Chapter 6:
EQUITY PORTFOLIO MANAGEMENT STRATEGIES
Lecturer: D r. L I NH D . N G U YE N
FA C U LT Y O F F I NA N CE
B A N K I N G UN I V E RS I T Y O F H C M C
CONTENT
2
1. Equity Valuation Models
2. Equity Portfolio Management Strategies
A. Passive Equity Portfolio Management Strategies
B. Active Equity Portfolio Management Strategies
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1. EQUITY VALUATION MODELS
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A. Intrinsic Value vs. Market Price
B. Dividend Discount Models
C. Free Cash Flow Valuation Approaches
D. Valuation by Comparables
E. Comparing the Valuation Models
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1. EQUITY VALUATION MODELS
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Fundamental analysis models base value on current
and future profitability
It identifies mispriced stocks relative to some
measure of “true” value derived from financial data
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A. INTRINSIC VALUE VS. MARKET PRICE
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The return on a stock is composed of dividends and
capital gains or losses
E ( D1 ) E ( P1 ) P0
Expected HPR= E ( r )
P0
The expected HPR may be more or less than the
required rate of return.
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INTRINSIC VALUE VS. MARKET PRICE
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Required Return:
CAPM gives the required return, k:
k r f E ( rM ) r f
k is the market capitalization rate or discount rate
If the stock is priced correctly, k = expected return
Trading Signal:
Expected HPR > k: Buy
Expected HPR < k: Sell or Short Sell
Expected HPR = k: Hold or Fairly Priced
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INTRINSIC VALUE VS. MARKET PRICE
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The intrinsic value (IV) is the “true” value,
according to a model
The market value (MV) is the consensus value of all
market participants
Trading Signal:
IV > MV: Buy
IV < MV: Sell or Short Sell
IV = MV: Hold or Fairly Priced
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INTRINSIC VALUE VS. MARKET PRICE
EXAMPLE
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ABC stock has an expected dividend per share, E(D 1),
of $4; the current price of a share, P0, is $48; and the
expected price at the end of the year, E(P1), is $52.
Suppose that rf = 6%, E(rM) − rf = 5%, and the beta of
ABC is 1.2
Let:
Compare expected HPR and required rate of return.
Calculate the intrinsic value (V )
0
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B. DIVIDEND DISCOUNT MODELS (DDM)
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The Constant-Growth DDM
Stock Prices and Investment Opportunities
Life Cycles and Multistage Growth Models
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DIVIDEND DISCOUNT MODELS (DDM)
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D1 D2 D3
V0 ...
1 k 1 k 1 k
2 3
V0 = intrinsic value at the current time (t = 0)
Dt = dividend at time t
k = required rate of return
DDM says V0 = the present value of all expected
future dividends into perpetuity
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DIVIDEND DISCOUNT MODELS (DDM)
THE CONSTANT-GROWTH DDM
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D0 1 g D1
V0
k g k g
V0 = current value
Dt = dividend at time t
k = appropriate risk-adjusted interest rate
g = dividend growth rate
E.g: ABC stock has g = 0.05, the most recently paid
dividend was D0 = 3.81 and k = 12%. Let calculate the
intrinsic value of this stock.
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DIVIDEND DISCOUNT MODELS (DDM)
THE CONSTANT-GROWTH DDM
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Preferred Stock and the DDM
No growth case (fixed dividends)
Value a preferred stock paying a fixed dividend of $2
per share when the discount rate is 8%:
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DIVIDEND DISCOUNT MODELS (DDM)
THE CONSTANT-GROWTH DDM
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Preferred Stock and the DDM
No growth case (fixed dividends)
Value a preferred stock paying a fixed dividend of $2
per share when the discount rate is 8%:
$2
Vo $25
0.08 0
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DIVIDEND DISCOUNT MODELS (DDM)
THE CONSTANT-GROWTH DDM
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Example: XYZ stock just paid an annual dividend of
$3/share. Dividend is expected to grow at 8% indefinitely.
Beta is 1.0, the risk-free rate is 6%, and the market risk
premium is 8%. Let calculate:
The require return (market capitalization rate – k) by using the
CAPM
The intrinsic value of XYZ
What would be your estimate of intrinsic value if you believed
that the stock was riskier, with a beta of 1.25?
