Quantitative Research: is a formal, objective, systematic process in which numerical data are used to obtain information about the world. This research method is used: to describe variables; to examine relationships among variables.
Qualitative Research: is primarily exploratory research. It is used to gain an understanding of underlying reasons, opinions, and motivations. It provides insights into the problem or helps to develop ideas or hypotheses for potential quantitative research.
These two former research methods are the two ways equity researchers can attack an investment thesis. Each research method has its own costs and benefits. Deploying both methods into the same research thesis can become a very valuable tool (quantitative and qualitative research together is called mixed method research). The premise of this article is to unlock the value behind quantitative and qualitative research, for the equity researcher. We will also be discussing the cost and benefits of each research method on a standalone basis. Finally in the end of the article, we will show the benefits of using a quantitative and qualitative approach, or mixed method approach, for individual equity research.
My Research Methodology
When I first started to research companies and invest in stocks I was mainly just the numbers guy. I loved (and still love), looking at how a company has grown its top line and bottom line over an arbitrary time period. The numbers of the company fascinate me. The growth in FCF, the rise and fall in revenues and earnings, the history of how a company has performed over a chosen history of time; I mean how could you not like looking at the numbers?
I soon met an investor who was into the operations or the qualitative aspect of research. I was aware of this kind of research for I read Common Stocks and Uncommon Profits (if you have not read this gem, I suggest you read it ASAP). Phillip Fisher's master piece got me interested in the qualitative aspect of research, but I guess I never thought a CEO would take me seriously. Due to the former, I never called up management. So anyways, the guy I met has talked to tons of CEO's and upper management (C-Suite level executives) thus far in his investing career, and has visited tons of companies as well. From observing the way he conducts his research and seeing the quality of his research, well it influenced me to adopt a mixed method research style.
I am still tweaking out the perfect way to do equity research but so far, my method (99% of the time), starts by using a screener. I like screening for certain metrics such as low EV/EBITDA stocks, high revenue or earning growth, low to no debt (I am not 100% bias against debt, but it does scare me), NCAV stocks, etc. If a company's key metrics look enticing, then I will then dig in deeper, by reading their 10-K. After reading a selected company's 10-K, I will then decide if I want to write up a thesis on the investable security (I usually will if they have an interesting story or if their business model makes sense to me).
I have just started incorporating in qualitative research in my work (as of the past month), and have only talked to 4-5 different management teams. Before I do any qualitative research, I go back to the bricks and figure the business out via numbers. I make sure I have a good understanding on how the business makes its money, why its revenues are growing or faltering, what drives profits, etc, before I talk to any management teams.
Setting up management calls really is not that hard (at least in the microcap realm). I have never tried to get ahold of a management team from a huge company, but from what I have observed thus far is that microcap management teams seem very interested in talking to investors about their company. I think the reason for this is due to the fact that their stocks are so hidden from most public eye and opinion, that management wants the publicity. Although, I have only been incorporating qualitative research for about a month now, so the former belief could be wrong to some degree.
Overall, I really like both methodical research methods. The numbers are quite enjoyable and looking into the past on how a company has performed, can be very entertaining. But I also like to talk to individuals and network. You can learn a ton talking to management (and I am sure you can learn a lot more visiting companies, which I plan on doing relatively soon). The goal of this article though, is to find out what research method works best for you, the reader. In it we will weigh the benefits and costs of each research technique. I hope this article will enlighten an equity researcher, or aspiring equity researcher into finding their niche in the research side of stocks.
The Costs and Benefits of Quantitative Research
If you are a numbers guy, if accounting is exciting and balance sheets, income statements and cash flow statements are stimulating to your mind, then you will probably love the quantitative aspect side of equity research. I too also find much fun in looking at how a business has performed in the past.
The way I start my quantitative research is simple. After I run a screen, I start looking at a company's key metrics. An easy place to see a ton of metrics at one time is on the Yahoo Finance screen called Key Stats. I have provided an example of what I look for when looking at a chosen company's key stats.
For this example, I chose to take a look at Tandy Leather Factory's (TLF) Key Statistics. One of the first things that I look for is the valuation of EV/Revenue and EV/EBITDA. For the EV/Revenue, I like seeing it below 1.00. For the EV/EBITDA, a valuation below 6 catches my eye (if the valuation is below 4 then I really get interested). Investors should note that I have researched companies that trade at a premium; EV/EBITDA of >10.00. If there is an interesting story, I will not hesitate to investigate further, despite a premium.
Note: Investors who are interested in learning more about EV/EBITDA methods are advised to read Deep Value by Tobias Carlisle. Carlisle does a great job of explaining the advantages of buying a security with a low EV/EBITDA multiple.
By looking at the financial highlight section, we can learn a few different things about the chosen company. If a company has a high profit margin (usually >20%), then we can theorize that the company has some sort of economic moat, or niche business that allows it to charge a premium. High operating margins, return on assets and return on equity also can tell us if the company is a price taker or price maker.
This page also can tell us if the company has been able to grow its revenue and earnings in the past quarter. We can see that TLF barely grew its revenues and its earnings power shrunk. I really like when a see double digit revenue growth and earnings growth when looking at a company. If you check out Omega Flex's (OFLX), key stats page, you can observe double digit earnings growth.
Note: Remember, this page only shows a short time period of what a chosen company has accomplished. Investors should take a look at the past decade of what a company has accomplished in order to make a better theoretical decision about the chosen security.
TLF has a very strong balance sheet. I love seeing a company that has a high cash position and a low debt position. This gives me comfort that the company has a low chance of bankruptcy in the near future. If I see that a company has a ton of debt and very little cash, well it worries me. As I have stated before, I am not going to totally dismiss a company that is heavily debt ridden.
