Equity Valuation and Portfolio Management

WAYS TO BUILD ACTIVE GLOBAL PORTFOLIOS

In order to answer this question, we examine alternative approaches to constructing global stock portfolios. However, we first need an investment strategy as the context in which to compare these different methods. For robustness purposes, we will use two such canonical investment strategies, value and momentum. Value says that, all else equal, we like stocks that are cheap versus stocks that are expensive. Momentum says that, all else equal, we like stocks that have been doing well, that is, “improving,” recently. To measure how cheap a stock is we look at its book-to-price ratio, and to measure momentum we look at a stock's prior one-year performance.⁴ Given these indicators, we next construct three long-short portfolios at each point in time, using techniques detailed in the rest of this section.

Naive Stock Selection

Naive stock selection is our straw man, representing a pure stock picker looking for cheap stocks or stocks with good momentum, without any regard to country membership. This approach may perhaps be overly naive, but it allows us to quantify the negative side-effects of not adequately considering country membership when constructing global stock portfolios.

With that said, let's go on to the portfolio construction methodology for this investor. Without an additional adjustment, choosing stocks based on the above value and momentum measures may yield large sector bets (i.e., stock valuations and returns within the same sector ...