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DIVIDEND DISCOUNT MODELS (DDM)
THE CONSTANT-GROWTH DDM
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The constant-growth DDM is valid only when g is less
than k
The constant-growth rate DDM implies that a stock’s
value will be greater:
The larger its expected dividend per share
The lower the market capitalization rate, k
The higher the expected growth rate of dividends
The stock price is expected to grow at the same rate as
dividends
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DIVIDEND DISCOUNT MODELS (DDM)
STOCK PRICES AND INVESTMENT OPPORTUNITIES
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Estimating Dividend Growth Rates
𝑔=𝑅𝑂𝐸 x𝑏
g = growth rate in dividends
ROE = Return on Equity
b = plowback ratio or earnings retention ratio (1 - dividend
payout ratio)
𝑔=𝑅𝑂𝐸×(1−𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑎𝑦𝑜𝑢𝑡𝑟𝑎𝑡𝑖𝑜)
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DIVIDEND DISCOUNT MODELS (DDM)
STOCK PRICES AND INVESTMENT OPPORTUNITIES
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DIVIDEND DISCOUNT MODELS (DDM)
LIFE CYCLES AND MULTISTAGE GROWTH MODELS
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Firms typically pass through life cycles
Early Years Later Years
• Ample opportunities for profitable • Attractive opportunities for
reinvestment in the company reinvestment may become harder to
find.
• Competitors may have not entered • Competitors enter the market
the market.
• Payout ratios are low • Payout ratios are high
• Growth is correspondingly rapid. • Dividend growth slows because the
company has fewer investment
opportunities.
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DIVIDEND DISCOUNT MODELS (DDM)
LIFE CYCLES AND MULTISTAGE GROWTH MODELS
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Example: Compute the price of GE Stock in 2016,
know:
Expected dividends equal 1.04$ in 2017, 1.22$ in 2018,
1.41$ in 2019 and 1.60$ in 2020.
In 2020, the dividend growth rate levels off. We forecast a
dividend payout ratio of 53%, ROE = 19.5% from 2020.
GE’s β = 1.10, r = 2.5%
f
Market risk premium = 8%,
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C. FREE CASH FLOW VALUATION APPROACH
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Free cash flow for the firm (FCFF)
Free cash flow to equity holders (FCFE)
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FREE CASH FLOW VALUATION APPROACH
FREE CASH FLOW FOR THE FIRM (FCFF)
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Value the firm by discounting free cash flow at
WACC
Free cash flow to the firm, FCFF, equals:
After tax EBIT
Plus depreciation
Minus capital expenditures
Minus increase in net working capital
FCFF EBIT (1 t ) Depreciation Cap. Exp. NWC
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FREE CASH FLOW VALUATION APPROACH
FREE CASH FLOW FOR THE FIRM (FCFF)
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Value of the Firm:
T
FCFFt Vt
FirmValue t
T
t 1 (1 WACC ) (1 WACC )
Where
FCFFT 1
Vt
WACC g
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FREE CASH FLOW VALUATION APPROACH
FREE CASH FLOW TO EQUITYHOLDERS (FCFE)
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Free cash flow to equity, FCFE, equals:
FCFF
Minus after tax interest
Plus increase in debt
FCFE FCFF Interest (1 t ) Debt
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FREE CASH FLOW VALUATION APPROACH
FREE CASH FLOW TO EQUITYHOLDERS (FCFE)
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Intrinsic Value of Equity:
T
FCFEt ET
IntrinsicValue of Equity t
T
t 1 (1 k E ) (1 k E )
Where
FCFET 1
ET
kE g
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D. VALUATION BY COMPARABLE
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Compare valuation ratios of firm to industry
averages
Ratios like price/sales are useful for valuing start-
ups that have yet to generate positive earnings
Limitations of Book Value:
Book values are based on historical cost, not actual market
values
It is possible, but uncommon, for market value to be less
than book value
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Price per share $ 49.71
Common shares outstanding (billion) 7.86
Market capitalization ($ billion) $ 391
Latest 12 months
Sales ($ billion) $ 86.90
EBITDA ($ billion) $ 29.20
Net income ($ billion) $ 10.50
Earnings per share $ 1.33
Valuation Microsoft Industry Average
Price/Earnings 17.2 29.1
Price/Book 5.3 8.7
Price/Sales 4.5
PEG 2.3 1.5
Profitability
ROE (%) 12.7 16.1
ROA (%) 8.2
Operating profit margin (%) 27.0 23.5
Net profit margin (%) 12.1 13.8
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E. COMPARING THE VALUATION MODELS
