Quantitative Stock Selection

Global Asset Allocation and Stock Selection
Quantitative Stock Selection
Campbell R. Harvey
Duke University
National Bureau of Economic Research

1. Introduction
Research coauthored with
Dana Achour
Greg Hopkins
Clive Lang

1. Introduction
Issue
Two decisions are important:
Asset Allocation (country picks)
Asset Selection (equity picks)

1. Introduction
Issue
Considerable research on the asset allocation
side
Research has paid off in that many models
avoided overvalued Asian markets in mid1990s
Many models began overweighing after the
onset of the Asia Crisis

1. Introduction
Issue
Little research on the stock selection side.
Why?
Sparse data on individual stocks
Information asymmetries among local and
global investors
Extremely high transactions costs

1. Introduction
With recent plummet in emerging markets,

stock selection is important.
If market is deemed cheap, (as many
asset allocation models would now suggest),
which stocks do we select?

2. Stock Selection Metrics
Ingredients for success:

Identify stable relationships
Attempt to model unstable relationships
Use predictor variables that reflect the future,
not necessarily the past
Do not overfit
Validate in up-markets as well as down
Tailor to country characteristics in emerging
markets

Methodologies:
Cross-sectional regression
Sorting
Hybrids

Cross-sectional regression:
For country j, estimate:
Ri ,t 0 1 Ai ,t 1 i ,t
where
i denotes firm i;
A is a firm specific attribute (could be multiple)
are common regression coefficients

Cross-sectional regression:
Used in developed market stock selection
Problem with unstable coefficients
Bigger problem given noisy emerging market
returns

Sorting:
Used in developed market stock selection
Potentially similar in stability problems
Can be cast in regression framework
(a regression on ranks, or a multinomial probit
regression)
Rank regression may have advantages given the

high variance (high noise) in emerging equity
returns

Sorting:
Simple methodology that provides a good
starting point to investigate stock selection

Hybrid:
Create portfolios based on stocks sorted by
attributes
Use regression or optimization to weight
portfolios
Produces a flexible, highly nonlinear way to
select stocks

3. Our methodology
Focus on three emerging markets:

Malaysia (representative of Asia)
Mexico (indicative of Latin America)
South Africa (unique situation)

3. Our methodology
Specify exhaustive list of firm specific factors

Includes many traditional factors
Extra emphasis on expectations factors
Specific a number of diagnostic variables
Includes factors that reflect the type of firm we
are selecting

3. Our methodology
Identify the best stocks and the worst stocks

Do not impose the constraints of a tracking
error methodology
[Tracking error can be dealt with at a later
stage of the analysis]

3. Our methodology
Steps:
1. Specify list of factors
2. Univariate screens (in sample)
3. Bivariate diagnostic screens
4. Battery of additional diagnostics emphasizing
performance through time
5. Bivariate selection screens

3. Our methodology
Steps:
6. Optimize to form scoring screen (in sample)
7. Run scoring screen on out-of-sample period
8. Diagnostics on scoring screen
9. Form buy list and sell lists
10. Purge buy list of stocks that are identified by
predetermined set of knock out criteria

3. Our methodology
Steps:
11. Investigate turnover of portfolio
various holding periods analyzed

4. Past research
Very few papers:

Rouwenhorst (JF) looks at IFC data
Claessens, Dasgupta and Glen (EMQ) look at
IFC data
Fama and French (JF) look at IFC data
Achour, Harvey, Hopkins, Lang (1998, 1999,
2000)

4. Past research
What we offer:
No one has merged IFC, MSCI, Worldscope,
and IBES data
First paper to look at comprehensive list of
firm attributes
First paper to look at expectational attributes

4. Factors
Fundamental factors
Dividend yield
Earnings yield
Book to price ratio
Cash earnings to price yield
Change in return on equity
Revenue growth
Rate of re-investment
Return on equity

4. Factors
Expectational
Change in consensus FY1 estimate - last 3 or 6
months
Consensus FY2 to FY1 estimate change
Consensus forecast earnings estimate revision
ratio
12 months prospective earnings growth rate
3 year prospective earnings growth rate
12 month prospective earnings yield

4. Factors
Momentum
One month/ 1 year price momentum
One year historical earnings
growth/momentum
Three year historical earnings growth rate

4. Factors
Diagnostic
Market capitalization
Debt to common equity ratio

5. Diagnostics
Average return
Average excess return
Standard deviation
T-stat (hypothesis that excess return=0)
Beta (against benchmark index)
Alpha
R2

5. Diagnostics
Average capitalization
% periods > market index (hit rate)
% periods > market index in up markets
% periods > market index in down markets
Max number of consecutive benchmark
outperformances

5. Diagnostics
Max observed excess return

Min observed excess return
Max number of consecutive negative returns
Max number of consecutive positive returns
Year by year returns

5. Diagnostics
Factor average for constructed portfolio

Factor median
Factor standard deviation

6. Summary Statistics: Malaysia Benchmark
400
350
300
250
87% drop
200
150
100
50
0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Malaysia IFC US$
Data through January 2001
Malaysia FX

6. Summary Statistics: Mexico Benchmark
1000
900
800
700
600
500
68% drop
400
300
200
100
0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Mexico IFC
Mexico FX

6. Summary Statistics: South Africa Benchmark
300
250
200
150
55% drop
100
50
0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
South Africa IFC US$
South Africa FX

