Our quantitative tool to optimize stock picking

What’s the Downside Risk Alert?

The Downside Risk Alert, or DRA, is a proprietary financial indicator based on extensive fundamental research. It provides reliable and objective medium-term forecasts (from 3 to 24 months) of which stocks are most likely and least likely to underperform markets and helps investors making sound investment decisions based on objective quantitative factors.

The DRA is built on specific investment attributes encompassing valuation, financials, and sentiment that have been identified as warnings of poor relative stock returns. Most of metrics behind DRA’s research concepts are intuitive and validated by independent academics and researchers.

Below an overview of the factors taken into consideration for the DRA score calculation:

The output of the method is a single metric, the DRA composite score, which assesses stock’s probability of underperforming markets’ average. All the input factors are weighted and summed into the DRA score. The DRA score grades stocks from 1 to 10, 1 being the best-expected result with the lowest probability to underperform while 10 would be the worst grade. This indicator allows sorting stocks easily by risk profile.

The following charts present the risk and return by DRA Score. Historically the lower a stock’s current DRA composite score, the more likely that stock will over-perform in the future. Additionally, DRA also appears to be an excellent predictor of future 12-month stock price volatility as stock with the least DRA also record the least volatility:

DRA investment philosophy is to hold stocks with low DRA scores and to avoid stocks with high DRA scores. The illustration below suggests that an actively managed portfolio based on DRA could easily outperform markets:

Source: Actively managed portfolios holding 100 equal-weighted (+ or – 0.25%) stocks at all times. Monthly rebalancing. Stocks in DRA’s 1st decile purchased and held if DRA <5. If not, replaced by the stock with the best DRA score that wasn’t already owned. Transaction costs of 50bps. http://www.revelationir.com/wp-content/uploads/2020/02/Downside-Risk-Alert-Factsheet.pdf

DRA research concepts were chosen and calibrated in such a way that it provides a relatively stable indicator. This gives money managers time to review scores periodically and minimize portfolio’s turnover over long-term investments:

Source: http://www.revelationir.com/wp-content/uploads/2018/08/Downside-Risk-Alert-U.S.-and-Intl-FAQ.pdf

How do we use it?

The DRA score acts as a first filter when choosing stocks for our funds.  It isolates probable underperformers and confirms or veto potential purchase/sell decisions. Our investment universe is limited to stocks with DRA scores below six before additional screening with other selection criteria. This strategy aims to optimize the chances of over-perform benchmarks. Weekly, we monitor DRA scores of all stock held in portfolios and apply strict rules by removing shares with deteriorating DRA scores, replacing them with improving ones.

Investors tend to focus on losers in a portfolio, meaning that avoiding them and minimizing losses is crucial. DRA has generally been efficient in separating relative winners and losers. Indeed the power of DRA is to identify “high risk-low return” stocks to avoid and “low risk-high return” stocks to consider buying.

The DRA research also allows us to evaluate new research ideas and identify investment opportunities.

This research tool offers us stock-specific risk-oriented insights into our portfolio management strategies. It helps to reduce behavioral biases (emotion-driven decisions) and improve equity portfolio performance while saving research time and portfolio’s volatility.

 

Louise Laborde
Senior Portfolio Analyst

To learn more:
info@kb-familyoffice.com

 

September 2020

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