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In practice
Values from these models may differ
Analysts are always forced to make simplifying assumptions
Problems with DCF
Calculations are sensitive to small changes in inputs
Growth opportunities and growth rates are hard to pin down
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COMPARING THE VALUATION MODELS
EXAMPLE: GE
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Model Intrinsic Value
Two-stage dividend discount model $53.40
DDM with earnings multiple terminal value 33.31
Three-stage DDM 35.70
Free cash flow to the firm 24.82
Free cash flow to equity 27.52
Market price (from Value Line) 30.98
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2. EQUITY PORTFOLIO MANAGEMENT STRATEGIES
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A. Passive versus Active Management
B. Passive Equity Portfolio Management Strategies
C. Active Equity Portfolio Management Strategies
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A. PASSIVE VERSUS ACTIVE MANAGEMENT
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Equity portfolio management strategies can be placed
into either a passive or an active category
One way to distinguish between these strategies is to
decompose the total actual return that the portfolio
manager attempts to produce:
Total Actual Return = [Expected Return] + [“Alpha”]
= [Risk-Free Rate + Risk Premium] + [“Alpha”]
Passive
Active
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PASSIVE VERSUS ACTIVE MANAGEMENT
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Passive equity portfolio management
Long-term buy-and-hold strategy
Usually tracks an index over time
Designed to match market performance
Manager is judged on how well they track the target index (try
to minimize tracking error)
Active equity portfolio management
Attempts to outperform a passive benchmark portfolio on a
risk-adjusted basis by seeking the “alpha” value - the
difference between the actual and expected return
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PASSIVE VERSUS ACTIVE MANAGEMENT
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2016 2008
Strategy % Change
($ billions) ($ billions)
Active equity $2,332.9 $1,281.7 82.0%
Passive equity 2,153.4 789.1 172.9
Active fixed-income 3,029.4 1,706.0 77.6
Passive fixed-income 639.4 211.2 202.7
Source: Pensions & Investments Money Manager Directory, May 29, 2017, and May
30, 2009
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B. PASSIVE EQUITY PORTFOLIO MANAGEMENT
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Overview
Index Portfolio Construction Techniques
Tracking Error and Index Portfolio Construction
Methods of Index Portfolio Investing
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
OVERVIEW
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Attempt to replicate the performance of an index
May slightly underperform the target index due to fees and
commissions
Strong rationale for this approach
Costs of active management (1 to 2 percent) are hard to
overcome in risk-adjusted performance
Many different market indexes are used for tracking
portfolios
S&P 500 Index
NASDAQ Composite Index…
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
INDEX PORTFOLIO CONSTRUCTION TECHNIQUES
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There are three basic techniques for constructing a
passive index portfolio:
Full replication
Sampling
Quadratic optimization
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
INDEX PORTFOLIO CONSTRUCTION TECHNIQUES
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Full replication
All securities in the index are purchased in proportion to
weights in the index
This helps ensure close tracking
Increases transaction costs, particularly with dividend
reinvestment
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
INDEX PORTFOLIO CONSTRUCTION TECHNIQUES
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Sampling
Buys a representative sample of stocks in the benchmark
index according to their weights in the index
Fewer stocks means lower commissions
Reinvestment of dividends is less difficult
Will not track the index as closely, so there will be some
tracking error
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
INDEX PORTFOLIO CONSTRUCTION TECHNIQUES
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Quadratic optimization (or programming techniques)
Historical information on price changes and correlations
between securities are input into a computer program that
determines the composition of a portfolio that will minimize
tracking error with the benchmark
This relies on historical correlations, which may change over
