### Combining Fundamental Analysis and Portfolio Optimization

**January 16, 2019** - Fundamental Valuation, Strategic Allocation

Can stock return forecasts from fundamental analysis make conventional mean-variance stock portfolio optimization work? In their December 2018 paper entitled “Optimized Fundamental Portfolios”, Matthew Lyle and Teri Yohn construct a portfolio that combines fundamentals-based stock return forecasts and mean-variance optimization and then compare results with portfolios from each employed separately. To suppress implementation costs, they focus on long-only portfolios reformed quarterly. Their fundamentals return forecasting model uses cross-sectionally normalized versions of book-to-market ratio, return on equity, change in net operating assets divided by book value and change in financial assets divided by book value. They update fundamental variables quarterly at the end of the reporting month. They generate stock return forecasts via a complicated multivariate regression of cross-sectionally normalized versions of the variables based on five years of rolling historical data. They then form a portfolio of the tenth (decile) of stocks with the highest expected returns, either value-weighted or equal-weighted. They consider several portfolio optimization methods, including minimum variance (requiring no return forecasts); mean-variance optimization with target expected return; and, Sharpe ratio maximization. Their combined approach employs fundamental stock return forecasts as inputs to those portfolio optimization methods that require returns. They use data from 1991-1995 to generate initial model inputs and 1996-2015 for out-of-sample testing. Using end-of-month data for a broad but groomed sample of U.S. common stocks with at least three years of historical data during January 1991 through December 2015, *they find that:*