Equity Valuation and Portfolio Management

THE QUANTITATIVE STOCK SELECTION MODEL

Before diving into the details of the quantitative investment process, let's look at what is at its core—the stock selection model. As explained in the previous section, the quantitative investment approach is rooted in understanding what separates strong performing stocks from weak performing stocks.¹ The quantitative investor looks for sources of information or company characteristics (often referred to as factors or signals)² that help to explain why one stock outperforms another stock. They assemble these characteristics into a stock selection model that can be run daily to provide an updated view on every stock in their investment universe.

The stock selection model is at the heart of the quantitative process. To build their model, the quantitative investor will look throughout history and see what characteristics drive performance differences between stocks in a group such as a universe (i.e., small cap, small-cap value, and large-cap growth) or a sector (i.e., technology, financials, materials).

The quantitative investor's typical stock selection methodology is buying stocks with the most attractive attributes and not investing in (or shorting if permitted by investment guidelines) stocks with the least attractive attributes. For instance, let's suppose retail stocks that have the highest profitability tend to have higher stock returns than those with the lowest profitability. In this case, if a retail stock had strong profitability, ...