Matthew Waterman, Investment Writer, New Age Alpha Jul 31, 2020 7:17:00 AM 11 min read Stock Insights

Alphabet Inc C (GOOG) Searching for Growth

Inside This Report:

The H-Factor System methodically identifies, measures and avoids stocks that erode returns. We believe Alphabet, the parent company of Google, is unlikely to erode your portfolio’s returns.

Alphabet’s H-Factor is 1.9%. Thus, according to the H-Factor, there is a 98.1% chance the company will deliver the growth to support the stock price.

Investors think in terms of picking winners, when their goal should be to avoid the losers. We believe stocks with high H-Factor are more likely to be losers.

Other stocks in Alphabet’s Industry Group have higher H-Factor. Consider replacing such companies with Alphabet’s stock.

(All information as of July 31, 2020 unless otherwise noted)

Alphabet Inc: Searching for Growth

The pandemic has created wholly unique hazards in the market, some never before seen in the history of investing. Conflicting anxieties battling it out in investors’ minds include the obvious economic devastation of the pandemic, the various forms of stimulus from central banks, the rise of the retail investor and so many other assorted themes and theories. Yet, amid this plethora of vague and ambiguous information, the FANMAG stocks (Facebook, Apple, Netflix, Microsoft, Amazon, Google) have escaped largely unscathed. In fact, as a group, both their share prices and their dominance of the S&P 500 have skyrocketed. By the end of June 2020 these six stocks represented approximately a quarter of the total market capitalization of the index.3

Unique among them, Alphabet Inc. (GOOG), the parent company of Google, has risen with the least clarity, however. While its stock performance is not unimpressive, it nonetheless lags behind its trillion-dollar market-cap peers. Apple, Amazon and Microsoft, for example, are all up more than 30% year to date while GOOG has returned only 12%. Some suggest GOOG is stalling—with a saturated market and its dominance over the mobile and web advertising markets, the company’s growth prospects are increasing limited. Yet others contend this outlook is provincial and relies on outdated models for low profit margin companies that don’t apply to Alphabet. Where does the truth lie? Let’s start by investigating how the company delivered historically.

In July 2007, Fortune published an article titled, “Don’t go gaga over Google,” in which the author argued, “The business is a dynamo. The stock is a pipe dream.” The author explained that, since the info-based economy doesn’t have high capital requirements, all the earnings the company generated couldn’t be reinvested and allowed to compound. Thus, Alphabet would need to grow its economic profit (that is, the return on capital minus the cost of capital in dollars) by $2 billion per year to justify its share price at that time.

H-Factor1 vs. GOOG Price

Well, here we are thirteen years later and how has GOOG done? It has indeed grown its economic profit by $2 billion per year. And then some. In 2019, for example, at least $25 billion of the company’s $40 billion pre-tax income was economic profit, dependent upon one’s assumptions about the company’s cost of capital. GOOG has not only done what Fortune claimed it couldn’t, it has rebutted the argument that internet companies cannot grow in perpetuity. The stock, incidentally, is up nearly 500% over that same time span.

Chalk one up to those claiming the low-margin models are outdated when applied to Alphabet. We now know that—historically, at least—GOOG has delivered the growth needed to support the stock price. Nevertheless, pessimistic views of GOOG’s growth have persisted, sometimes suppressing the stock price. In fact, we see evidence of this when examining the company’s H-Factor.

NAA_Google-01

Source: Yahoo Finance, New Age Alpha as of July 31, 2020.

H-Factor1 vs. GOOG Price

The H-Factor is a risk that comes from humans interpreting vague and ambiguous information in a systematically incorrect way. By zeroing in on the H-Factor, this allows us to focus on what we do know for certain about a stock. Rather than attempting to pick winners, we simply try to avoid the losers. Below is historical analysis showing the H-Factor of GOOG relative to its stock price.

As it stands now, GOOG, despite a 12% appreciation in its stock this year, has experienced a notable decline in its H-Factor from an already low 6.6% at the beginning of the year. This is important because the H-Factor speaks to the probability that the company will fail to deliver the growth to support its stock price. A declining H-Factor in combination with a rising stock price, particularly amid the uncertainty created by the pandemic, suggests the company continues to deliver the growth it needs. In this regard, the market may be underestimating Alphabet yet again.

The key to this conclusion is focusing on the known, rather than the unknown. As noted earlier, Google has historically proven doubters wrong by subverting their notions of growth. Doubters suggested there was nowhere else for the company to grow. But consider:

• In 2006, Google acquired YouTube, which would become the predominant free online video distributor
• In 2011, Google acquired Motorola, a defensive purchase to protect against Microsoft and Apple 
• In 2013, Google acquired Waze, building on its existing geo-mapping capabilities

H-Factor1 vs. GOOG Price

Before and after Google restructured to become Alphabet in 2015, the company continued to pioneer the field of artificial intelligence, while also continuing to grow revenue as the world became ever-more dependent on its existing technologies. Clearly, the doubters had a flawed definition of the word, “growth.” Rather, these investors would’ve done well to reimagine the very large profit margins a company like Alphabet possess and its impact on valuation. This is exactly why it’s critical to eliminate the impact of human behavior and examine the probability that a company’s growth will support its stock price.

