Portfolio selection under DEA-based relative

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financial strength indicators: case of US industries
NCP Edirisinghe∗ and X Zhang
The University of Tennessee, Knoxville, TN, USA
Fundamental analysis is an approach for evaluating a firm for its investment-worthiness whereby the firm’s
financial statements are subject to detailed investigation to predict future stock price performance. In this paper,
we propose an approach to combine financial statement data using Data Envelopment Analysis to determine
a relative financial strength (RFS) indicator. Such an indicator captures a firm’s fundamental strength or
competitiveness in comparison to all other firms in the industry/market segment. By analysing the correlation
of the RFS indicator with the historical stock price returns within the industry, a well-informed assessment can
be made about considering the firm in an equity portfolio. We test the proposed indicator with firms from the
technology sector, using various US industries and report correlation analyses. Our preliminary computations
using RFS indicator-based stock selection within mean–variance portfolio optimization demonstrate the validity
of the proposed approach.
Journal of the Operational Research Society (2008) 59, 842–856. doi:10.1057/palgrave.jors.2602442
Published online 20 June 2007
Keywords: data envelopment analysis; fundamental analysis of financial statements; portfolio selection and
optimization; relative financial strength

Introduction
Prediction of stock price returns (or their direction) is central
to financial portfolio decision-making. Often, such predictions
are complicated by factors that are external as well as
internal to a given firm. On the one hand, stock prices of
firms within a given industry may behave in some overall
predictable manner due to external factors such as economic
conditions that determine market demand for products/
services.

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