Welcome to lesson four of our course on how to pick stocks! Lesson one looked at setting investment goals, lesson two looked at how to analyse those stocks with quantitative analysis and lesson three looked at earnings reports and how to read them.

In lesson four we will learn how to look beyond the numbers to get a more complete picture of a company using qualitative analysis. We will cover:

• What is qualitative analysis
• The main areas qualitative analysis looks at

By the end of this lesson you should be able to:

• Understand what qualitative analysis is
• Use qualitative analysis to get a more complete picture of a company

Lets get started!

 

Looking Beyond the Numbers with Qualitative Analysis

Fundamental analysis is a tool enabling investors to assess the value of a company before buying. Investor education sites assessing the quantitative side of the business – the numbers dominate the landscape, leading some investors to forget or ignore the second part of fundamental analysis – qualitative analysis.

Quantitative analysis uses mathematics, statistics, and computer modeling to construct measurable numerical data tracking a company’s financial and operational performance, and stock price movement over time.

Numbers alone do not tell the whole story. There are critical components of a company that are inherently subjective and not subject to translating into numerical data. Qualitative analysis looks at the unmeasurable side of a business. The quality of a company’s management is an intangible yet critical component of a successful company, as is the competitive advantage it has in its market, also an intangible. Perhaps the most important target of a qualitative analysis assessment is the business model. Quantitative analysis can tell you how much the company sells and keeps as profit, but it cannot tell you how the company does it. That is where qualitative analysis steps into the picture.

 

The Business Model

A business model is a profit making strategy outlined in a plan or blueprint for how the company will create, deliver, capture, and maintain value for itself and its customers. Think of businesses as “problem solvers” They make products or offer services designed to solve problems for a targeted segment of the population – their customers. 

The answer to the problem solved question is at the heart of what market experts call the value proposition, arguably the most important plank in the business model platform.

The Value Proposition

Companies create value with the character of the problems they address and the quality of their solutions. Here are some key issues to consider about a stock you are considering:

• A “one and done” solution adds less value than a recurring problem solution.
• Is the problem solution unique to the company or readily available from multiple sources?
• Do the products or services provided create and maintain customer loyalty over time?

The Revenue Model

Quantitative analysis can tell you how much the company makes, how much they spend, and how much they keep but it does not delineate which revenue generation methods the company employs. Here are some issues to consider, first for startups and then for established companies

• At what point does a company start making more than it spends and stops spending more than it makes?
• Does revenue come from one time sales?
• Are one time sales payable on delivery or as accounts receivables?
• Does the company generate revenue from recurring subscription?
• Does the company rely on multiple revenue sources, including licensing, ads, and investments?

 

The Sector, the Industry, the Company Competitors , and their Customers

Financial ratios are the bedrock of quantitative analysis and there is not a single one that tells an investor anything about the cyclical nature of some business sectors, or the industry in which they operate.

The Sector and the Industry

• The business sector classification is the broadest grouping to which the company belongs. Investors need to familiarize themselves with the sector of their targeted stock. Some are cyclical in nature, changing with the seasons or periods of demand. Commodity stocks experience tailwinds and headwinds driven by the price of the commodity they produce.
• The industry may be a red-hot newcomer disrupting markets with new technology. Artificial Intelligence (AI) stocks are the latest example.
• Some industries have been around forever and may be in the declining stages of consumer and commercial demand for the products and services they offer.
• Once thriving industries can get crushed by new and disruptive products, like word processing ending the typewriter industry.

Competitors and Customers

• Markets can be segmented so investors need to know where the company they are assessing fits and what share of the market it controls. They also need to know the market share of their competitors
• Competitors can be a direct threat to an investor’s targeted company should they produce similar products or services of higher quality or lower prices. Check for new offerings in a competitor’s development pipeline.
• Customers, be they consumers, commercial and industrial businesses, or government agencies, are the life blood of a company. Look for stocks with identifiable brands, satisfied employees, solid customer service reputations, and repeat customers.

 

The Company Management Team

Broadly speaking there are two parts to a company’s management team – the board of directors and the management team of executives directly employed by the company. The board of directors acts as a watchdog over a company’s operations, with the power to hire and fire and approve acquisitions and mergers. The strategic planning and operational day to day operations are controlled by the company’s management team.

• Look for a board with a diverse mix of CEO’s of other companies and non-CEOs, both with experience in the industry in which the company operates.
• Look for a management team with experience and a proven track record of performance in the industry in which the company operates, including some with technical expertise and in-depth knowledge of the competitive landscape, and legal expertise in regulatory compliance.
• With both the board and the management team investors should look for insider ownership. Stock ownership from the board and the management team is a sign of confidence in the company. Pay attention to insider buying.
• A strong management team includes expert “bean counters” to monitor the company’s operating and capital expenditures. This is especially true in biotechnology and pharmaceutical early stage companies where management teams dominated by researchers and physicians often ignore the cash register.
• Look for performance based pay structures grounded in long-term incentives, not short-term movements in the stock price.
• Look for stability in the management team.

 

Key Points

• Qualitative analysis looks beyond the ‘hard’ numbers and data of quantitative analysis to the ‘soft’ intangible factors that affect a company’s valuation
• The main areas to consider are the business model, the sector and industry and the management team
• The business model is how the company plans to create and deliver value for its customers and shareholders.
• The sector and industry are broad groupings of companies that operate in a similar area.
• Competitors are other companies within the same sector and industry that they will be competing with for customers
• The management team is made of the board of directors, that decide the company’s overall direction, and executives that oversee day-t0-day operations