Equity Valuation and Portfolio Management

The Frank J. Fabozzi SeriesFixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineauProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozziInvestment Performance Measurement by Bruce J. FeibelThe Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. FabozziFoundations of Economic Value Added, Second Edition by James L. GrantFinancial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. PetersonMeasuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,

Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. FabozziThe Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad ChoudhryThe Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad ChoudhryThe Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and

Frank J. FabozziShort Selling: Strategies, Risks, and Rewards edited by Frank J. FabozziThe Real Estate Investment Handbook by G. Timothy Haight and Daniel SingerMarket Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. LevySecurities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. MannFat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and

Frank J. FabozziFinancial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.

Focardi, and Petter N. KolmAdvanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by

Frank J. Fabozzi, Lionel Martellini, and Philippe PriauletAnalysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.

Goodman, and Frank J. FabozziHandbook of Alternative Assets, Second Edition by Mark J. P. AnsonIntroduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad ChoudhryFinancial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and

Teo Jasic Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas,

Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. ManningRobust Portfolio Optimization and Management by Frank J. Fabozzi, Petter N. Kolm,

Dessislava A. Pachamanova, and Sergio M. FocardiAdvanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,

Stogan V. Stoyanov, and Frank J. FabozziHow to Select Investment Managers and Evaluate Performance by G. Timothy Haight,

Stephen O. Morrell, and Glenn E. RossBayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and

Frank J. FabozziStructured Products and Related Credit Derivatives by Brian P. Lancaster, Glenn M. Schultz, and Frank J. FabozziQuantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, Sergio M. Focardi, and

Petter N. KolmIntroduction to Fixed Income Analytics, Second Edition by Frank J. Fabozzi and Steven V. MannThe Handbook of Traditional and Alternative Investment Vehicles by Mark J. P. Anson, Frank J. Fabozzi,

and Frank J. JonesThe Theory and Practice of Investment Management, Second Edition edited by Frank J. Fabozzi and

Harry M. Markowitz

John Wiley & Sons, Inc.

Equity Valuation and Portfolio Management

FRANK J. FABOZZIHARRY M. MARKOWITZ

EDITORS

Copyright © 2011 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Contents

v

Preface xiiiAbouttheEditors xxiiiContributingAuthors xxv

CHAPTER1AnIntroductiontoQuantitativeEquityInvesting 1Paul Bukowski

Equity Investing 1Fundamental vs. Quantitative Investor 2The Quantitative Stock Selection Model 7The Overall Quantitative Investment Process 9Research 9Portfolio Construction 18Monitoring 21Current Trends 22Key Points 23Questions 24

CHAPTER2EquityAnalysisUsingTraditionalandValue-BasedMetrics 25James L. Grant and Frank J. Fabozzi

Overview of Traditional Metrics 25Price Multiples 32Fundamental Stock Return 36Traditional Caveats 38Overview of Value-Based Metrics 39Key Points 58Appendix: Case Study 60Questions 69

vi CONTENTS

CHAPTER3AFranchiseFactorApproachtoModelingP/EOrbits 71Stanley Kogelman and Martin L. Leibowitz

Background 72Historical Data Observations 75Formulation of the Basic Model 81P/E Myopia: The Fallacy of a Stable P/E 85Two-Phase P/E Orbits 91Franchise Valuation under Q-Type Competition 96Franchise Labor 97Key Points 101Questions 102

CHAPTER4RelativeValuationMethodsforEquityAnalysis 105Glen A. Larsen Jr., Frank J. Fabozzi, and Chris Gowlland

Basic Principles of Relative Valuation 106Hypothetical Example 115Key Points 123Questions 124

CHAPTER5ValuationovertheCycleandtheDistributionofReturns 125Anders Ersbak Bang Nielsen and Peter C. Oppenheimer

