Academic journal article Journal of Global Business Issues

Applicability of Rosenberg's Beta Factor Decomposition Analysis to the Construction of a Growth Stock Portfolio within the Standard & Poor's 1500 Index

Academic journal article Journal of Global Business Issues

Applicability of Rosenberg's Beta Factor Decomposition Analysis to the Construction of a Growth Stock Portfolio within the Standard & Poor's 1500 Index

Article excerpt

ABSTRACT

Since the turn of this Century, there has been a decided investment bias towards value over growth in the selection of stock portfolios by investors. Growth portfolios have lagged considerably. This could be due to the change in the risk orientation of investors. It could also be due to the fact that growth portfolio construction has remained fixated on ex-ante growth prospects without taking into account this possible shift in investor psychology, especially after 9/11. One of the most important papers in the origin of Modern Portfolio Theory, authored by Barr Rosenberg, decomposed the then-relatively unexplored concept of beta of the Capital Asset Pricing Model. This paper re-explores this extremely important initial academic work to see whether its conclusions could be applied to the construction of a growth stock portfolio to enhance its return. This "back to the future" approach appears to have investment merit in the construction of growth stock portfolios.

INTRODUCTION

One of the most interesting changes that has occurred since the rise of the 21st Century, particularly post 9/11, has been the attitude of investors towards risk and return. This has been most dramatically noted in the performance of value versus growth stock portfolios. The tilt of investing, prior to these historical dates, favored growth. Since those dates, the tilt has been toward value. One cannot help ask: Is this change permanent? Styles of investing seem to change in short (3 to 5 years) time frames. This bias to value over growth has dominated for both the past five and ten year periods. Growth investing has become hazardous to one's financial health.

One possible reason for the lag in returns from growth investing relative to value investing might be the selection process of stocks for inclusion in portfolios. One way to improve this under-performance may involve a return to more fundamental and safer financial characteristics in growth stock selection.

This paper undertakes the task to determine whether fundamentals are useful in selecting growth stocks that will consistently outperform benchmarks and value stocks. It first examines the early days of Modern Portfolio Theory and takes a detailed look at one of the most important contributors to the field, Barr Rosenberg. More importantly, it studies the many fundamental and observed financial characteristics that influence a stock beta as first noted by Rosenberg. In the new finance, the Capital Asset Pricing Model's beta is all-important. It not only measures the risk but prescribes return as well.

The construct of the beta therefore is of paramount interest to investors. It will be noted that the beta has a "memory" of fundamental financial characteristics. If these fundamental financial characteristics are acknowledged and incorporated into growth portfolios, these portfolios many provide the necessary competitive risk-adjusted return over value portfolios.

MODERN PORTFOLIO THEORY

Modern Portfolio Theory had its origins in the 1950s in the research of Harry Markowitz. His monumental work was initiated with the publication of "Portfolio Selection" Markowitz (1952) His work clearly showed the importance of portfolio optimization in stock portfolio construction. Returns would no longer be judged solely on their magnitude, but would also be judged on their variance. This gave rise to mean-variance analysis in the construction of stock portfolios.

The next key advance in Modern Portfolio Theory came in the 1960s predominately, but not exclusively, by William F. Sharpe (1963). He developed the concept of the Capital Asset Pricing Model which postulated the universal and unrestricted use of Markowitz's portfolio optimization. This was expressed in Sharpe's (1964) paper, "Capital Asset Prices."

The pragmatic outcome of Sharpe's paper is that a single factor could make one stock different from another, even if the two had the same expected return and variance. …

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