There is a debate between two approaches among investors: qualitative vs. quantitative. In reality, every investor adopts at least a little of both approaches; but may emphasize one or the other.
Qualitative Approach
The qualitative approach concentrates on the quality of the company. Emphasis is put on the company’s products, services, management, competitors, etc. Special attention is given to finding companies with sustainable competitive advantages .
Qualitative investing requires assumptions about the future that are made on the basis of quality. The analyst will make judgements on the prospects of the stock based on the qualitative attributes of the company.
This approach is associated with Warren Buffet. Buffett is known for buying “wonderful companies” at a fair or reasonable price. Less emphasis is put on diversification versus finding and sticking to quality investments. An investor with an exceptionally long time horizon and the desire to buy and hold for many years might lean towards this approach.
If you bought a better than average company its performance may make up for the fact that you did not pay a bargain price. In other words, if you hold a stock for 20 or 30 years it might not matter that you paid a fair price (versus a bargain price) for a stock. For a long holding period the quality of the company may be more important than the price paid.
Holding a quality company for several decades can easily overcome paying a little too much for a stock. However, unlike Buffett, most investors don’t think in terms of holding a stock for decades. The shorter the holding period the more important the price you pay.
In reality the average holding period for a stock is less than one year. This is most likely one of the reasons studies show the average investor underperforms the market by 3 – 5 percentage points a year.
Quantitative Approach
Short holding periods (I would define as less than 5-7 years) increases the importance of the quantitative approach. It also increases the need for a margin of safety.
A quantitative approach concentrates on the income statements, balance sheets, and cash flows, and analyzes the relationship between price and intrinsic value . Current valuations are compared to historical valuations and other similar companies.
The difference between what you pay and intrinsic value of the stock is the margin of safety. The reason for having a margin of safety is to make accurate forecasts about the future irrelevant. Let’s face it; few of us can accurately predict the future.