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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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