We’re pleased to share this five-part series on investment, from one of our Directors, Paul Reilly. Paul has had a long-standing career providing financial advice and in this series digs into some important investment principles to increase your understanding of sound investment.

 

EXPLORING INVESTMENTS: ARTICLE 2 – QUANTITATIVE ANALYSIS AND QUALITATIVE ANALYSIS

 

One of the ways an investment strategy is determined is through systematic analysis, or what is also called quantitative analysis.

This type of analysis is objective rather than subjective, and removes emotions by looking at possible investments using a systematic approach.

So let’s explore quantitative analysis and how it is used to examine potential investment opportunities.
 

What is Quantitative Analysis?

Quantitative analysis is remarkably similar to any other sort of investment, in that the following inputs are examined:

• Income Statements
• Profit and loss
• Balance sheets
• Cash flows
• The financials

The quantitative data analysis method used to look at this information about companies is through a slightly different lens, an objective lens, in a systematic and disciplined fashion.

The analysis looks at research and determines ways of ascertaining which companies to invest in and how much to invest. That’s done in a completely unemotional context by testing ideas and looking at academic research to do financial analysis.

A consistent set of rules is applied methodically and isn’t overruled with interpretations and biases. It’s easy to be emotional when it comes to investments, so that emotion is removed along with behavioural biases.
 

 

How is Quantitative Analysis Done?

Let’s use an example to explain what a typical quantitative analysis model looks like by drawing an analogy to a water treatment plant.

With a water treatment plant, the water comes into the plant unfiltered and dirty. The water moves through multiple layers of filters, each of which removes impurities. The water gets cleaner through each layer and when finished is a cleansed, refined product.

With the quantitative analysis model, possible investments move through several layers of filters. Each layer removes investments that don’t pass the test. The 100 biggest companies on the Australian Securities Exchange (ASX) are passed through a range of filters.

There are different filters, such as a value filter. This looks at whether a company is currently cheap or expensive. There are quality filters, which determines whether it is a profitable, stable, and growing business.

At each level a number of companies is removed due to the filters. Those that remain go to the next level of analysis or filter. At the bottom, or the end of the analysis, there is an investment portfolio that remains.
 

 

What is an Example of Quantitative Analysis?

Now let’s explore an example of quantitative analysis for management based on comparing two companies.

An accrual filter in the accounting sense is the difference between reported profits and cash flow. Accounting standards allow for some flexibility that allows companies to report the same financials in very different ways. One of the things that’s important to analyse is whether a company’s reported profit is backed up by cash flow.

If a company states that is has made a million dollars, there should be a million dollars in cash flow coming into the business; there should be more cash flow at the end of the year than at the beginning.

This is in simple terms, but this filter gives confidence that the reported profits are real.

Let’s say we have two car wash companies, one owned by Donald and one owned by Sally. They charge $10 per car wash and each of them washes five cars. In January they send out their invoices but one customer has not paid.

Donald reports his revenue of $50 because he washed five cars at $10 a piece. He’s entitled to report $50 in revenues, but he also reports a net income of $50. His cash flow from operations is only $40, which means he is left with an accounts receivable of $10.

Sally also has $50 in revenue, but doesn’t believe the delinquent customer will ever pay. So she writes off that $10, and reports $40 in income. Sally’s net income, net profit and cash flow line up, each at $40, and she has no accounts receivable.

In this example, you would think that the market would value each of these companies similarly, but in reality it does not. The market is actually willing to pay more for Donald’s company than Sally’s because investors focus too much on reported profits and not enough on cash flow.

In this example, our analysis may not value Donald’s company as high as Sally’s because our analysis wants to ensure that reported profit is backed up by cash flow.
 

 

Final Thoughts

At Financial Framework, a systematic or quantitative analysis ensures an investment portfolio has passed enough measures to indicate quality and an investment that can work for our clients.

We believe we have constructed some of the best managed funds in Australia, with a focus on beneficial ownership and transparency.

Contact us today to find out more.