Stock Selection

Global Asset Allocation and Stock Selection
Quantitative Stock Selection
Campbell R. Harvey

1. Introduction
Research coauthored with

• Dana Achour
• Greg Hopkins
• Clive Lang
1
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
mid-1990s
• Many models began overweighing after the
onset of the Asia Crisis
2
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?
3
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
4
Cross-sectional regression:
For country j, estimate:
Ri ,t = γ 0 + γ 1 Ai ,t −1 + ε i ,t
where
i denotes firm i;
A is a firm specific attribute (could be multiple)
γ are common regression coefficients

Cross-sectional regression:
• Used in developed market stock selection
• Problem with unstable coefficients
• Bigger problem given noisy emerging market
returns
5
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
6
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)
7
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]
8
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”
9
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)
10
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
11
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
12
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
13
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
14
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$ Malaysia FX

Data through January 2001
15
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

16
0
5
-30
-25
-20
-15
-10
0
5
-5
10
15
20
25
30
35
-5
10
15
Ca Ca
p p
D D
RO RO
I I
D/ D/
1Y E 1Y E
rE rE
a D a D
3 Y rn M iv 3 Y rn M iv
r E om r E om
arn arn
M M
om om
D E D E
FY /P FY /P
I3 I3
D m D m
FY o FY o
I I
FY 6mo FY 6mo
1t 1t
oF oF
Y Y
6. Mexico: Factor returns
Top
Top
Re 2 Re 2
vR vR
6. Malaysia: Factor returns
ati ati
o o
B/ B/
P P
1 m CE/ 1 m CE/
oM P oM P
1 y om 1 y om
Bottom
Bottom
rM rM
om om
Pr
op opP r Pr
op opP r
3y E/ 3y E/
12 r D P 12 r D P

mo Ear mo Ear
n n
24 Prop 24 Prop
mo E/ mo E/
Pr P Pr P
op op
E/ E/
P P
D D
Re Re
Re v Re v
inv inv
es es
t t
Ind RO Ind RO
ex E ex E
ret ret
ur ur
n n
17
0
0
5
10
20
30
40
50
60
70
10
15
20
25
30
Ca Ca
p p
D D
RO RO
I I
D/ D/
1Y E 1Y E
rE rE
a D a D
r E om r E om
arn arn
M M
om om
D E D E
FY /P FY /P
I3 I3
D m D m
FY o FY o
I I
FY 6mo FY 6mo
1t 1t
oF oF
Y Y
Top
Top
Re 2 Re 2
vR vR
ati ati
o o
6. South Africa: Factor returns
B/ B/
P P
1 m CE/ 1 m CE/
oM P oM P
Bottom
Bottom
1 y om 1 y om
rM rM
om om
Pr
op opP r Pr
op opP r
3y E/ 3y E/
12 r D P 12 r D P

mo Ear mo Ear
n n
24 Prop 24 Prop
mo E/ mo E/
Pr P Pr P
op op
E/ E/
P P
D D
Re Re
6. Malaysia: % Periods Benchmark Outperformance

Re v Re v
inv inv
es es
t t
RO Ind RO
E ex E
ret
ur
n
18
0
0
10
20
30
40
50
60
70
10
20
30
40
50
60
70
Ca Ca
p p
D D
RO RO
I I
D/ D/
1Y E 1Y E
rE rE
a D a D
r E om r E om
arn arn
M M
om om
D E D E
FY /P FY /P
I3 I3
D m D m
FY o FY o
I I
FY 6mo FY 6mo
1t 1t
oF oF
Top
Y Y
Top
Re 2 Re 2
vR vR
ati ati
o o
B/ B/
P P
1 m CE/ 1 m CE/
oM P oM P
Bottom
Bottom
1 y om 1 y om
rM rM
om om
Pr
op opP r Pr
op opP r
3y E/ 3y E/
12 r D P 12 r D P

mo Ear mo Ear
n n
24 Prop 24 Prop
mo E/ mo E/
Pr P Pr P
op op
E/ E/
P P
6. Mexico: % Periods Benchmark Outperformance
D D
Re Re
Re v Re v
inv inv
es es
t t
6. South Africa: % Periods Benchmark Outperformance

RO RO
E E
19
6. Malaysia: Dividend Yield Screen: Index=100 each year
250
200
150
100
50
0
92
89
90
91
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19
Top Benchmark Bottom

6. Mexico: Historical Earnings Momentum Screen:
Index=100 each year
300
250
200
150
100
50
0
92
89
90
91
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19
20
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
98
93
94
95
96
97
19
19
19
19
19
19

6. Book to Price: Low-High Spread
50
40
30
20
10
0
-10
-20
-30
South Africa
-40
Mexico
-50
Malaysia
89
90
91
92
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19
21
6. IBES Revision Ratio: Low-High Spread
50
40
30
20
10
0
-10
-20
-30
South Africa
-40
Mexico
-50
Malaysia
89
90
91
92
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19