The Link Between Earnings and Returns 126The Phases Can Be Interpreted in Relationship to the Economy 132Asset Class Performance Varies across the Phases 137Incorporating Cyclicality into Valuations 139Appendix: Dates and Returns of the Phases 142Key Points 146Questions 146

CHAPTER6AnArchitectureforEquityPortfolioManagement 147Bruce I. Jacobs and Kenneth N. Levy

Architectural Building Blocks 148Traditional Active Management 151Passive Management 156Engineered Management 157

Contents vii

Expanding Opportunities 160The Risk-Return Continuum 163The Ultimate Objective 167Key Points 168Questions 169

CHAPTER7EquityAnalysisinaComplexMarket 171Bruce I. Jacobs and Kenneth N. Levy

An Integrated Approach to a Segmented Market 172Disentangling 176Constructing, Trading, and Evaluating Portfolios 184Profiting from Complexity 186Key Points 187Questions 188

CHAPTER8SurveyStudiesoftheUseofQuantitativeEquityManagement 189Frank J. Fabozzi, Sergio M. Focardi, and Caroline L. Jonas

2003 Intertek European Study 1892006 Intertek Study 1972007 Intertek Study 205Challenges for Quantitative Equity Investing 224Modeling After the 2007–2009 Global Financial Crisis 226Key Points 228Questions 229

CHAPTER9ImplementableQuantitativeEquityResearch 231Frank J. Fabozzi, Sergio M. Focardi, and K. C. Ma

The Rise of Econophysics 233A General Framework 235Select a Sample Free from Survivorship Bias 238Select a Methodology to Estimate the Model 239Risk Control 246Key Points 248Questions 249

viii CONTENTS

CHAPTER10TrackingErrorandCommonStockPortfolioManagement 251Raman Vardharaj, Frank J. Fabozzi, and Frank J. Jones

Definition of Tracking Error 251Components of Tracking Error 254Forward-Looking vs. Backward-Looking Tracking Error 255Information Ratio 256Determinants of Tracking Error 257Marginal Contribution to Tracking Error 261Key Points 262Questions 263

CHAPTER11Factor-BasedEquityPortfolioConstructionandAnalysis 265Petter N. Kolm, Joseph A. Cerniglia, and Frank J. Fabozzi

Factor-Based Trading 266Developing Factor-Based Trading Strategies 269Risk to Trading Strategies 271Desirable Properties of Factors 273Sources for Factors 273Building Factors from Company Characteristics 274Working with Data 275Analysis of Factor Data 283Key Points 287Questions 289

CHAPTER12Cross-SectionalFactor-BasedModelsandTradingStrategies 291Joseph A. Cerniglia, Petter N. Kolm, and Frank J. Fabozzi

Cross-Sectional Methods for Evaluation of Factor Premiums 292Factor Models 300Performance Evaluation of Factors 310Model Construction Methodologies for a

Factor-based Trading Strategy 317Backtesting 328Backtesting Our Factor Trading Strategy 330Key Points 331Appendix: The Compustat Point-in-Time,

IBES Consensus Databases and Factor Definitions 333Questions 337

Contents ix

CHAPTER13MultifactorEquityRiskModelsandTheirApplications 339Anthony Lazanas, António Baldaque da Silva, Arne D. Staal, and Cenk Ural

Motivation 340Equity Risk Factor Models 342Applications of Equity Risk Models 350Key Points 370Questions 371

CHAPTER14DynamicFactorApproachestoEquityPortfolioManagement 373Dorsey D. Farr

Methods of Active Management 376Modeling 385Implementation 392Key Points 395Questions 395

CHAPTER15AFactorCompetitionApproachtoStockSelection 397Joseph Mezrich and Junbo Feng

The Problem 397The Solution 403Which Factors Get Picked? 407Does the Alpha Repair Process Work? 408Key Points 411Questions 412

CHAPTER16AvoidingUnintendedCountryBetsinGlobalEquityPortfolios 413Michele Aghassi, Cliff Asness, Oktay Kurbanov, and Lars N. Nielsen

