIT / Average of (Net fixed Assets + Net Working Capital)

And for a bargain price he uses earnings yield.

Earnings yield = EBIT / EV.

Companies are ranked according to these two metrics. Then the 20 to 30 companies with the highest ranks are purchased at a rate of two to three positions per month over a 12-month period. Exclude utility and financial stocks – and foreign companies. Re-balance portfolio once per year, selling losers one week before the year mark and winners one week after the year mark (Tax reason in US). Continue over a long-term (5–10+ year) period.

Although many back tests and real world experiences have not reached Greenblatt’s extraordinary original results (returns over 30 % per year) we can confirm the book title to be true – the “Magic Formula” strategy beats the market.

 

Greenblatt’s original Magic Formula – developed with Richard Pzena – is also worth of mention. To start, Greenblatt used Graham’s traditional net-nets formula to screen for bargains. Greenblatt also wanted his deep value strategy to outperform, with less risk than the wider market. In an attempt to remove any ‘junk’ firms from the list Greenblatt added the P/E ratio to help.

Originally Greenblatt tested four different portfolios, each with a different P/E screening criteria. Best results (returns over 40 % per year) achieved following portfolio:

Stocks selected for portfolio

– Price below 85% of NCAV

– P/E of less than 5

– No dividends required

Stocks with a market cap of less than $3 million were discarded from the study (April 1972 – April 1978). Stocks were sold after a 100 % gain or two years had passed, whichever resulted first.

Interestingly, this portfolio performed much better than Greenblatt’s world famous “Magic Formula”!

 

Another great quantitative value study is made by Wesley R. Gray and Tobias E. Carlisle in their book Quantitative Value. They have studied most important quantitative value methods from Ben Graham to Joel Greenbaltt’s “Magic Formula”. I highly recommend to read the whole book, but here I want to pick up a few interesting things. Numerous academic studies have proofed that quantitative value strategies beat the market. Simple low P/E and P/B strategies still work, but interesting is that as a single value measure EV/EBIT seems to outperform all the other price ratios. As you remember this was Greenblatt’s definition for bargain price (reverse earnings yield) and what is the most fun of all, it works alone better than together with Greenblatt’s wonderful business factor return on capital. It shows how difficult it is to find workable quantitative measure for wonderful business.

Base of knowledge that EBIT enterprise multiple performs well and Greenbaltt’s “Magic Formula” tends to overpay for quality Gray and Carlisle create their own qualitative value strategy checklist. Although it is difficult to improve EBIT enterprise multiple they found that removing small portions of stocks that might be frauds, financial statement manipulators or at high risk of financial distress improves final results. Last but not at least an important teaching of Quantitative Value book is how to perform sound, fundamental analysis without allowing human emotions to dictate bad decisions.

 

Pros and cons

Every investing strategies have their pros and coins.

Quantitative value investing:

What is typical?

Typical for quantitative value method is to try to buy stock below the fundamental intrinsic value of the company (quantitative measured). True quants just look at the numbers and decide if the stock is a good value or not. They diversify the portfolio into many undervalued stocks. Shorter holding period is normal because stocks will be sold when they have reach fair/over value. Or after strict time period if investment has not achieved its goals.

Advantages

+ value true publicly available data

+ academic evidence

+ powerful screen

+ overcome behavioral bias

+ time friendly

Disadvantages

– practice is not always same as the theory

– bad apples can pass your screen

– all valuable company information will not be used

 

Qualitative value investing:

What is typical?

The qualitative approach concentrates on the quality of the company. Normally you try to buy great companies at a fair or reasonable price. Your portfolio is often concentrated selecting few positions that have been thoroughly researched, your best ideas. And you hold stocks for a long time horizon – in the best case permanent.

Advantages

+ company and industry knowledge give you additional value

+ analyzing you can avoid frauds

+ use only your best ideas

+ time is favor of your wonderful businesses

Disadvantages

– behavioral mistakes are possible, even for the best

– you can be too self-confident

– need more time for analysis

 

Conclusion

Buffett spoke in his 1987 Shareholder Letter following:

“In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgement with an ability insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”

It is certainly true – at least to Buffett. I prefer to start with quantitative analysis. For example screening stocks accordance fundamental ratios is pure quantitative method. It suits well for my investment style and creates proven and predictable base for selecting right investment candidates. I am somewhat strict if quantitative criteria are not met, the stock is not for me.  Although the fact is that I don’t make any investment decision without further research. Reading company websites, SEC filings and other research articles are mostly under qualitative analysis. When used correctly I feel all of this information are very important and often crucial before making final investment decision. Also using check list is in most cases both qualitative and quantitative operation.