Quantitative Analysis Explained

Researching Stocks with Quantitative Analysis

All investors committed to picking their own stocks for investment face the challenge of separating the wheat from the chaff. The two most prevalent methods for doing so are fundamental analysis and technical analysis.

Technical analysis is arguably the more complicated method, using a variety of mathematical tools to examine the historical price and volume movements of a particular stock to assess potential future price movements.

Fundamental analysis attempts to determine the intrinsic value of a stock to assess potential future price movements. There are two parts to fundamental analysis – Quantitative Analysis and Qualitative Analysis.

What is Quantitative Analysis

Quantitative Analysis uses statistical and mathematical analysis of “hard” data to assess potential stock investments.

In today’s world algorithms and mathematical models along with statistical analysis have exploded, relying on the abundance of readily available historical financial information from corporate financial reporting and company announcements to the market.

In earlier years, quantitative analysis was beyond the reach of most average retail investors. Now the work is done for them by market experts and financial analysts.

Algorithm-based mathematical models are a hallmark of managed funds available to individual investors who can afford them. While mutual funds and exchange traded funds (ETFs) are generally affordable, entry fees for managed hedge funds are beyond the reach of many retail investors, accessible primarily to “high net worth” individuals.

Statistical analysis of a company’s past and projected financial performance is readily available to retail investors in the form of ratio analysis.

While it is possible for sophisticated and experienced individual investors to sort through the financial statements of an individual company available on the ASX website and the majority of Australian financial websites, that is a task performed, revised, and updated by experts.

Financial analysts comb through a company’s Balance Sheet, Income Statement, and Statement of Cash Flows looking for relationships in the reported numbers for a variety of metrics. The end results of their analysis is an exhaustive list of ratios based on the company’s historical and projected financial performance.

The task for the retail investor then becomes sorting through the list of ratios to find those best suited to fit their investment strategy.

For example, the price to earnings ratio (P/E) is arguably the ratio most relied on by investors. Those looking for “value” stocks at bargain prices will gravitate towards stocks with low P/Es, indicating market sentiment may be undervaluing the stock. Those looking for “growth” stocks will gravitate towards stocks with high P/Es, indicating market participants are willing to pay more for a stock’s expected future growth.

Some investors limit their decision making to the P/E ratio and the other valuation ratios:

• Price to Earnings Growth (P/EG)
• Price to Book (P/B)
• Price to Sales (P/S)

There are a multitude of additional ratios grouped into the following categories:

• Profitability
• Liquidity
• Leverage
• Operating Efficiency

Proponents of a strict reliance on quantitative analysis point to the strength of relying on the actual “hard” numbers found in financial reporting and analysis.

However, there are limitations to relying on quantitative analysis alone, especially with ratio analysis.

The Limitations of Quantitative Analysis

First, some investors stop short of comparing numerical ratios of a single stock against the ratios seen in other stocks operating in the same sector. This can be challenging given discrepancies in what even a similar company does.

Second, all approaches to quantitative analysis – from algorithmic based statistical modeling to ratio analysis –depend on accurate data. Corporate financial reporting aims to paint the most positive picture of a company’s performance, sometimes leading to a bit of “spruiking” the performance numbers.

Third, some analysts point to the complexity of some statistical models  focus on historical data limiting their effectiveness at assessing future outcomes.

Fourth, statistical models often fail to account for unexpected events, with weather disasters, the COVID 19 pandemic, and the Great Financial Crisis (GFC) as prime examples.

Finally, quantitative analysis restricted to statistical modeling or ratio analysis tells the investor nothing about  what the company does.

Quantitative versus Qualitative Analysis

Qualitative Analysis is the second step in a complete fundamental analysis. Qualitative analysis goes beyond the numbers, examining the intangible issues that can contribute to a company’s success or failure.

The products and services a company provides both currently and in the future are vital to assessing its future success.

In a world going increasingly global, it makes a difference where a company sells whatever it is it does to generate a profit.

In a world going increasingly digital, it makes a difference how a company distributes and sells its products, with more and more companies adopting multi-channel distribution, selling both online and in brick and mortar stores.

A successful company will breed competitors. Quantitative analysis provides no information on who these competitors are and what they are doing.

Management quality is another intangible essential for corporate success. Corporations that build internal cultures that promote employee involvement also contribute to long-term success.

Quantitative analysis alone has nothing to add about the industry and the regulatory environment in which the stock under analysis operates.

A company’s reputation and branding image are difficult to express numerically, although ranking surveys do exist.

Local and global economic conditions do not show up in corporate’s financial statements.

Retail investors can access and assess these intangibles in a variety of ways, beginning with corporate websites. Most announcement summaries of full year and half year financial results include a section for management commentary and analysis.

Some financial websites list company competitors. Articles in these website from financial analysts and market experts cover many intangible topics, sometimes including access to analyst reports and coverage summaries.

Publicly listed companies make periodic announcements to the market on relevant business issues. The ASX website includes access to market announcements going back years.

Quantitative Analysis in Practice

In practice, most stock market analysts combine quantitative analysis with qualitative analysis. Some quantitative analysis statistical models do address issues that can in some way be quantified, such as social media searches to quantify market sentiment, assigning numerical values to brand recognition, including scoring mechanisms for management quality and corporate culture, and accessing customer satisfaction surveys.

Retail investors determining which stocks to buy can assess potential targets in two ways – fundamental analysis and technical analysis.

Technical analysis offers a variety of mathematical tools for using a stocks price movement and trading volume history to predict future performance.

Fundamental analysis has two steps – a quantitative analysis of hard financial performance and operating efficiency data available in corporate financial statements – and qualitative analysis that asses intangible issues affecting corporate success or failure.

Ratio analysis is a mathematically based assessment method performed by financial analysts researching the financial statements of the company being assessed. Although retail investors can calculate ratios on their own, financial websites include analyst calculated ratios for valuation, profitability, liquidity, leverage, and operating efficiency.