6. IBES 12-month Prospective Earnings Yield: L-H Spread
50
40
30
20
10
0
-10
-20
-30
South Africa
-40
Mexico
-50
Malaysia
89
90
91
92
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19
22
6. One-year Momentum: Low-High Spread
50
40
30
20
10
0
-10
-20
-30
South Africa
-40
Mexico
-50
Malaysia
89
90
91
92
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19

6. Size Effect: Low-High Spread
50
40
30
20
10
0
-10
-20
-30
South Africa
-40
Mexico
-50
Malaysia
89
90
91
92
93
94
95
96
97
98
19
19
19
19
19
19
19
19
19
19
23
6. Malaysia: Scoring Screen Various Holding Periods
15
10
5
0
-5
-10
-15
-20
et
ly
al
ark
erl
nth
KO
nu
art
M
an
Mo
w/
Qu
mi
al
Se
nu
an
mi
Se
Top Bottom

6. Mexico: Scoring Screen Various Holding Periods
35
30
25
20
15
10
0
et
y
al
thl
erl
ark
nu
on
art
an
M
M
Qu
mi
Se
Top Bottom
24
6. South Africa: Scoring Screen Various Holding Periods
20
15
10
-5
-10
et
y
al
thl
erl
ark
nu
on
art
an
M
M
Qu
mi
Se
Top Bottom

6. Malaysia: Scoring Screen
% Periods Benchmark Outperformance
100
90
80
70
60
50
40
30
20
10
0
ly
al
erl
nth
KO
nu
art
an
Mo
w/
Qu
mi
al
Se
nu
an
mi
Se
Top Bottom
25
6. Mexico: Scoring Screen
100
90
80
70
60
50
40
30
20
10
0
ly
al
erl
nth
nu
art
an
Mo
Qu
mi
Se
Top Bottom

6. South Africa: Scoring Screen
100
90
80
70
60
50
40
30
20
10
0
ly
al
erl
nth
nu
art
an
Mo
Qu
mi
Se
Top Bottom
26
6. Malaysia: Scoring Screen: Index=100 each year
250
200
150
100
50
0
92
97
89
90
91
93
94
95
96
98
19
19
19
19
19
19
19
19
19
19
Top Bottom

6. Mexico: Scoring Screen: Index=100 each year
300
250
200
150
100
50
0
92
97
89
90
91
93
94
95
96
98
19
19
19
19
19
19
19
19
19
19
Top Bottom
27
6. South Africa: Scoring Screen: Index=100 each year
200
180
160
140
120
100
80
60
40
20
0
93
94
95
96
97
98
19
19
19
19
19
19
Top Bottom

6. Malaysia: Scoring Screen IN SAMPLE OUT OF SAMPLE
900.00 160.00
TOP
FR
800.00
140.00
CUMULATIVE RETURNS - OUT OF SAMPLE
700.00
120.00
CUMULATIVE RETURNS - IN SAMPLE
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 0.00
12/31/88 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
28
6. Mexico: Scoring Screen IN SAMPLE OUT OF SAMPLE
2100.00 250.00
TOP
2000.00
1900.00
1800.00
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
BOTTOM
400.00 50.00
300.00
200.00
100.00
0.00 0.00
12/31/88 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

6. South Africa: Scoring Screen
IN SAMPLE OUT OF SAMPLE
350.00 120.00
TOP
300.00
100.00
250.00
80.00
IFCG SOUTH
200.00 AFRICA
60.00
150.00
BOTTOM
40.00
100.00
20.00
50.00
0.00 0.00
12/31/92 12/31/93 12/31/94 12/31/95 12/31/96 12/31/97
29
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
30
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?
31
5) 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?
32

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Global Asset Allocation and Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Research coauthored with

Quantitative Stock Selection

Quantitative Stock Selection

With recent plummet in emerging markets,

If market is deemed “cheap,” (as many

Ingredients for success:

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Focus on three emerging markets:

Specify exhaustive list of firm specific factors

Specific a number of diagnostic variables

Quantitative Stock Selection

Identify the best stocks and the worst stocks

1. Specify list of factors

Quantitative Stock Selection

6. Optimize to form “scoring screen” (in sample)

11. Investigate turnover of portfolio

Quantitative Stock Selection

Very few papers:

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

• Max observed excess return

• Factor average for constructed portfolio

Quantitative Stock Selection

Malaysia IFC US$ Malaysia FX

Mexico IFC Mexico FX

Quantitative Stock Selection

150 55% drop

South Africa IFC US$ South Africa FX

6. Mexico: Factor returns

Quantitative Stock Selection

Quantitative Stock Selection

6. Malaysia: % Periods Benchmark Outperformance

Quantitative Stock Selection

6. South Africa: % Periods Benchmark Outperformance

Quantitative Stock Selection

Top Benchmark Bottom

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

Quantitative Stock Selection

500.00 IFCG MALAYSIA

400.00 IBES DATA

CUMULATIVE RETURNS - OUT OF SAMPLE

Quantitative Stock Selection

1) Comparison of regression method and

Quantitative Stock Selection

2) What are the characteristics of countries that

3) What causes the shifting importance of factors

Quantitative Stock Selection

4) Can the country selection process be merged

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

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