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Sometimes the search for alpha and risk management takes us on interesting journeys. This is especially so when we experience that some of our established strategies of diversification and performance management might not be working as well as we would have thought. Knowing that you can be fooled by randomness in your journey, you realize that you need to avoid the use of vague and ambiguous information. You may just need to rely on the use of probabilities versus trying to forecast the future. Finding your way sometimes just depends on knowing what you are looking for.
To explore an interesting and successful investment journey, we were introduced to Julian Koski, Chief Investment Officer of New Age Alpha – a Rye, NY based investment management firm that, like the Oakland A’s back in the time of Manager Billy Bean, understood how to subvert an established long-standing system of evaluating assets (in this case stocks vs players). Their radically different approach sprang from the belief that there was an imperfect understanding of where alpha comes from. The true goal they determined was to capture performance not by picking winners, but focusing on avoiding losers, and that asset managers can improve decision-making and performance by using data and analytics in that pursuit.
New Age Alpha employs an investment approach focusing on avoiding the worst-performing "loser" stocks in an index or portfolio rather than trying to pick the winners. Their disciplined and systematic investment methodology is driven by their proprietary h-factor Probability Score which is calculated by combining actuarial science with data and technology to identify losing stock positions in order to outperform the broader index or ETF portfolio by removing the stocks most likely to underperform.
We asked them questions to better understand how they developed their systematic investing techniques and analytics-driven stock selection approach. We also explored how the firm applies its methodology not only to its mutual fund products but also to index construction and a customizable separately managed account platform called SPACE which allows the firm to work with advisors in a variety of capacities beyond just providing investment products.
Hortz: Can you share with us how you developed your investment process? What research or personal experience motivated you to look for a different investment approach?
Koski: I think it is less about how and more about why it was developed. It was developed because, at the end of the day, I grew up around actuaries in my life, and from that perspective, I believe that a lot of what happens on Wall Street is about luck and not all about skill. You are dealing with a lot of lucky outcomes, which essentially lead to random outcomes. And the question becomes how do you deal with randomness? And the best practitioners of dealing with randomness are insurance actuaries.
Insurance actuaries do their jobs in a very, very specific way. First of all, their idea is to be less wrong, not to be right. They are not trying to underwrite risk or trying to pick “healthy” winners. If I asked an audience of portfolio managers, how would you design a portfolio to beat the S&P 500? Most would say they would focus on stock selection to pick the winners. But to pick a winner, you have to have some knowledge of the future. The future by definition is not known. And the more you try to forecast this unknown future, the more you are increasing the odds you are going to be wrong and invest in a loser. Insurance actuaries are not trying to figure out who is going to live the longest. They want to figure out what is the probability someone is going to die early and avoid them.
There is also a pivotal point here. They do not use information that is not known information. They do not ask questions like: Are you going to quit smoking? Are you going to go to the gym? They do not care about what you think you are going to do and do not make assumptions about you. Their underwriting of risk is only based on what they know about you.
When we think about stocks, we think about investing in the exact same way. We manage investment risk like an actuary, not like a portfolio manager. When you think about a stock, there are only two things you absolutely know about a stock at any point in time - the stock price and the financial statements. We use that information to try to avoid a loser, a company that will lose money, or another way to look at that, is a company that is unable to deliver revenue growth indicated by its stock price.
Hortz: Can you further explain your perspective on avoiding a losing stock?
Koski: Well, most analysts are trying to figure out if a stock is under or overvalued. I have no interest in trying to worry about that. What we want to know is what is the probability that the company is going to fail to deliver the growth implied or indicated by its current stock price. Stock price means something. The company has to deliver something for that stock price. We work backwards from that stock price and figure out what that price implies - what revenues do they need to generate to support that price.
What we then want to measure is the likelihood of failure, and we want to avoid those companies that have a high likelihood of failure for the same reason that insurance actuaries do what they do. They want to avoid the likelihood that somebody will die early. I want to avoid the companies that are going to fail to deliver on growth. It's as simple as that. Our math is the same. We calculate a probability of failure. So that is really what we do.
Hortz: You mentioned on your website that you have a three-step process to determine a company's ability to deliver revenue growth. Can you briefly walk us through that process?
Koski: The methodology, as I mentioned before, is built around actuarial science. We are looking at a stock price and the question we are going to ask is: What is the probability, the likelihood, that the company is going to fail to deliver the growth implied in their stock price?