 

NAA_Google_2-01

Price Data: Provided by Bloomberg as of July 31, 2020


H-Factor Data: Provided by New Age Alpha as of July 31, 2020

The historical H-Factor Information cited above is being provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security.

H-Factor1 vs. GOOG Price

Using New Age Alpha’s H-Factor System to take a broader view of the industry, we see an interesting development regarding Alphabet. GOOG’s H-Factor is very low at 1.9%. This H-Factor as of July 31, 2020, suggests there is a 98.1% probability the company will deliver the growth to support its stock price. And, among its peers in the Interactive Media & Services Industry, the H-Factor of both Facebook and Twitter are also low at 2.2% and 3.2%, respectively, suggesting they are similarly strong investment options. Among their peers in the Media & Entertainment Industry Group, however, the situation is much different. Facebook, Twitter, and Alphabet, with some of the lowest H-Factor scores, sit atop the rankings of 19 companies in this group. Meanwhile, DISH Network Corp. resides at the bottom (not shown) with an H-Factor of over 90%.

We believe companies like DISH Network should be avoided. This is one of the supreme benefits of the H-Factor System. Remember, investors think in terms of picking winners, when their goal should be to avoid the losers. The H-Factor System methodically identifies, measures and avoids stocks that erode a portfolio’s returns.

How to invest using the H-Factor2

We argue that it’s imperative to compare peer companies and isolate those with more certainty regarding their ability to deliver the growth to support their stock price. If formerly the investor had chosen DISH Network for its exposure in the Media & Entertainment sector, GOOG might be a better option. Just like Facebook and Twitter, we believe each represents an investment with a higher probability of delivering.

Importantly, it’s worth remembering that investment isn’t necessarily a zero-sum choice. Just because Alphabet has a slightly lower H-Factor doesn’t mean an investor should abandon Facebook outright. Both Alphabet and Facebook, with such low H-Factors, can be winners. The key point is to strip out the human behavior—the H-Factor—that erodes the alpha in your portfolio.

At New Age Alpha, we don’t try to guess winners, we simply avoid the losers. We seek to do this by using the H-Factor to measure the amount of vague and ambiguous information that has been interpreted in a systematically incorrect way. We believe that stocks with a high H-Factor are unnecessarily risky and should be avoided. Remember, a good company at the wrong price will be a bad investment and a bad company at the right price will be a good investment.

Try the H-Factor System for Free

210112_NAA_blog_HFS banner_transparent-01 (1)

Analyze your investments and empower yourself to ask the right questions. How much of your portfolio is subject to the H-Factor? With H-Factor scores for over 5000 stocks globally, use the H-Factor System to analyze, construct and audit portfolios that avoid the H-Factor.

Try the H-Factor System


Appendix

1The H-Factor

The efficient market hypothesis holds that all information both the known (financial statements) and vague and ambiguous information is priced into a company's stock. Humans may interpret vague or ambiguous information in a systematically incorrect way causing mispricing. The H-Factor measures the amount of vague and ambiguous information priced into a company’s stock. The H-Factor is a probability measured from 0% to 100% and the higher the H-Factor the greater the chance of loss.

We look at risk very differently than many managers. Instead of worrying about volatility or beta, or any other risk measure for that matter, we focus on asking one question and one question only. Can the company deliver the growth implied by its stock price? The more vague and ambiguous information priced into a company's stock price, the harder it becomes for the company to deliver the growth implied by its stock price. We measure the company’s risk (the H-Factor) relative to the company’s fundamentals only; we remove the vague and ambiguous information from our determination. We believe the H-Factor is a risk that investors are unaware of, which erodes alpha, and they don’t get compensated for taking. We want to avoid this risk.

2How to invest using the H-Factor

The H-Factor is not to be used in absolute terms but rather on a relative basis. An H-Factor of 1.9% for Alphabet is very low, implying there is a high probability GOOG will deliver the growth to support its stock price. Therefore, if an investor is seeking an option in the Media & Entertainment Industry Group, it may be prudent to avoid other companies in this space with higher H-Factors. If you were to invest in the sector, we would suggest weighting your portfolio by H-Factor, therefore attributing more of your portfolio to companies with a lower H-Factor. We believe some of the companies in this sector with high H-Factors have been priced based on analysis of vague and ambiguous information making it difficult for these companies to deliver the growth to support the stock price.

The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. Past performance is not a guarantee of future results. These statements and views are for informational purposes only and do not represent actual portfolio results, but rather it is intended to show the application of the H-Factor to an actual security. The views stated herein are only current through the date stated and are subject to change at any time based on market or other conditions and New Age Alpha disclaims any responsibility to update such views. At the time of this publication, New Age Alpha has a position in GOOG in one or more of its funds but did not have a position in it for the entire period stated herein. New Age Alpha typically holds securities in its portfolio only if it becomes part of the established universe of eligible securities that are part of each specific investment strategy (e.g. the S&P 500®). It is important to note that there can be no guarantee that the application of the H-Factor to investment portfolios or certain stock or securities can produce profitable results. For full disclosure, click here.

September 2020