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 QUANTITATIVE APPROACH 101
 

   This is a translation of the former paper published by André Gosselin on the OrientationFinance.com web site on December 22 2004 (Read the original paper in French here).

 

   Quantitative analysis in investment came to exist with the advent of personal computers and stock exchange databases. The idea that stock portfolios could be managed with the help of computers became so popular, that a new approach was born, characterized by its rigour and discipline.

   The quantitative analysis is founded on the regular and systematic evaluation of the quantifiable and measurable financial factors which have the most impact on the return of a portfolio. Thanks to computers and the financial databases about traded companies, the manager makes so that its portfolio is always composed of the securities which match the best to the current factors which are the most profitable and paying.

   The grid of selection of a quantitative portfolio manager will thus evolve with the economic situation and the management styles which are the most successful. If his data-processing program shows him that it is the "value" approach which succeeds the best, its grid of selection will then contain especially criteria like a low price/earnings ratio, a high dividend yield, etc.

   On the other hand, if his research shows him that the best securities are those of the companies which know strong earnings growth, with declared profits exceeding analysts' expectations, its grid of selection will then be composed of the criteria which make the success of "growth" style investors.

   The portfolio managers with a more traditional style use the same criteria as the quantitative managers to make their security choices. The difference lies in the number of securities that each one examines, in the frequency of evaluation of each security, in the number of factors taken into account to build a portfolio and in the precision used to balance each criterion to obtain a maximum return.

   Thus, a significant difference between the "traditional" fundamental analysis and the quantitative analysis are that this last one starts its research on the broadest possible pool of securities (all those from the New York or Toronto Stock Exchange for example) and systematically determines the purchases and the sales of securities by using a limited number of criteria of selection.

   The fundamental analysis concentrates on a more restricted sample of securities, with more subjective and qualitative criteria of selection like the company management skills, the value of its marketing plan, the quality of its products, the chances of fusion or acquisitions, etc.

   Because it has the means of doing it (with computers and sifting programs on several stock exchange markets), the quantitative analyst tries to diversify his portfolio everywhere where that is possible. The traditional fundamental analysis rather puts the emphasis on the selection of the securities without dealing too much with optimal diversification.

   Some quantitative analysis strategies can use only one criterion to select the securities of its portfolio, but it will systematically be done, year after year, with always the same rigour. It is the case of the strategy centered on the dividend yield, which consists in choosing within a stock exchange market the 10, 20 or 30 companies (it does not matter the number) whose dividend yield is the highest. Once per year, the portfolio is rebalanced, with always the same criterion of composition.

   Other quantitative analysis strategies will contain more than ten criteria of selection. However, it should not be believed that the more criteria, the better the portfolio. The majority of the quantitative investors rather noted that the most powerful strategies contain only 3 or 4 criteria, not more.

   Throughout the 90s, the ten criteria the most used by the professional investors to build their portfolios were as follows: 1- the surprise earnings which exceed analysts' expectations; 2- the return on equity; 3- the earnings estimate revisions; 4- the price/cash flow ratio; 5- the expected earnings growth for the next five years; 6- the earnings momentum; 7- the model of the discounted dividend; 8- the price/book ratio; 9- the debt/equity ratio; 10- the dividend yield.

   The quantitative investors' investigations have shown that some of these factors allow the investor, in the long term, to get returns higher than the average. It is the case in particular with the criterion of the price/book ratio. The less expensive one security is compared to its company share book value, the more likely it is to provide good long-term returns.

   It was also noted that the company size had a significant impact on the portfolio return. Thus, the more a portfolio is composed of small size companies (measured by market capitalizations, or the number of outstanding shares multiplied by the price of the share), the larger are its chances to carry out a high return.

   If, since the beginning of the 20th century, these two criteria generated the best returns on the Stock Exchange, it should be admitted that the 90s decade have changed the deal. Indeed, it is the big size companies that have high book/price multiples which have given the best returns to the North-American and European investors.

   Thus, some selection criteria of securities are very powerful at the time of a given economic situation, whereas others are not good at all; and a few years later the opposite happens. The wheel turns without any clear explanation why the powerful factors of yesterday are not good today any more, and why the powerful factors of today were of so little help yesterday.

   The only way of not being trapped by these stock market cycles, as claimed by some quantitative investors, is to identify the most powerful and stable factors in the long term, i.e. on a period of approximately 20 years. A totally reasonable placement scope for the serious investor.

   André Gosselin

 
 
 
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