SSTOCK TOCK SSELECTION ELECTION

Portfolio Management

Prof. Ali Nejadmalayeri

Active vs. PassiveFactors in Return:

1. Market

2. Industry• Growth• Cyclical• Stable• Energy

3. Individual

Factors in Risk:• Beta or Market Risk• Extramarket Covariance

or Industry Risk• Residual or Specific

Active Management Passive Management

Active Strategies

• Market Timing:– Set strategies based on “Market” movement

• Selective vs. Diversification:– Able to find “gems” or simply hedge risk

• Group Rotation:– Shift between overrepresented (over-bought) and

underrepresented (over-sold) industries or group, e.g., shifting from growth to value at the end of 1999

Market Timers• An strategy that tries to anticipate short-term

market direction and make buy and sell decisions accordingly. – Evidence support the idea that in general

professional managers have lousy timing when in comes to buy or sell stocks!

– Exception for: • Mutual Fund timing• Currency trading: Soros & Bank of England• Supposedly some technical traders!?

Major Selection Methods• Value Oriented:

– Dividend Discount Model Rate of Return (DDM)– Earnings Retention Yield (EPS-Dividend/Price)– Earning Yield (trailing 12-month EPS/Price)– Dividend Yield (Dividend per Share/Price)– Book-to-Price (Book Value per Share/Price)

• Growth Oriented:– ROE Change (5-year ROE)– Sales Growth Rate (5-year Sale’s Growth)– EPS Momentum

• Others:– Capitalization (Small vs. Large)– EPS Variability (Stdev[EPS]/Price)

Value Methods• Dividend Discount Model Rate of Return (DDM)

– Find internal rate of return from a three-stage DDM• Select stocks with highest discount rate

• Earnings Retention Yield (EPS-Dividend/Price)– Earning retention yield based on past four quarters

• Above average retention is preferred

• Earning Yield (trailing 12-month EPS/Price)– Reciprocal of historical P/E

• Higher yield, i.e., lower P/E, is favored

• Dividend Yield (Dividend per Share/Price)– Excludes zero dividend stocks

• Higher dividend yield stocks are preferred

• Book-to-Price (Book Value per Share/Price)– BM ratio calculated at the end of fiscal year

• Higher BM stocks are preferred

Value Methods

• Graham & Dodd, Buffett (Annual ReportsAnnual Reports)– Margin of safety; price << intrinsic value

• Intrinsic value = Liquidation Value – Debt

• Intrinsic value = CF/10-yr T-bond Yield

• Earning Power Value – Growth as margin of safety

• PV/EPV = margin of safety– PV = Capital (ROC – g) / (r – g)

» ROC is return on capital

– EPV = Capital (ROC / r)

Growth Methods• ROE Change (5-year ROE)

– Run a regression of ROE on TIME over past five years

– Take the slope as the five-year ROE change• Growing ROE is favored

• Sales Growth Rate (5-year Sale’s Growth)– Take the natural log of sales

– Run a regression of log(sales) on TIME over past five years

– Take the slope as the sale’s growth• Above average growth is favored

• EPS Momentum – Take the [I/B/E/S (First Call)] consensus EPS estimate for current year

– Divide that by the last year’s reported EPS• Higher percentage change stocks are favored

Growth Method

• Growth At Reasonable Price (GARP)– Louie Navallier; Mike Moe; etc.– P/E to Growth P/E/G

• PEG < 1.0 for high growth is a sign of investors disbelief

• PEG > 1.0 for high growth is a sign of investors euphoria

– P/S is quite important for very young firms• P/S vis-à-vis growth is a sign of relative expensiveness

– Macro factors + Micro attributes• Inflation + Interest rates + Indexes + Investor Sentiment +

Inflows (outflows) of Mutual Funds + IPO Pricing + Earning Growth & Consistency

Other• Capitalization (Small vs. Large)

– Based on market capitalization rank stocks into quintiles• The lowest quintiles (small stocks) are better• This effect is pronounced in January

• EPS Variability (Stdev(EPS)/Price)– Find the trailing seven years EPS variation– Divide that by Price

• Stocks with highest earning variability are favored

• Analyst Coverage– Find the number analyst following a stock

• Stocks with fewer analyst are favored

• Insider Trading– Find insiders (officers and major shareholders) last quarter purchases– Divide the number shares purchased to the outstanding shares

• Stocks with highest percentage insider purchase are favored

Group Rotation• In equilibrium each sectors represents certain

percentage of the total market cap. The proportion of the value of these sectors to other sectors, however, changes thru time. If the proportion is mean reverting, i.e., hovers around some long-run average, then when one sectors gets overloaded, it ought to come down and vice versa.– ETFs based strategies– Services provided for rotating the sectors

Sector Rotation

This chart is based on Sam Stovall's S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle.

