Equity Valuation and Portfolio Management

FRANK J. FABOZZI, PHD, CFA, is Professor of Finance at EDHEC Business School and a member of the EDHEC-Risk Institute. Prior to joining EDHEC in August 2011, he held various professorial positions in finance at the Yale School of Management from 1994 to 2011 and was a visiting professor of finance and accounting at the MIT Sloan School of Management from 1986 to 1992. He is also Editor of the Journal of Portfolio Management. HARRY M. MARKOWITZ, PHD, is a consultant in the area of finance. In 1990, he was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for his groundbreaking work in portfolio theory. In 1989, he received the John von Neumann Theory Prize of the Institute for Operations Research and the Management Sciences for his work in portfolio theory and other applications of mathematics and computers to business practice.

Preface xiii About the Editors xxiii Contributing Authors xxv Chapter 1 An Introduction to Quantitative Equity Investing 1 Paul Bukowski Equity Investing 1 Fundamental vs. Quantitative Investor 2 The Quantitative Stock Selection Model 7 The Overall Quantitative Investment Process 9 Research 9 Portfolio Construction 18 Monitoring 21 Current Trends 22 Key Points 23 Questions 24 Chapter 2 Equity Analysis Using Traditional and Value-Based Metrics 25 James L. Grant and Frank J. Fabozzi Overview of Traditional Metrics 25 Price Multiples 32 Fundamental Stock Return 36 Traditional Caveats 38 Overview of Value-Based Metrics 39 Key Points 58 Appendix: Case Study 60 Questions 69 Chapter 3 A Franchise Factor Approach to Modeling P/E Orbits 71 Stanley Kogelman and Martin L. Leibowitz Background 72 Historical Data Observations 75 Formulation of the Basic Model 81 P/E Myopia: The Fallacy of a Stable P/E 85 Two-Phase P/E Orbits 91 Franchise Valuation under Q-Type Competition 96 Franchise Labor 97 Key Points 101 Questions 102 Chapter 4 Relative Valuation Methods for Equity Analysis 105 Glen A. Larsen Jr., Frank J. Fabozzi, and Chris Gowlland Basic Principles of Relative Valuation 106 Hypothetical Example 115 Key Points 123 Questions 124 Chapter 5 Valuation over the Cycle and the Distribution of Returns 125 Anders Ersbak Bang Nielsen and Peter C. Oppenheimer The Link Between Earnings and Returns 126 The Phases Can Be Interpreted in Relationship to the Economy 132 Asset Class Performance Varies across the Phases 137 Incorporating Cyclicality into Valuations 139 Appendix: Dates and Returns of the Phases 142 Key Points 146 Questions 146 Chapter 6 An Architecture for Equity Portfolio Management 147 Bruce I. Jacobs and Kenneth N. Levy Architectural Building Blocks 148 Traditional Active Management 151 Passive Management 156 Engineered Management 157 Expanding Opportunities 160 The Risk-Return Continuum 163 The Ultimate Objective 167 Key Points 168 Questions 169 Chapter 7 Equity Analysis in a Complex Market 171 Bruce I. Jacobs and Kenneth N. Levy An Integrated Approach to a Segmented Market 172 Disentangling 176 Constructing, Trading, and Evaluating Portfolios 184 Profiting from Complexity 186 Key Points 187 Questions 188 Chapter 8 Survey Studies of the Use of Quantitative Equity Management 189 Frank J. Fabozzi, Sergio M. Focardi, and Caroline L. Jonas 2003 Intertek European Study 189 2006 Intertek Study 197 2007 Intertek Study 205 Challenges for Quantitative Equity Investing 224 Modeling After the 20072009 Global Financial Crisis 226 Key Points 228 Questions 229 Chapter 9 Implementable Quantitative Equity Research 231 Frank J. Fabozzi, Sergio M. Focardi, and K. C. Ma The Rise of Econophysics 233 A General Framework 235 Select a Sample Free from Survivorship Bias 238 Select a Methodology to Estimate the Model 239 Risk Control 246 Key Points 248 Questions 249 Chapter 10 Tracking Error and Common Stock Portfolio Management 251 Raman Vardharaj, Frank J. Fabozzi, and Frank J. Jones Definition of Tracking Error 251 Components of Tracking Error 254 Forward-Looking vs. Backward-Looking Tracking Error 255 Information Ratio 256 Determinants of Tracking Error 257 Marginal Contribution to Tracking Error 261 Key Points 262 Questions 263 Chapter 11 Factor-Based Equity Portfolio Construction and Analysis 265 Petter N. Kolm, Joseph A. Cerniglia, and Frank J. Fabozzi Factor-Based Trading 266 Developing Factor-Based Trading Strategies 269 Risk to Trading Strategies 271 Desirable Properties of Factors 273 Sources for Factors 273 Building Factors from Company Characteristics 274 Working with Data 275 Analysis of Factor Data 283 Key Points 287 Questions 289 Chapter 12 Cross-Sectional Factor-Based Models and Trading Strategies 291 Joseph A. Cerniglia, Petter N. Kolm, and Fr