The Risk/Return Tradeoff For Technology Stocks

Can I make 20% returns consistently in technology stocks? I was posed with this very simple looking question, but the more I thought about it the more I realized that the answer was not simple.

The problem here is how do we define ‘consistently’? We know it is cannot be ‘guaranteed’ because that would be ‘risk-free’. So it boils down to how much risk (read - portfolio fluctuation) you are willing to take before you bail out of your stocks. To answer this question I looked back last 10 years and collected 506 tech companies that satisfy the following criteria

1. The company is in the ‘Technology Sector’
2. The stock was trading from Jul 1997 till Jul 2007, That means no new IPO companies like Google (GOOG) were considered.
3. The stock was traded in NASDAQ, NYSE or AMEX market (no OTC).

So I should point out that there is some ’survivor bias’ in our collection logic, and we are also ignoring companies that merged or were bought out. The following chart shows the Risk vs Return Efficient Frontier for these 506 stocks.

click to enlarge

Average Annual Returns of Technology Stocks from Aug 97 to Jul 2007

Let me point out some interesting observations.

1. If you held all these companies in your portfolio for all the 10 years (and invested equally in all of them in Jul 1997) your average annual return will be 24% (Yeah!) but you will see very large fluctuations in your fortune (i.e will take a lot of risk). Your annual returns for the entire portfolio will fluctuate from 107% (in year 2000) to -25% (years 2001, 2002).
2. In the same period the S&P500 companies returned only 10% but saw lesser fluctuations.
3. The more interesting observation is made when you compare the individual stocks with S&P 500 risk/returns. Look at the stocks above the red dotted line passing S&P500 point. All the stocks above this line are those stocks which give better risk/return tradeoff compared to S&P500.
4. The stocks closer to the top curved efficient frontier line are better performing stocks than those below them.

So to summarize, yes you can make 20% in Technology stocks (looking at history) if you have a stomach to stay in the market. You also need to select a broad basket of stocks. I have not thought how you could have identified the winner stocks ahead of time, but for the curious here is the list of stocks that did better than S&P500 risk/return tradeoff. A lot of unknown names here for me, and more importantly most of the names I would have thought to be here are NOT! So there is a high chance that we may end up picking the wrong stocks.

Winning Stocks

Ansys Inc (ANSS)
Electronic Arts Inc (ERTS)
Apple Inc (AAPL)
Quality Systems Inc (QSII)
Scansource Inc (SCSC)
Factset Research Systems Inc (FDS)
Daktronics Inc (DAKT)
Mesa Laboratories Inc (MLAB)
Comtech Telecommun (CMTL)
Intuit Inc (INTU)
Anixter Intl Inc (AXE)
Progress Software Corp (PRGS)
Napco Security Systems Inc (NSSC)
Symantec Corp (SYMC)
DST Systems Inc (DST)
Affiliated Computer Services (ACS)
Innodata Isogen Inc (INOD)
Aeroflex Inc (ARXX)
Epiq Systems Inc (EPIQ)
Micros Systems Inc (MCRS)
Rimage Corp (RIMG)
Amphenol Corp (APH)
Ansoft Corp (ANST)
Cam Comm Solutions Inc (CADA)
THQ Inc (THQI)
O I Corp (OICO)
Caci Intl Inc (CAI)
Polycom Inc (PLCM)
Yahoo Inc (YHOO)
Cass Information Systems Inc (CASS)
National Instruments Corp (NATI)
Diodes Inc (DIOD)
Adobe Systems Inc (ADBE)
Fiserv Inc (FISV)
Citrix Systems Inc (CTXS)
CDW Corp (CDWC)
Measurement Specialties Inc (MEAS)
Manatron Inc (MANA)
Microsemi Corp (MSCC)
Silicom Ltd (SILC)
NCR Corp (NCR)
Rofin Sinar Technologies Inc (RSTI)

Comments

[Werlingdervish]

Is there a caveat here. Some Questions. Why are my highly speculative PANL and TIVO stocks slightly rising while my cash rich quality stuff and recently high risers are being hammered? On a broader question why are bread and butter companies, i.e. consumer retailers that normally survive bad times, going down in a supposedly good economy with high employment? And why are the precious metals going down also? I think that the dirty, no-longer-secret truth is, that the highly leveraged fund managers are exiting their over extended borrowing and lending practices by selling the hard earned cash value of their best stocks (our profits) in order to survive.

More to the point about Apple, the survival mind set of the hedge fund manager is to take the profits in cash or commodities for their credit bailout by selling the most valuable things in the house first before they are foreclosed on by their international banking creditors. They will publically attribute this large sale of profitable companies as profit taking and are praying that JQ public will not realize what a sh*t bag of a financial mess they have created.