One investment that has returned shareholders 50-75% (depending on if you sold), in two months since I wrote about the investment opportunity. This security had tons of debt on its balance sheet as well. This investment is Otelco (OTEL). If you check out OTEL's cash to debt position you can see that it is substantial. I suggest that you read my articles on OTEL so you can see why you should not dismiss a company just because of its debt.
One of the final items that I look at on the key stats page is the avg. volume, shares outstanding, and insider/institutional ownership. I typically invest and research microcap and nanocap stocks so looking at the volume traded per day is important. Some very small companies have a very little amount traded per day. For an example, take a look at OurPet's (OTCQX:OPCO) average volume traded. OPCO has ~2,348 shares that are traded every three months. What is means is that it may be very hard to build a huge position in the company compared to TLF.
Note: Some investors are hesitant about investing in microcap stocks due to the fact that there is low liquidity. Instead of being worried about liquidity, worry about being right. Right as in the thesis of the investment opportunity.
I like seeing a decent amount of insider ownership >20%, but if insiders own >50%, then you must do further due diligence on management. I also like seeing hardly any institutional ownership (at least in microcap opportunities). The less institutional ownership the better, at least in my opinion. I like TLF's insider ownership position, but institutional owners own >40% which means the company is not as off the radar as I would usually like a company to be.
There are many benefits of doing quantitative research, as an equity researcher. In fact, I do not think a successful equity researcher could get by without doing any quantitative research on a chosen equity. Seeing the numbers of a company can tell researchers a story about the equity they are researching. It can show how well the company has performed in the past, or how bad it has performed in the past. History does not always dictate the future, but it rhymes.
One of the higher benefits of doing quantitative research on a chosen equity is that it takes very little money (if none at all) for one to start researching with this methodology. An individual interested in getting into equity research, can start from home with his or her computer. I have listed some of the benefits of quantitative research below.
I have also listed some of the costs to quantitative research.
The Costs and Benefits of Qualitative Research
Qualitative equity research is more intangible than and not as exact as quantitative research (in theory). It deals with positive or negative associations with management, the trustworthiness of the board of directors, customer satisfaction of the products a chosen company sells, the competitive advantage (or moat), and other similar methods. Some advocates of qualitative research or proponents, would say that the analyst listens to their gut, more than they rely on facts (this could be argued though).
When I first started doing freelance equity research, I always tried to incorporate my thoughts on the management team. The management team write up was always the hardest for me to do (probably because it has more to do with opinion than factual information). Since I have started to call management teams of companies I am investigating, well the qualitative aspect is getting easier for me to write about (still going to take a lot more work and time to perfect it, if perfection is even possible).
The first thing a qualitative researcher may do when looking into a company that seems interesting is to get ahold of the management team. Learning about the individuals running the show is very valuable information (it can tell you a lot about how the company will run in the future). Some questions that the qualitative researcher may ask is; does management have experience in this industry, what is managements professional background, do they have a good reputation, and do they have prior business success? These are just a few questions.
Qualitative researchers may also look for the employee turnover rate, how much management is paying themselves, the workplace culture, the way sales are conducted (from start to finish), the customers, the end products, the operations, etc. Like quantitative research, qualitative research will take practice. Qualitative researchers are also known for visiting companies. I have listed some questions a qualitative researcher may ask themselves.
One of the biggest benefits of doing qualitative research is that your research will be more valuable. There are not many investors who incorporate qualitative research, so in turn (due to the fact that it is rarer than quants), you will separate yourself from the crowd of quants. There are tons of quants out there but very little quals. Your research will be pure and original.
One of the biggest drawbacks to doing qualitative research is the cost. It can be very time consuming and cost tons of money visiting companies. Peter Lynch was a qualitative researcher and he got burned out in 13 years due to the time it took to do this kind of research. Quants on the other hand can go into the office, read the 10-K's and 10-Q's and leave the office at 5. Quals on the other hand may have to work around everyone else's schedule and travel frequently (which can burn someone out fast).
Being a quant or a qual really depends on your personality as well. If you hate talking to people and networking, then a quant would most likely suit your personality better. If you love talking to people and hate looking at financial statements, then a qual researcher would most likely suit your personality better. It all depends on what you like doing as an individual. Both research methods are important and valuable for successful equity research.
Combing the two Research Methods to Create a Synergy (Mixed Methods Research)
A combination of quant and qual to create a mixed method approach can be a very valuable research strategy. I have done this a few time (to an extent). The most recent time was when I did work on Socket Mobile (SCKT). In the report I published on SCKT I did tons of quantitative research and incorporated qualitative research as well. In the qual part, I called up the CEO and CFO and had a great conversation. I incorporated my call in the article which can be found here. I believe that it was very valuable for other readers due to the fact that no other researcher on Seeking Alpha has done that for SCKT. This made the research stand out a little more than just providing quantitative work.
Combining both methods can give the researcher an idea of where the company is headed from a numbers point of view and a networking point of view. It provides information that will help the researcher identify a more powerful thesis. Combining both of these methods into one piece of work, can become very time consuming, but quality is better than quantity.
A mixed method research methodology will allow the researcher to see what has happened in the past on a numbers point of view and what may happen in the future on a qualitative point of view. The research will be pure and extensive. There will be a lot more details and value produced. As an investor, I would like to see a mixed method approach more often in other research than just a quantitative approach or qualitative approach.
What is the way you conduct your research? Do you start with a quantitative method then move to qualitative manner? Or do you just stick with one method? There are advantages and disadvantages of both, but a combination of both of these methods can produce a very powerful end product (which can help formalize an investment hypothesis more clearly). As time passes, I hope to incorporate both methods of research into my work on Seeking Alpha. As a reader, what do you like to see in an article? Is an interview with management valuable? Or do you just want to see numbers? Thanks for reading and happy investing.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.