Improving Your Batting Average in the Stock Market

A bird in the hand is worth two in the bush. --Aesop

Investing is part art, part science. These parts correspond to the two ends of the spectrum when it comes to fundamental stock analysis: qualitative (art) and quantitative (science). Which end of this spectrum do you sit on? The answer has a lot of implications about the investment "pitches" you swing at, and the number of times you strike out.

Quantitative vs. Qualitative
Before I go further, I should clarify that by "quantitative," I don't mean technical analysis or charting or price momentum or anything like that. I'm referring to fundamental quantitative measures such as price/earnings, price/book, and discounted cash-flow analysis.

Quantitative investors focus primarily on these types of valuation metrics and are typically classified as "value" investors, though they could also be classified as "price-conscious" investors. At the extreme are those who base their buy/sell decisions purely on quantitative factors--they are classified as "deep value" investors. They ignore factors such as a company's economic moat and growth opportunities. They want cheap stocks--their sole focus is on valuation relative to fundamental, often historical, metrics.

Marty Whitman from Third Avenue is a successful investor who falls into this category. Another is the management team at  Aegis Value Fund (AVALX). Of course, the most famous investor to fall into this category would be Benjamin Graham. Graham was known to have an almost maniacal focus on valuation--he didn't spend nearly as much time thinking about a company's economic moat or management team as he did on its valuation. He's probably the most famous cheapskate in stock market history, but he was also a very successful investor.

On the opposite end of the spectrum are qualitative investors--those who focus almost exclusively on a company's competitive position and growth opportunities. Although they are typically classified as "growth" investors, they could also be thought of as "non-price conscious" investors--they are not as concerned with a company's fundamental valuation as they are with its sustainable growth opportunities. The Janus Funds are known for this style of investing and were particularly good at it in the 1990s. Alberto Vilar from Amerindo is an extreme example; his funds produced eye-popping returns in the 1990s bull market and equally eye-popping losses during the recent bear market.

Where Do You Sit?
Most investors fall between these two ends of the style spectrum, but in my experience, much closer to the qualitative end. They look at a company's competitive position, its market cap, its brand name, its management team, its patents, and then do a cursory analysis of its price/earnings ratio to decide whether to buy or not. They are looking for the fabled "ten-bagger," so they loosen their valuation discipline (or throw it out the window), and pay up for a great story.

Individuals focus more on qualitative factors because it's easier and more interesting to them. It takes a relatively sophisticated understanding of financial theory and an intermediate understanding of accounting to do an in-depth valuation of a company. You have to be able to tear apart a balance sheet, decipher a cash-flow statement, and project future financial statements by looking at the past. This takes a lot of time and requires a fair amount of technical know-how. There are shortcuts, but there's no getting around the fact that if you've never had an accounting class, you can miss some big red flags. If you've never read a book on valuation methodology, you won't have the slightest idea how to do a discounted cash-flow analysis.

To be honest, many individual investors are bored silly with this type of stuff. They'd sooner undergo a root canal than voluntarily read an accounting textbook. So they focus their efforts on the qualitative aspects of a company, such as moat and management and growth. They look for stories.

I don't want to minimize the importance of qualitative factors--here at Morningstar we spend a lot of time analyzing these things. And the truly great investors can do both. Warren Buffett is the classic example, of course, but there are lots of others. Bill Nygren is one. Bill Miller is another--although it seems to me that Miller is closer to the qualitative side than Buffett or Nygren is. But given a choice between the ability to understand a company's story or determine its intrinsic valuation, I'd have to say that, for most investors, more emphasis should be placed on the latter than the former.

Swinging for the Fences
Qualitative investing is a low-probability way to invest, similar to a baseball player who constantly swings for the fences. In the process, he'll strike out more than most other players. If you've read Moneyball by Michael Lewis, you know that this type of player tends to be overrated (and overvalued) relative to his contribution to the overall winning percentage of a team.

In my opinion, the same is true in investing. If you have a limited amount of time to analyze a stock, I think it's better to spend most of that time figuring out whether the stock is cheap, and less on the qualitative aspects of a company. Stocks such as  Sirius Satellite Radio (SIRI) and Sina.com  are great stories, but very low probability investments. You have to be early, and right, and you have to endure extreme volatility.

And just as home-run hitters tend to be overvalued in the baseball world, story stocks tend to be overvalued in the investment world. Benjamin Graham once wrote, "The investor cannot hope for better than average results from buying new offerings, or 'hot' issues of any sort, meaning thereby those recommended for a quick profit. The contrary is almost certain to be true in the long run." In Common Stocks and Uncommon Profits, Phil Fisher wrote, "The only true test of whether a stock is 'cheap' or 'high' is not its current price in relation to some former price, but whether the company's fundamentals are significantly more or less favorable than the current financial community appraisal of that stock."

Avoiding story stocks guarantees that you'll miss the next  Microsoft (MSFT), but it also means you'll miss the next Enron (Enron never looked cheap) or Internet Capital Group . Focusing on quantitative more than qualitative factors improves the probability that your investments, on average, will do well over time, and greatly decreases the probability that you'll suffer permanent capital impairment by purchasing a stock that goes down and never comes back up.

Make the pitcher throw one right down the middle. Look for singles and walks, not home runs. Your portfolio will thank you.