Concepts

In this section, we will answer the following questions:

 

1. Theory Behind the System

The theory behind the HRA Sell/Buy Model is to identify stocks with significant earnings growth and expectations that are undervalued by the market. And, of course, it is essential to buy these stocks before they become overpriced.

Knowing when stocks are overpriced became the first problem to be resolved by William A. Halvorson when he began his research in 1969. Because he was an active investor, who had studied investments at the University of Wisconsin, he was aware that market prices seldom matched book values, but were dependent more on current earnings and earning trends and expectations.

Companies with high recent growth rates in earnings were able to command a higher Price/Earnings ratio (P/E or PE) than the stocks whose earnings were stable. In searching for the rationale behind this accepted fact, Halvorson found that growth expectations, to a certain extent, could be quantified. He also discovered that the investor was not willing to assume that the company's recent growth would continue indefinitely. But instead, he found that investors would hedge their assumptions about earnings growth, and pay only a discounted present value of such hedged future earnings.

This present value, called the HRA Theoretical Market Price (TMP) thus would be based on three factors, namely:

  • 1. Current earnings for the latest 12 month period.
  • 2. The growth rate expected by a study of recent trends in earnings growth but hedged for projecting such growth trends in the future; and
  • 3. The discount rate, called the Desired Yield or DY, for determining the present value of future earnings. The level of the Desired Yield would depend on current inflation expectations, and the alternative yield that the investor could achieve by investing in long term corporate and government bonds. The DY or discount rate includes a margin for the additional risk inherent in stock investing, where there are no guarantees of results.

The current growth rate use by HRA in calculating the HRA Theoretical Market Price is a 4 year Actual - Projected Growth Rate, which uses the history of the stock's earnings over the last 4 years but gives extra weight to the change in earnings over the last year. Because of this extra weighting of the most recent change in earnings, HRA calls the growth rate a 4-year Actual - Projected Growth Rate or AGR. A growth rate of 1.000 means that HRA expects earnings to double over the next 4 years, based on past experience. An AGR of .60 would mean that earnings are expected to increase only 60% over the next 4 years.

2. Prime Factors Used

We have described the Desired Yield (DY), the Theoretical Market Price (TMP), and the 4-year Actual projected Growth Rate (AGR) in the previous section. HRA also found it valuable to use the following factors in our HRA Sell/Buy System:

    1. The trend in the growth rate, that is, are earnings slowing down or speeding up over the most recent year.
  • 2. Projected last 12 months earnings for a period ending 6 to 9 months into the future, as estimated by one or more of the major advisory services.
  • 3. Use of these projected earnings permits HRA to estimate a Future Theoretical Market Price in 6 to 9 months, called FTMP.
  • 4. The mean and standard deviation of each stock's Sell Index, which permits HRA to determine the 80% (approximately) confidence level of the stock's high and low range in the price, as compared with it's Theoretical Market Price Index.

All of the above factors are used by HRA for classifying stocks into either a BUY or SELL or HOLD Classification.

3. HRA Sell/Buy Classifications

BUY Class Stocks

At any one time, 20 to 40% of all HRA database stocks may be classified as BUY Class stocks.

BUY Class stocks have minimum AGR's, or 4-year Actual-Projected Growth rates, of at least 60% (.60). The current trend in their growth rates is such that HRA expects their AGR to remain over .60 for at least several quarters.

Not all BUY Class stocks will meet the needs of a particular investor since the price to buy it may exceed a person's willingness to take risks. On the other hand, if a stock price is abnormally low, it is excluded from the BUY Class.

SELL Class Stocks

At any one time, 25 to 30% of all HRA database stocks may be classified as SELL Class stocks.

SELL Class stocks are stocks with any level of growth, but are all priced higher that the market by a substantial margin, or are priced in excess of their respective 80% confidence level highs.

HOLD Class Stocks

Hold Class stocks make up 30 to 50% of all stocks at any one time, since the prices of these stocks, or their current growth rates, do not qualify these stocks as either a BUY or SELL. These stocks are expected to perform in line with the general market, since they cannot be evaluated otherwise by using HRA methods. It is HRA's recommendation that these stocks be replaced in any portfolio by stocks in the HRA BUY Class, in order to improve market gain expectations.

4. An Explanation of the Overpriced/Under priced Market Conditions

HRA has developed a measure of the extent to which the general market is over-priced or under-priced by looking at all 800 stocks we monitor. In a nutshell, the Over-Priced/Under-Priced Market Condition Index measures the extent of greed, optimism, pessimism, or fear in the market. We simply track the actual price to Theoretical Market Prices, the P/T ratios, and determine the mean and standard deviations for all of the stocks in our database. These standard deviations are used to measure market sentiment, or the Over or Under-Priced conditions of the market. This provides us with a reliable indicator for arriving at decisions on recommended investment levels.

We calculate this index every 2 weeks and will make this available to the financial markets free-of-charge on the front page of our web site.

5. Summary of How Best to Use our System

HRA studies show that the HRA classification separates the better performing stocks from those that cannot keep up with the averages. As we have discovered in all of our tests of the system, it is important for investors to have a fairly large number of stocks, such as 20 or more, to achieve the averages. It is also important to have a feel for whether the market is over-priced to such an extent that it is subject to a major correction. Our Over-Priced/Under-Priced Level index will help you determine when turns in the market, either up or down, are a high probability. We all know that you can make most of your money in a few months when the market condition is under-priced and you can lose most of your gains just as fast when the market condition is over-priced. Therefore, our final recommendation is to be careful, use the indices and analysis we provide to you, look at our top 30 stocks and top 6 stocks and then do your own research.

Good Luck Investing and Be Careful!