time, leading to failure to track the index
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
TRACKING ERROR AND INDEX PORTFOLIO CONSTRUCTION
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The goal of the passive manager should be to minimize the
portfolio’s return volatility relative to the index, i.e., to
minimize tracking error
Tracking error measure
Return differential in time period t
N
Δ t wi Rit Rbt R pt Rbt
i 1
Where
Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t
Tracking error is measured the
TE as P
standard deviation of Δt , normally
annualized
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
TRACKING ERROR AND INDEX PORTFOLIO CONSTRUCTION
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Over the last eight quarters, the returns to this portfolio, as well as
the index returns and the return difference between the two, were:
Period Manager Index Difference (Δ)
1 2.3% 2.7% -0.4%
2 -3.6 -4.6 1.0
3 11.2 10.1 1.1
4 1.2 2.2 -1.0
5 1.5 0.4 1.1
6 3.2 2.8 0.4
7 8.9 8.1 0.8
8 -0.8 0.6 -1.4
Let the manager’s annualized tracking error for this two-year
period
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
TRACKING ERROR AND INDEX PORTFOLIO CONSTRUCTION
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The periodic average and standard deviation of the
manager’s return differential (i.e., “delta”) relative to the
benchmark are:
Average Δ = 0.2%
σ =1.0%
Thus, the manager’s annualized tracking error for this two-
year period is 2.0 percent (= 1.0 % × ).
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
TRACKING ERROR AND INDEX PORTFOLIO CONSTRUCTION
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Expected Tracking Error
(Percent)
4.0
3.0
2.0
1.0
500 400 300 200 100 0
Number of Stocks
Exhibit: Expected Tracking Error between the S&P 500 Index and Portfolios
Composed of Samples of Fewer Than 500 Stocks
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
METHODS OF INDEX PORTFOLIO INVESTING
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Index Funds
In an indexed portfolio, the fund manager will typically
attempt to replicate the composition of the particular index
exactly
The fund manager will buy the exact securities comprising the
index in their exact weights
Change those positions anytime the composition of the index
itself is changed
Low trading and management expense ratios
The advantage of index mutual funds is that they provide an
inexpensive way for investors to acquire a diversified portfolio
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PASSIVE EQUITY PORTFOLIO MANAGEMENT
METHODS OF INDEX PORTFOLIO INVESTING
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Exchange-Traded Funds (ETF)
ETFs are depository receipts that give investors a pro rata
claim on the capital gains and cash flows of the securities
that are held in deposit by a financial institution that issued
the certificates
A significant advantage of ETFs over index mutual funds is
that they can be bought and sold (and short sold) like
common stock
The notable example of ETFs
Standard & Poor’s 500 Depository Receipts (SPDRs)
iShares
Sector ETFs
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C. ACTIVE EQUITY PORTFOLIO MANAGEMENT
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(Intentionally blank slide)
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ACTIVE EQUITY PORTFOLIO MANAGEMENT
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Goal is to earn a portfolio return that exceeds the return
of a passive benchmark portfolio, net of transaction
costs, on a risk-adjusted basis
Need to select an appropriate benchmark
Practical difficulties of active manager
Transactions costs must be offset by superior performance vis-
à-vis the benchmark
Higher risk-taking can also increase needed performance to
beat the benchmark
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ACTIVE EQUITY PORTFOLIO MANAGEMENT
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Equity Portfolio Investment Philosophies and Strategies
Passive Management Strategies
1. Efficient Markets Hypothesis
Buy and hold
Indexing
Active Management Strategies
2. Fundamental Analysis
“Top down” (e.g., asset class rotation, sector rotation)
“Bottom up” (e.g., stock undervaluation/overvaluation)
3. Technical Analysis
Contrarian (e.g., overreaction)
Continuation (e.g., price momentum)
4. Factors, Attributes, and Anomalies
Security characteristic factors (e.g., P/E, P/B, earnings momentum, firm size)
Investment style factors (e.g., value, growth, volatility, company quality)
Calendar effects (e.g., weekend, January)
Information effects (e.g., neglect)
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