Country Membership and Individual Stock Returns 414Ways to Build Active Global Portfolios 416Studying the Naive Portfolio 419Empirical Results 420Why Does the Naive Stock Selection

Portfolio Make Country Noise Bets? 422Key Points 423Questions 424

x CONTENTS

CHAPTER17ModelingMarketImpactCosts 425Petter N. Kolm and Frank J. Fabozzi

Market Impact Costs 426Liquidity and Transaction Costs 427Market Impact Measurements and Empirical Findings 430Forecasting and Modeling Market Impact 433Key Points 439Questions 440

CHAPTER18EquityPortfolioSelectioninPractice 441Dessislava A. Pachamanova and Frank J. Fabozzi

Portfolio Constraints Commonly Used in Practice 442Benchmark Exposure and Tracking Error Minimization 450Incorporating Transaction Costs 454Incorporating Taxes 460Multi-Account Optimization 465Robust Parameter Estimation 469Portfolio Resampling 471Robust Portfolio Optimization 474Key Points 480Questions 481

CHAPTER19PortfolioConstructionandExtremeRisk 483Jennifer Bender, Jyh-Huei Lee, and Dan Stefek

Measures of Extreme Loss 484Constraining Shortfall 485Performance 485Imposing Benchmark Neutrality 487Analysis 489Key Points 493Appendix: Constructing Out-of-Sample Shortfall Betas 494Questions 495

CHAPTER20WorkingwithHigh-FrequencyData 497Irene Aldridge

What is High-Frequency Data? 497

Contents xi

How is High-Frequency Data Recorded? 499Properties of High-Frequency Data 500High-Frequency Data are Voluminous 501High-Frequency Data are Subject to Bid-Ask Bounce 503High-Frequency Data are Irregularly Spaced in Time 509Equity Correlations Decay at High Frequencies 517Key Points 519Questions 520

CHAPTER21StatisticalArbitrage 521Brian J. Jacobsen

Pairs Trading 523General Models 532Key Points 534Questions 534

AbouttheWebsite 535Index 537

Preface

xiii

In an editorial in the Winter 2011 issue of the Journal of Portfolio Man-agement, Mark Kritzman notes the following regarding what is popularly

referred to as Markowitz portfolio theory: “Mean-variance optimization is about to begin its 60th year and by all accounts it has aged extremely well.” He goes on to say, “As with many innovations, however, practitioners of the old technology resisted change and defended their resistance with a variety of excuses, which persist even today.” There are several reasons why practi-tioners were reluctant or slow to adopt a more quantitative approach such as that offered by the mean-variance framework. The computing power needed to manipulate the databases used to obtain the required inputs for mean-variance analysis and then efficiently solve for the optimal portfolios was very limited in the years that followed its introduction in 1952. Major advances in computing power have taken care of this obstacle, as well as the availability of commercial software for solving large complex optimization problems.

A second reason for the reluctance or inability to adopt a more quanti-tative approach was simply practitioners’ lack of the mathematical skill set necessary to appreciate the advantages of a quantitative approach. Since the late 1970s, however, university finance programs have armed their gradu-ates with the mathematical and statistical skills needed to deal with quan-titative models. In fact, over the past decade, a good number of universities have augmented their degree offerings beyond the traditional MBA with a specialization in finance to degree programs that bear titles such as “com-putational finance,” “quantitative finance,” “mathematical finance,” and “financial engineering,” in recognition of the need to equip students with strong quantitative skills.

Finally, the classical mean-variance model required refinements and extensions to deal with real-world institutional constraints and market fric-tions and allow it to be effectively implemented in the real world. In this book, the contributors provide the state-of-the-art methods for implement-ing equity valuation models, trading models, and portfolio management strategies. Both traditional equity management and quantitative equity management are covered. All of the contributors to this book have had experience as equity portfolio managers or equity strategists.