Master’s Thesis Submitted to: Reykjavik University School of Business INVESTMENT MANAGEMENT BEHAVIOURAL INFLUENCES IN PORTFOLIO COMPOSITION Capitalizing on stock market mispricing through fundamental analysis Andrew Britten-Kelly 15.05.2015 Supervisor Már Wolfgang Mixa Reykjavik, May 2015 Abstract The efficient markets explanation for pricing anomalies has faced mounting challenges from the field of behavioural finance in recent times, with growing research suggesting evidence of sustained asset mispricing across equity markets. This study examines whether there are benefits to be gained from incorporating behavioural influences into the portfolio composition process. This is achieved through examination of behavioural theory and its successful practitioners in achieving excess returns on the market through fundamental analysis. Based upon this examination a framework was researched, devised and implemented through the asset selection and asset allocation process. The study found that the resultant portfolio achieved above market risk adjusted returns, across multiple weighting combinations. The results suggest that behavioural driven fundamental analysis can aid in capitalizing on equity mispricing in the market, and furthermore behavioural influences can bring benefit to the asset selection and allocation process of portfolio composition. Keywords: Behavioural finance, value investing, fundamental analysis, mispricing, portfolio composition, asset selection, asset allocation. P a g e | ii Acknowledgements Foremost I would like to convey my utmost gratitude to my advisor Már Wolfgang Mixa for providing the inspiration behind the choice of subject for this thesis, for his motivation and enthusiasm in getting the job done, and for lending his wealth of knowledge in his advisory role. His valued guidance is very much appreciated; it is difficult to imagine this project without his influence. I would like to additionally convey a special thanks to Júlíana and Emma who made this difficult period bearable, and for bringing joy and light to my life. Reykjavik University May, 2015 P a g e | iii Declaration of Research Work Integrity This work has not previously been accepted in substance for any degree and is not being concurrently submitted in candidature of any degree. This thesis is the result of my own investigations, except where otherwise stated. Other sources are acknowledged by giving explicit references. A bibliography is appended. By signing the present document I confirm and agree that I have read RU’s ethics code of conduct and fully understand the consequences of violating these rules in regards of my thesis. .................................................................................................................................. Date and place Kennitala Signature Reykjavik University May, 2015 P a g e | iv Table of Contents 1. Introduction ............................................................................................................................... 1 1.1 Background ......................................................................................................................... 1 1.2 Research Aims .................................................................................................................... 2 2. Behavioural Finance ................................................................................................................. 4 2.1 Introduction ......................................................................................................................... 4 2.2 Efficient Market Hypothesis ............................................................................................... 4 2.3 Behavioural Finance ........................................................................................................... 5 2.3.1 Limits to Arbitrage ....................................................................................................... 6 2.3.2 Psychology ................................................................................................................... 6 2.4 Behavioural Finance Discussion ......................................................................................... 8 3. The Guru Investors .................................................................................................................. 10 3.1 Introduction ....................................................................................................................... 10 3.2 Benjamin Graham ............................................................................................................. 10 3.3 Peter Lynch ....................................................................................................................... 12 4. Financial Ratios ....................................................................................................................... 15 4.1 Introduction ....................................................................................................................... 15 4.2 Market Ratios .................................................................................................................... 15 4.3 Liquidity and Debt ratios .................................................................................................. 18 4.4 Financial Ratio Summary .................................................................................................. 19 5. Portfolio Management ............................................................................................................. 20 5.1 Investment Philosophy ...................................................................................................... 20 5.2 Asset classes ...................................................................................................................... 22 5.3 Asset Allocation ................................................................................................................ 23 5.4 Mean Variance Model ....................................................................................................... 23 5.5 Portfolio Performance Measures ....................................................................................... 24 6. Empirical study ....................................................................................................................... 26 6.1 Introduction ....................................................................................................................... 26 6.2 Data ................................................................................................................................... 28 6.2.1 Introduction ................................................................................................................ 28 6.2.2 Market ........................................................................................................................ 28 6.2.3 Horizon / Time Frame ................................................................................................ 29 6.2.4 Sources ....................................................................................................................... 29 6.3 Part I – Screening Process ................................................................................................. 32 6.3.1 Methodology .............................................................................................................. 32 Reykjavik University May, 2015 P a g e | v 6.3.2 Results ........................................................................................................................ 41 6.2.3 Discussion .................................................................................................................. 42 6.4 Part II – Portfolio Construction ......................................................................................... 45 6.4.1 Methodology .............................................................................................................. 45 6.4.2 Results ........................................................................................................................ 52 6.4.3 Discussion .................................................................................................................. 59 6.5 Part III – Performance Testing .......................................................................................... 63 6.5.1 Methodology .............................................................................................................. 63 6.5.2 Results ........................................................................................................................ 64 6.5.3 Discussion .................................................................................................................. 69 7. Conclusion .............................................................................................................................. 75 Appendix I - Financial Ratio Definitions .................................................................................... 77 Appendix II – Utility Theory ...................................................................................................... 80 Appendix III - Mean Variance Model ......................................................................................... 81 Appendix IV – Portfolio Performance Measures ........................................................................ 86 Appendix V – Part I Screening Results ......................................................................................