TIPs Summary for Investors

The ranking of stocks and investing with TIPs is based on a proprietary quantitative analysis model that generates the rate of return that can be expected over a three-month time horizon for each stock in a chosen universe.

TIPs combines fundamental factors such as earnings prospects, company growth rates, dividend yields, and price/book ratios with the technical patterns produced by TIPs to generate one overall rate of return projection. These projections are then ranked from highest to lowest to depict the expected performance of each stock.

In addition to generating a relative performance ranking, TIPs is also capable of computing a measure of the absolute expected return for each stock. This is depicted by a rating scale that uses the expected rate of return of Treasury bills as the standard unit against which acceptable performance is measured. To help with your investing choices the absolute ratings are classified as follows:

A     Excellent expected return
B     Acceptable expected return
C+   Moderately positive return that is expected to exceed that of T-bills
C-    Return that is equal to or moderately below that of T-bills
D     Moderately negative expected return
F     Most unfavorable

Investments in A or B-rated stocks are regarded as being worthwhile holdings in the sense that they are expected to significantly outperform treasury bill returns although the A rated are obviously regarded as the better candidates for purchase. We would avoid or sell C-, D or F rated stocks since they are expected to under-perform treasury bills.

There is no requirement that a certain percentage of stocks in the universe must be assigned a given rating. It is possible, for example, that all stocks could be rated A or F. Such a condition might suggest that the overall stock market is very attractive (or unattractive). Investors who are willing to vary the allocation of their portfolios between equities and money market securities based upon the ability to find stocks with very attractive returns may use the absolute ratings as a guide to equity exposure. Investors who wish to be fully invested in equities at all times, on the other hand, may use the relative ranking as a guide as to which securities are expected to perform relatively the best (or the worst) under any general market condition.

One way to rank or value stocks is to calculate the total rate of return (r) that they are expected to produce. The most general formula that maybe used to make this calculation is as follows:

Most conventional valuation models currently employed in the investment community are actually special cases of this general model as is shown below:

Special Case #1: P/B always equals 1



Thus investors who use the P/E ratio as a standard of value are actually using a special case of our general model. Furthermore, this special case is not very realistic since it is clearly not true that stocks will always gravitate to a P/B ratio equal to one.

Special Case #2: Change in P/B equals O



The dividend discount model that is the most conventional model used to value stocks is also seen to be a special case of our general model. It uses the (unrealistic) assumption that, over the long run, a stock's P/B ratio will not change.

Only the general model permits stocks to be valued correctly taking into account their level of earnings and cash flow, the growth in their cash flow and potential changes in their P/B (or P/E) ratio.

The General Model Requires:

1. A forecast of earnings to get a forecast of ROE

2. A forecast of company growth (g)

3. A pricing function to indicate degree of cheapness or dearness. This can be a P/E ratio. However, P/E ratios can be very volatile (being negative if earnings are negative, rising to infinity if earnings are zero, and so forth). P/B ratios are more stable and they are related to P/E ratios based upon the following relationship:


Therefore, P/B ratio is as good a value standard as P/E and it is less volatile.

4. Change in P/B ratio. This has been the most significant problem for traditional methods of analysis. Analysts can estimate ROE and g based on fundamentals. They tend to have difficulty estimating change in P/B or change in P/E. Consequently, most earning and dividend discount model formulations conveniently ignore the problem by assuming it away (change in P/B =0). Therefore, fundamental analysis ends up being a valuation that uses a special case assumption.

If some way could be found for estimating change in P/B, the general valuation formula could be used and there would be no need to use special cases that require unrealistic assumptions. This is what TIPs does.

CAVEAT : There is no magic in TIPs. It produces estimates of the change in P/B function. Estimates of anything whether change in P/B, ROE, or g are just as good as the data that goes into them. Therefore, the TIPs model that employs the general valuation formula is not infallible. It is vulnerable to bad estimates of ROE, g, and change in P/B just like fundamental analysis is vulnerable to bad forecasts. But, isn't it better to use a valuation model that incorporates all of the variables that determine value than one that does not? If TIPs is only reasonably successful in addressing the change in P/B problem, it represents an improvement over a purely fundamental technique.

To our knowledge, TIPs is the only quantitative approach that combines both fundamental and technical analysis into one quantitative rate of return formula without requiring an arbitrary weighting between the two.