Related Topics• Equity risk premium:

– Stocks or Bonds? Check AIMR’s Conf.

• Equity Valuation:– Systematic approach: AIMR readings

– Quantitative Methods: AIMR readings

• Technical Analysis:– Price charts: CFA magazine

Investment Strategies

Expected Market Return

Excess Return over Market (Positive Alpha)

Return below Market (Negative Alpha)

Standard Deviation

Expected Return

Index Fund Disciplined

Stock Selection Totally Active

Investment Strategies

• Passive:– Maintain return and risk close to market’s

• Totally active:– Select stocks that improves return; tradeoff risk

• Disciplined Stock Selection:Disciplined Stock Selection:– Improve return but limit risk of doing so

• Become skilled, “good” at understanding a segment

• Increase stocks followed and portfolio rebalanced

• Follow thru with the plan but check performance

Disciplined Investment

• Imagine return of a disciplined fund, rD, when a benchmark generated rM

Then, it should be the case that• The average excess return, α, is large

• The excess return is consistent, σα is small– If we measure the regression every quarter, then quarterly

dispersion of a is low

MD rr

Fundamental Law of Active Management

• Universal goal for an active manager is to Universal goal for an active manager is to maximize “information ratio”, maximize “information ratio”, IRIR, of the fund, of the fund

where,– IC; is the information coefficient

– BR; is the breadth

– TC; is the transmission coefficient

TCBRICIR

Analogy

How can you construct a good fund?

≡ How can you fill up a pool fast?

– Good skill ≡ High water pressure• INFORMATION COEFFICIENT

– Repeated Activity ≡ Large pipe• BREADTH

– Follow-thru ≡ Good maintenance • TRANSMISSION COEFFICIENT

Information Coefficient• Information coefficient is:

– Correlation between prediction and realization• Manager A buys 10 stocks predicting that returns are north

of 20%. Only 6 stocks come thru.• Manager B buys 7 stocks predicting that returns are north

of 8%. Only 6 stocks come thru.

– Who’s more the skilled manager?– Manager BB, because he’s accurate more times!

• Information coefficient is then about “Information coefficient is then about “good good selection techniques”selection techniques”

Optimal Selection Process

• Good predictability of return– Distinguish between attractive and unattractive

stocks; this needs in-depth field-knowledge

• Access predictability continually

• Systematic portfolio construction– Incorporate selection automatically into weights

• Given frictions, like transaction costs, etc., rebalance the portfolio

Breadth

• Imagine a casino. How does it make money? Consistency: Repeated Games!

• Now imagine stock investing. What is the most important source of risk? Market!

• Can anyone predict the market? NO!

• So repeat what

Selection and Management

Rebalancing

Method 1

Method 2

Method 3

Method 4

Stock appraisal process

RETURN

Composite Forecast

Market factor

Growth factor

Cyclical factor

Energy factor

Multi-index risk model

RISK

Stock Risk Assessment

Portfolio Optimizer

Recommended Holdings &

Weights

Trading, Portfolio Construction &

Transaction Costs

Multiple Models Predictability

• Use forecasted return and actual return the recommended stocks to construct ex ante (before) and ex post (after) rankings

• Run regression of actual ranking on predicted ranking

• Name the slope coefficient “Information Coefficient”, IC, measuring predictability.– IC 0.25 is good

Portfolio Construction Rules

• Portfolio risk should be in line with Market– Limit percentage investment in each stock – Keep portfolio beta between 0.95 and 1.05

• Keep sector risk in balance– If energy is 20% of the market then energy stocks in

the portfolio should have same %

• Keep portfolio well-diversified– Number of stocks should be between 60 and 90

Optimization

• Use conditional optimization:– Control for individual stock weights– Control for sector contribution– Keep alpha high

• Try to maximize R2 of the portfolio beta regression close to “ONE”– R2 between 0.90 and 0.97 is good

Transaction Costs

• Minimize transaction costs– Tradeoff between portfolio rebalancing for better

performance and portfolio maintenance for lower transaction costs

– The higher the IC the more frequent rebalancing can be done

• Even minute transaction costs can add up quickly when you have hundreds of stocks

Long/Short Strategies

• Long “positive” alpha stock and Short “negative” alpha stocks– Positive alpha reflects undervalued stocks, whereas

negative reflects overvalued ones

• Same guidelines as before for each of the LONG and SHORT portfolio applies

• Works best when tracking error of each portfolio and correlation of the two are low