What is Qualitative Analysis
Qualitative analysis is a securities analysis that uses subjective judgment based on unquantifiable information, such as management expertise, industry cycles, strength of research and development, and labor relations. Qualitative analysis contrasts with quantitative analysis, which focuses on numbers that can be found on reports such as balance sheets. The two techniques, however, will often be used together in order to examine a company's operations and evaluate its potential as an investment opportunity.
BREAKING DOWN Qualitative Analysis
The distinction between qualitative and quantitative approaches is similar to the distinction between human and artificial intelligence. Quantitative analysis uses exact inputs such as profit margins, debt ratios, earnings multiples, and the like. These can be plugged into a computerized model to yield an exact result, such as the fair value of a stock or a forecast for earnings growth. Of course, for the time being, a human has to write the program that crunches these numbers, and that involves a fair bit of subjective judgment. Once they are programmed, though, computers can perform quantitative analysis in fractions of a second, while it might take even the most gifted and highly-trained humans minutes or hours.
Qualitative analysis, on the other hand, deals with intangible, inexact concerns that belong to the social and experiential realm rather than the mathematical one. This approach depends on the kind of intelligence that machines (currently) lack, since things like positive associations with a brand, management trustworthiness, customer satisfaction, competitive advantage and cultural shifts are difficult, arguably impossible, to capture with numerical inputs.
Elements of Qualitative Analysis
Qualitative analysis can sound almost like "listening to your gut," and indeed many qualitative analysts would argue that gut feelings have their place in the process. That does not mean, however, that it is not a rigorous approach. Indeed, it can consume much more time and energy than quantitative analysis.
People are central to qualitative analysis. An investor might start by getting to know a company's management, including their educational and professional backgrounds. One of the most important factors is their experience in the industry. More abstractly, do they have a record of hard work and prudent decision-making, or are they better at knowing – or being related to – the right people? Their reputations are also key: are they respected by their colleagues and peers? Their relationships with business partners are also worth exploring, since these can have a direct impact on operations.
Perhaps more important is the way employees view the company and its management. Are they satisfied and motivated, or do they resent their bosses? The rate of employee turnover can indicate employees' loyalty or lack thereof. What is the workplace culture like? Overly hierarchical offices promote intrigue and competition and sap productive energy; a sleepy, unmotivated environment can mean employees are mainly concerned with punching the clock. The ideal is a vibrant, creative culture that attracts top talent.
Admittedly, answers to these questions can be difficult to come by. Fortune 500 CEOs are not known for sitting down with small-time investors for a chat or showing them around the corporate headquarters. In part, Warren Buffet is able to use qualitative analysis so effectively because people are so willing to give him access to their time and information. The rest of us have to sift through news reports and companies' filings to get a sense of managers' records, strategies and philosophies. The management discussion and analysis (MD&A) section of a company's 10-K filing and quarterly earnings conference calls provide a window into strategies and communication styles. Clear, transparent communication and coherent strategies are good. Buzzwords, evasiveness and short-termism, not so much.
Qualitative Analysis in Context
Customers are the only group more crucial to a company's success than management and employees, since they are the source of its revenue. Ironically, if a company places customers' interests before shareholders, it may be a better long-term investment. If feasible, it's a good idea to try being a customer. Say you're considering investing in an airline that has reined in costs, beat earnings estimates in three consecutive quarters and plans to buy back shares. When you try to actually use the airline, however, you find the website bug-ridden, the customer service reps cranky, the extra fees petty and your fellow passengers resentful. Now the financials appear to tell a less attractive story: a jaded incumbent squeezes more from its customers while giving less in return, throwing sops to investors until a better firm comes along to sweep them away.
A company's business model and competitive advantage are a key component of qualitative analysis. What gives the firm an enduring leg up over its rivals? Has it invented a new technology that competitors will find hard to replicate, or that has intellectual property protection? Does it have a unique approach to solving a problem for its customers? Is its brand globally recognized—in a good way? Does its product have cultural resonance or an element of nostalgia? Will there still be a market for it in twenty years? If you can plausibly imagine another company stepping in and doing what this one does just a little bit better, then the barrier to entry may be too low. If the company is not yet established, why will it be the one to create or disrupt its chosen market, and why won't it then be replaced in turn?
The idea behind quantitative analysis is to measure things; the idea behind qualitative analysis is to understand them. The latter requires a holistic view and a fact-based overarching narrative. Context is key. For example, a CEO who dropped out of college would be a red flag in some cases, but Mark Zuckerburg and Steve Jobs are exceptions. Silicon Valley is, for better or worse, a different beast. A look at McDonald's Corp's financials a few years ago would have told you nothing about a looming backlash against, cheap, nutritionless food. On the other hand, a purely qualitative approach is vulnerable to distortion by blindspots, over-narrativizing and personal biases. Quantitative measures can act as a check on these tendencies.