6. Malaysia: Factor returns
15
10
5
0
-5
-10
-15
-20
-25
-30
Top
Bottom

6. Mexico: Factor returns
35
30
25
20
15
10
5
0
-5
Top
Bottom

6. South Africa: Factor returns
30
25
20
15
10
5
0
Top
Bottom

6. Malaysia: % Periods Benchmark Outperformance
70
60
50
40
30
20
10
0
Top
Bottom

6. Mexico: % Periods Benchmark Outperformance
70
60
50
40
30
20
10
0
Top
Bottom

6. South Africa: % Periods Benchmark Outperformance
70
60
50
40
30
20
10
0
Top
Bottom

6. Malaysia: Dividend Yield Screen: Index=100 each year
250
200
150
100
50
0
Top
Benchmark
Bottom

6. Mexico: Historical Earnings Momentum Screen:
Index=100 each year
300
250
200
150
100
50
0
Top
Benchmark
Bottom

6. South Africa: Change in Consensus FY1-3 mo. Screen:
Index=100 each year
200
180
160
140
120
100
80
60
40
20
0
Top
Benchmark
Bottom
South Africa
Malaysia
50
40
30
20
10
0
-10
-20
-30
-40
-50
Mexico
6. Book to Price: Low-High Spread
South Africa
Malaysia
50
40
30
20
10
0
-10
-20
-30
-40
-50
Mexico
6. IBES Revision Ratio: Low-High Spread
South Africa
Malaysia
50
40
30
20
10
0
-10
-20
-30
-40
-50
Mexico
6. IBES 12-month Prospective Earnings Yield: L-H Spread
South Africa
Malaysia
50
40
30
20
10
0
-10
-20
-30
-40
-50
Mexico
6. One-year Momentum: Low-High Spread
South Africa
Malaysia
50
40
30
20
10
0
-10
-20
-30
-40
-50
Mexico
6. Size Effect: Low-High Spread

6. Malaysia: Scoring Screen Various Holding Periods
15
10
5
0
-5
-10
-15
-20
Top
Bottom

6. Mexico: Scoring Screen Various Holding Periods
35
30
25
20
15
10
5
0
Top
Bottom

6. South Africa: Scoring Screen Various Holding Periods
20
15
10
5
0
-5
-10
Top
Bottom

6. Malaysia: Scoring Screen
% Periods Benchmark Outperformance
100
90
80
70
60
50
40
30
20
10
0
Top
Bottom

6. Mexico: Scoring Screen
100
90
80
70
60
50
40
30
20
10
0
Top
Bottom

6. South Africa: Scoring Screen
100
90
80
70
60
50
40
30
20
10
0
Top
Bottom

6. Malaysia: Scoring Screen: Index=100 each year
250
200
150
100
50
0
Top
Bottom

6. Mexico: Scoring Screen: Index=100 each year
300
250
200
150
100
50
0
Top
Bottom

6. South Africa: Scoring Screen: Index=100 each year
200
180
160
140
120
100
80
60
40
20
0
Top
Bottom

6. Malaysia: Scoring Screen
900.00
IN SAMPLE
OUT OF SAMPLE
160.00
T OP
FR
800.00
CUMULATIVE RETURNS - IN SAMPLE
700.00
120.00
600.00
100.00
500.00
IFCG MALAYSIA
80.00
400.00
IBES DATA
ADDED
60.00
300.00
40.00
200.00
BOT T OM
20.00
100.00
0.00
12/31/88
0.00
12/31/89
12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
CUMULATIVE RETURNS - OUT OF SAMPLE
140.00

6. Mexico: Scoring Screen
IN SAMPLE
2100.00
OUT OF SAMPLE
250.00
T OP
2000.00
1900.00
1700.00
200.00
1600.00
1500.00
1400.00
1300.00
150.00
1200.00
IFCG MEXICO
1100.00
1000.00
900.00
100.00
800.00
700.00
600.00
500.00
BOT T OM
50.00
400.00
300.00
200.00
100.00
0.00
12/31/88
0.00
12/31/89
12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
1800.00

6. South Africa: Scoring Screen
IN SAMPLE
350.00
OUT OF SAMPLE
120.00
T OP
100.00
250.00
80.00
IFCG SOUT H
AFRICA
200.00
60.00
150.00
BOT T OM
40.00
100.00
20.00
50.00
0.00
12/31/92
0.00
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
300.00

7. Research Directions
1) Comparison of regression method and

multivariate screening process
Panel multinomial probit models
How do we reduce the noise in emerging market
equity returns?

2) What are the characteristics of countries that

make some factors work and other not work?
Stage of market integration process

Industrial mix
Openness of economy
Microstructure factors

3) What causes the shifting importance of factors

through time, e.g. value versus growth?
Can the cross-section of many stock returns help
us identify when a factor is likely to work?

4) Can the country selection process be merged

with the stock selection exercise?
Should buy portfolios be used in top-down
optimizations?
Does country-specific tracking error really matter
in global asset allocation?

5) Stability and migration tracking

Should we consider the behavior of the stock
moving from fractile to fractile?

6) Should we expand our view of risk in both the

stock selection and country selection exercises?
Mean, variance, skewness?
What are the driving forces of changing variance?
What are the determinants of skewness?

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