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S TOCK S ELECTION Portfolio Management Prof. Ali Nejadmalayeri
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Active vs. Passive Factors 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 ManagementPassive Management
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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
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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!?
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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)
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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
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Value Methods Annual ReportsGraham & Dodd, Buffett (Annual 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)
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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
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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
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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
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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
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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.S&P's Guide to Sector Rotation
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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
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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
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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
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Disciplined Investment Imagine return of a disciplined fund, r D, when a benchmark generated r M Then, it should be the case that The average excess return, α, is large The excess return is consistent, σ α is small –If we measure the regression every quarter, then quarterly dispersion of a is low
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Fundamental Law of Active Management Universal goal for an active manager is to maximize “information ratio”, IR, of the fundUniversal goal for an active manager is to maximize “information ratio”, IR, of the fund where, –IC; is the information coefficient –BR; is the breadth –TC; is the transmission coefficient
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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
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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? B –Manager B, because he’s accurate more times! Information coefficient is then about “good selection techniques”Information coefficient is then about “good selection techniques”
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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
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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
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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
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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
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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
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Optimization Use conditional optimization: –Control for individual stock weights –Control for sector contribution –Keep alpha high Try to maximize R 2 of the portfolio beta regression close to “ONE” –R 2 between 0.90 and 0.97 is good
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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
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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
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