Equity Valuation and Portfolio Management

WHY DOES THE NAIVE STOCK SELECTION PORTFOLIO MAKE COUNTRY NOISE BETS?

Having explained how to detect and measure the extent of country noise bets, let us now explain how and why they arise in the naive stock selection portfolio. Both naive stock selection and country-neutral stock selection are intended to compare stocks, while country selection is intended to compare countries. Any comparison is naturally relative to some notion of what is typical within the sample of reference. Crucially, what is typical for a stock is not necessarily the same as what is typical for a country. Naive stock selection falls into the trap of not recognizing this distinction and therefore makes accidental, i.e., noisy, country bets. The primary reason for the difference in what is typical is simply that various countries are not equally represented in the cross-section of stocks. Countries that are over-represented in the cross-section of stocks will dominate a country-agnostic stock average.

This inconsistency in the definition of “typical” is what yields country noise. Let us present a simple example to make these issues more concrete. Consider a hypothetical global market of 90 U.S. stocks, five U.K. stocks, and five Japanese stocks, with book-to-price ratios randomly distributed around a mean of 0.50 for the United States, 0.75 for the United Kingdom, and 1.00 for Japan, respectively. The average country score, taken over the cross-section of countries, is 0.75 (= 1/3 × 0.50 + 1/3 × 0.75 + 1/3 ...