Improve Your Investment Batting Average

Physician's Money Digest, May 31 2004, Volume 11, Issue 10

Investing is part art, part science.And these parts correspond to thetwo ends of the spectrum when itcomes to fundamental stock analysis:qualitative (art) and quantitative (science).Which end of the spectrum do yousit on? Your answer says a lot about theinvestment pitches you swing at and thenumber of times you strike out.

Artists vs Scientists

Let me point out that the term quantitativedoes not refer to technical analysis,charting, or price momentum. Itrefers to fundamental quantitative measuressuch as price/earnings (P/E), price/book, and discounted cash flow analysis.Quantitative investors focus primarily onthese types of valuation metrics and aretypically classified as value investors;sometimes these investors are classifiedas price conscious investors.

At the extreme end of the spectrumare those investors who base their buyand sell decisions purely on quantitativefactors. These investors are classified asdeep value investors and ignore suchfactors as a company's economic moatand growth opportunities. Instead,deep value investors focus solely on acompany's valuation relative to fundamental—often historical—metrics intheir search for cheap stocks.

The most famous investor who fallsinto this category is Benjamin Graham,who was known to have an almost maniacalfocus on valuation. He didn't spendnearly as much time thinking about acompany's economic moat or managementteam as he did thinking about itsvaluation. And while Graham is probablythe most famous cheapskate in thehistory of the stock market, he managedto be a very successful investor.

On the opposite end of the spectrumare qualitative investors. These investorsfocus almost exclusively on a company'scompetitive position and growth opportunities. Although they are typically classifiedas growth investors, they could alsobe thought of as nonprice consciousinvestors. That's because they are not asconcerned with a company's fundamentalvaluation as they are with its sustainablegrowth opportunities.

Under the Microscope

Most investors today fall betweenthe two ends of the spectrum—althoughthey're much closer to the qualitativeend. They look at a company's competitiveposition, market cap, brand name,management team, and patents andthen do a cursory analysis of their P/Eratio before deciding whether to buy.They're looking for the fabled "10-bagger"(ie, a stock that makes an investor10 times their original investment). Sothey loosen their valuation disciplineand pay up for a great story stock (ie, astock whose price is currently moving,or expected to move, due to someimportant company news).

Investors focus more on qualitativefactors because it's easier and moreinteresting. It takes a relatively sophisticatedunderstanding of financial theoryand an intermediate understanding ofaccounting to do an in-depth valuationof a company. The process also takes alot of time and requires a fair amountof technical know-how. There areshortcuts, but if you've never taken anaccounting class you can miss the redflags. The truth is many investors wouldsooner undergo a root canal than readan accounting textbook.

The bottomline

Of course, the importance of qualitativefactors should not be minimized.The truly great investors can use bothquantitative and qualitative factors.And while Warren Buffett is the classicexample, there are a lot of otherinvestors today who can use both factors.Investors Bill Nygren and BillMiller are two good examples. : If you are ever given a choicebetween the ability to understand acompany's story and the ability todetermine its intrinsic valuation, youshould probably choose the latterinstead of the former.

Investors as Players

Moneyball

Qualitative investing is a low probabilityway to invest. A qualitativeinvestor is similar to a baseball playerwho constantly swings for the fence. Inthe process, the athlete strikes out morethan most players. As Michael Lewispoints out in his book (W. W. Norton & Company; 2004), thistype of player tends to be overrated—and overvalued—relative to his contributionto the overall winning percentageof the team.

The same is true in the investingworld. If you have a limited amount oftime to analyze a company's stock, it'sbetter to spend more time figuring outwhether the stock is cheap and less timeevaluating the qualitative aspects of thecompany. Stocks such as Sirius SatelliteRadio and Sina.com are great storystocks, but they're very low probabilityinvestments. You have to be early, right,and endure extreme volatility.

Common Stocks and Uncommon Profits

And just as home run hitters tend tobe overvalued in the baseball world,story stocks tend to be overvalued inthe investment world. In his book(John Wiley & Sons; 2003) investinglegend Philip Fisher wrote, "The onlytrue test of whether a stock is ‘cheap' or‘high' is not its current price in relationto some former price, but whether thecompany's fundamentals are significantlymore or less favorable than thecurrent financial community appraisalof that stock."

And while avoiding story stocksguarantees that you'll miss the nextMicrosoft, it also guarantees that you'llmiss the next Enron (Enron never lookedcheap) and Internet Capital Group.Focusing on quantitative more than qualitativefactors improves the probabilitythat your investments, on average, willdo well over time. It also greatly decreasesthe probability that you'll suffer permanentcapital impairment because of astock that goes down and never comesback up. If you make the pitcher throwdown the middle, and look for singlesand walks instead of home runs, yourportfolio will thank you.

Mark A. Sellers is equities strategistfor Morningstar. He manages twoMorningstar portfolios and is theeditor of Morningstar StockInvestor.To order a free trial issue, call800-735-0700. He has played akey role in developing Morningstar's stock analysismethodology and proprietary measures. He iscurrently enrolled in the MBA program at theKellogg School of Management at NorthwesternUniversity. He welcomes questions or commentsat mark_sellers@morningstar.com, but cannotgive personalized investment advice.