Investment Analysis

PART 1 (7 MARKS)

Vincent T, Macquarie Bank’s quantitative analysis, has developed a portfolio construction model about which he is excited. To create the model, Vincent made a list of the stocks currently in the ASX SPI 200 Index and obtained annual operating cash flow, price, and total return data for each issue for the past five years. As of each year-end, this universe was divided into five equal-weighted portfolios of 40 issues each, with selection based solely on the price/cash flow rankings of the individual stocks. Each portfolio’s average annual return was then calculated.

During this five-year period, the linked returns from the portfolios with the lowest price/cash flow ratio generated an annualized total return of 18.5%, or 3.9% percentage points better than the 14.6% on the ASX SPI 200 Index. Vincent also noted that the lowest price-cash flow portfolio had a below-market beta of 0.88 over this same time span.

(1.1)

Beta (β) is used as a measure of the sensitivity of security’s returns to fluctuations in the market. However, single factor models using the beta as the only variable (such as the CAPM), are constrained by the simplicity of their underlying assumptions which limits their ability to explain and predict actual returns. Fama and French (1992) found that the relationship between beta and average returns is flat (i.e that beta had little or no ability to predict expected returns), and instead identified market value (size) and the ratio of book to market equity (BM) as the two major determinants of the cross-sectional expected returns. The three factor model developed by Fama and French (1993) as a response to these findings includes risk size, represented by SMB (Small Minus Big) and value risk, or HML (High Minus Low) as additional risk factors to overcome the constraints of single factor models. Fama and French (1992) in their empirical study, found that the addition of risk factors successfully explained much more of the variation...