The first step we have to figure out is what is the indicated growth rate in that stock price? And remember, we do not want to make any assumptions here about the company’s future growth rate. I use the current stock price and work backwards using methods like discounted free cashflow to calculate the indicated growth rate to support that current stock price. So that is just all math.
The second step in the process is to look back to see how many times over the past twelve quarters the company has actually delivered that growth rate. So, you can see historically what level of performance it has been delivering.
In the third step, I take the company’s indicated growth rate that we determined in step one, and I plot it on a distribution of possible growth rates to determine the quantifiable percentage chance that this company will fail to deliver the growth implied in its stock price. In other words, we can apply a specific number around the percentage chance that the company is going to fail to deliver the revenue that is implied in the stock price.
Now the question for many becomes is that good or bad? Is this a good or bad company? The answer to that is we do not know. The way to look at it is, it’s simply the probability of failure of supporting its stock price. I always say to our clients, I do not know if that stock represents a good or bad company, and I do not care. But what I care about is what other people think about. There is something about that stock and stock price that investors believe, and it is pushing that stock price up to an extent where that indicated growth rate is bordering on failure or not. I would consider it risky in the light of other stocks that have a better probability of reaching their indicated growth rate.
Hortz: Why do you also refer to that percentage number outcome as the h-factor?
Koski: The reason we call this the h-factor is because, if you are dealing with stock prices and financial statements, then what is happening? If you know that the stock price and financial statements are your known piece of information, then it must be that investors are relying on vague and ambiguous information, things like news, and they are impounding that into the stock price. And that is the h-factor, the human factor. That is the risk.
Humans impound vague and ambiguous information into stock prices, and it causes a dislocation between the stock price and the financials. That is what is going on here. I am not saying it is a bad company, I'm just saying I am not going to take the risk in a company that has a 35% chance of failure when, say in the S&P 500, there are about a hundred companies that have got a far lower probability of failure. What we know for sure is that as an investment firm, low h-factor stocks outperform high h-factor stocks consistently over time.
That is all I care about. Essentially, what I am concerned about here is that there is this gambling mentality going on in the investment markets and we are calculating the odds as a casino; on being right or wrong on that company’s growth prospects relative to its current stock price. This probability score helps you avoid some of the speculation in active investing and helps you avoid the losers. Every single day you have risks coming from humans that you cannot diversify away from. And that is the magic of what this investment approach is doing. It is addressing a risk that no one is looking at. That is what we are doing here. I am not trying to be right. I am trying to be less wrong. That is really what it is.
Hortz: How are you applying your investment methodology and h-factor to index construction and your separate account SPACE platform for financial advisors?
Koski: Our investment methodology is the h-factor and that is the cornerstone of the entire business. Mutual funds, separately managed accounts, indexing, those are all products where we apply our h-factor methodology to. They are different vehicles and different ways advisors can access us to deploy our form of asset management to their client portfolios. For instance, our SMA platform, which we call SPACE, allows advisors to build or strengthen portfolios for their clients using the h-factor.
Hortz: How exactly do you work with advisors and what are the specific benefits you offer them?
Koski: We provide our SPACE SMA platform for free as a value-add tool to our advisor community. We do that because I have learned that the key to asset management today is not just good products and good performance. Those are table stakes. You have to provide a unique story and a unique service. When was the last time an advisor and their clients were told and offered something new or different?
With our SPACE platform you have a way to demonstrate a different investment service that clients have not seen before; something that makes sense and can help advisors grow their business by demonstrating the h-factor’s unique flexibilities and applications for your clients:
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Advisors can load their own portfolios onto this platform, and it will give a perspective on what names are causing under performance in their portfolios.
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A prospective client’s current portfolio could be placed on the platform and running an analysis can demonstrate specific areas of weakness and underperformance potential.
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Advisors can even apply our h-factor methodology to our competitor products to remove some of the stocks with a higher probability of failing to improve the overall performance of other products.
And that is what SPACE is all about. We can help advisors build their business in a different way with this platform. It is about extending their value proposition.
This offering is particularly timely as the S&P 500 is becoming a core holding of many passive investors, but they are being forced to own names that are going to underperform. And yes, the solution in the past was to go to active stock pickers, but in some respects, I think, based on relative performance studies like SPIVA and, as we just discussed, the potential of adding to the risk of assumptions and gambling on top of that. I believe that there are managers that are good at picking stocks but there are many that were trained to look at stocks a certain way. It is important to also add a different way of thinking. What we are saying is there is a better way, a better way of dealing with underperformance risk.
Related: Going Beyond Active and Passive Investment Thinking