Mastering the Art of Quality Investment Research
Part I
In one of our earliest articles, we talked about using stock screeners to find good companies that are fairly priced. These tools use financial data to sort through lots of stocks and point out promising options. While stock screeners are a great place to start, they don’t tell you everything you need to know about whether a company is a smart investment.
This article focuses on the next step—qualitative analysis. While financial ratios provide insights into performance, understanding a company’s long-term potential requires a closer look at what sets it apart, the strength of its leadership, and the trends or risks in its industry.
Because we believe qualitative analysis is such a crucial part of evaluating a company, we’ve decided to divide this topic into multiple posts. This approach allows us to dive deeper into the various aspects of qualitative research without oversimplifying key points. Each post will explore specific elements, ensuring you gain the insights needed to make better investment decisions. For today - Part I - we will talk in depth about the MOAT of a firm and the importance of having a good management.
To make this process more tangible, we’ll once again use the fictional company "The Golden Croissant" as an example throughout this article. By analyzing its strategies, leadership, and competitive edge, we can illustrate how qualitative research can uncover valuable insights about a business.
Protecting the Castle
One of the most important qualitative factors to consider when analyzing a company is its MOAT—a term popularized by Warren Buffett. A MOAT refers to a company’s ability to maintain a competitive advantage and protect its market position over time. Just like a medieval castle relies on its moat for defense, a business with a strong MOAT can fend off competitors and sustain profitability.
Competitive advantages are the cornerstone of any great business. That’s why it’s absolutely essential to determine whether a company truly possesses these qualities. A strong and sustainable competitive advantage acts like armor, protecting the business from competitors looking to chip away at its market share. It also allows companies to charge premium prices and fuels future growth.
Finding MOATS in a company isn’t always easy, therefore we will give you some tips on how we do it:
Analyze financial statements for consistently high profit margins or return on assets, as these can indicate the presence of a sustainable advantage.
Additionally, study the industry landscape to see how difficult it is for new competitors to enter the market.
Make sure to understand the business model the company has so you understand how they deliver value to their customers.
There are countless types of MOATs, and we’ll dive deeper into them in a future article. For now, let’s put our bakery, The Golden Croissant, to the test and see how well its defenses stack up against the competition.
Let’s start by looking at The Golden Croissant’s brand as a MOAT. Thanks to its massive following on Instagram, it has become a household name in the city. Everyone sees it as the go-to bakery for the best pastries, even if they haven’t tried them yet. This perception creates long lines of eager customers who are not only willing to wait but also happily pay premium prices for their croissants.
Another key MOAT for The Golden Croissant is its prime location in the heart of the city. Situated near busy shopping streets and office hubs, the bakery attracts heavy foot traffic throughout the day. This strategic location not only drives consistent sales but also creates high visibility, reinforcing its reputation.
The Golden Croissant also benefits from proprietary recipes and baking techniques that have been perfected over time. These trade secrets make it nearly impossible for competitors to replicate the same taste and quality.
Every company and industry features different types of MOATs, and not all MOATs are equally strong. Some businesses rely heavily on their brand, while others gain an edge through cost efficiencies or unique know-how. Recognizing the type and strength of a company’s MOAT is key to understanding its ability to fend off competitors and grow sustainably. We’ll continue to explore specific MOATs and their applications in future articles, helping you sharpen your ability to evaluate long-term competitive advantages.
Why Management Matters
Strong leadership has the ability to drive growth, create innovation, and inspire teams, while poor management can lead to inefficiencies, lost opportunities, and even failure. That’s why critically analyzing the people at the helm of a company is a crucial part of any qualitative evaluation. In this section, we’ll explore the key traits and behaviors that make a leadership team worth trusting and highlight red flags to watch out for.
1. Insider Ownership
Insider ownership refers to how much of the company’s stock is owned by its executives and board members. High insider ownership shows that management has a personal stake in the company’s success, aligning their interests with those of shareholders. It often leads to more prudent decision-making and long-term focus.
2. Meeting Their (Own) Expectations
Good management teams consistently set realistic goals and deliver on their promises. This builds trust with investors and demonstrates that leadership understands their business and market conditions. Missing targets repeatedly can signal poor planning or overconfidence.
It’s equally important for management to manage external expectations effectively. Investors often base their decisions on whether a company meets, exceeds, or falls short of these expectations. This means stock performance is not just about absolute growth but also about relative performance compared to forecasts. Poor expectation management can result in sharp price drops, even when a company delivers solid results.
For instance, if "The Golden Croissant" reports a 75% increase in croissant sales over the previous year but analysts anticipated 100% growth, the stock price may fall despite impressive performance. This illustrates how mismatched expectations can lead to disappointment. Effective management should not only deliver strong results but also guide external expectations carefully to create realistic benchmarks. By setting achievable targets and communicating transparently with investors, leadership can maintain credibility and protect shareholder value.
3. Capital Allocation
How a company reinvests its profits speaks volumes about its leadership. Effective capital allocation involves balancing reinvestment in growth opportunities, paying down debt, and returning value to shareholders through dividends or buybacks. Growth must also be evaluated in relation to the Return on Invested Capital (ROIC). High ROIC indicates that the company is efficiently generating returns on its investments, making growth more sustainable. In a recent article, we talked about how this is reflected in the value through a DCF analysis, so go check that out if you want to learn more on this topic.
Tracking investments in innovation are another critical factor. To maintain long-term growth and competitiveness, companies must allocate capital toward research, development, and new technologies. For example, The Golden Croissant reinvested its profits into upgrading kitchen equipment and launching a new delivery service, boosting efficiency and revenue. These investments not only improved short-term performance but also positioned the business for sustainable growth without taking on excessive debt.
Be sure to dive into the investment section of the annual reports and take a moment to reflect on whether these investments are likely to drive the company’s future growth. In the following years, keep a close eye on metrics like ROIC and revenue growth. These indicators will reveal whether the investments are truly creating value for the business.
Concluding Part One
Qualitative analysis is a cornerstone of smart investing. It goes beyond the numbers, helping investors understand the deeper factors that drive a company’s long-term success. By examining MOATs and assessing management, we can better evaluate a company’s competitive positioning and growth potential.
This article has laid the groundwork for understanding key elements like competitive advantages and leadership quality. However, there’s much more to explore. In the next post, we’ll dive deeper into topics like recession resistance or antifragility, pricing power, and immunity to innovation. These factors play a critical role in identifying businesses that can thrive in changing market conditions.
Stay tuned as we continue our journey through qualitative analysis, providing you with the tools to make more informed and confident investment decisions, of course without giving investment advice.