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Value investing: The qualitative factors

May 7, 2009

In line with our continued endeavour to bring to you investing perspectives from value investing guru Benjamin Graham, we shall take a look at Graham's take on evaluating qualitative factors in investing. Graham was firmly of the opinion the qualitative factors resist even reasonably accurate appraisal. In a previous article, we spoke of the various factors that affect share prices. One set of factors were 'future value factors' - things like company management, reputation of the company, competitive conditions and prospects, possible and probable changes in sales, margins and profits, the trend of yearly increase in earnings etc. Graham expounded on a host of reasons as to why one should be circumspect in basing investing decision on such qualitative factors.

First off, he points out that the placing of an overriding emphasis on the historical trend of earnings/sales is something that is most likely to result in errors of overvaluation or undervaluation. This is true because it is extremely difficult to fix rational limits on how far ahead the trend should be projected. Consequently, the process of valuation, while seemingly mathematical, ends up being in reality psychological and quite arbitrary. The trend is infact a statement of future prospects in the form of an exact prediction. Thus, the trend may well be considered a qualitative factor in its practical implications, even though it may be stated in quantitative terms.

Similarly, conclusions about factors like the nature of the business and the abilities of its management play a significant role in judging the 'outlook' of a particular company. As such, all qualitative factors have the same basic difficulty; it is next to impossible to judge to what extent they may reflect themselves in the price of a security.

That is the very conundrum that causes markets to overshoot in both directions. That's because in most cases, such factors, if they are recognised at all, tend to be overemphasised both on the positive and the negative side. Their influence is constantly at work in the general market. The recurring excesses of the market's advances and declines are thus due at bottom to the fact that when values are determined chiefly by the outlook, the resultant judgments are not subject to any mathematical controls and are almost inevitably carried to extremes.

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