Stock selection using data envelopment analysis

Abstract

PurposeThe purpose of this study is to adopt data envelopment analysis (DEA) to construct portfolios, and compare their return rates with the market index to examine whether DEA portfolios created superior returns. In addition, this study investigated whether using the “size effect” as a stock selection strategy is appropriate in Taiwan.Design/methodology/approachThis study applied two DEA models to evaluate the efficiency of the firms and construct portfolios by selecting stocks with high efficiency. Furthermore, the return rates of the portfolios constructed by small‐size firms, DEA models and market indices were compared via empirical data analysis.FindingsThe results showed that size effect seems inappropriate as a stock selection strategy in the Taiwan stock market. However, the portfolios constructed by DEA models achieved noticeable superior returns.Research limitations/implicationsFuture studies can apply DEA models to other stock markets in different countries to confirm the effectiveness of DEA methods in stock selection.Originality/valueThis study is the first attempt to select stocks using DEA models and compares the performances of the portfolios composed by DEA analysis, small‐size firms and the stock market indices. The proposed approach provides useful managerial implications in stock selection and insight to improve financial efficiencies of corporations.