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I am a retired engineer with a PhD in Engineering Science (mostly exotic math) together with a Masters in Statistics. I currently manage my website www.superchargeretirementincome.com, where I use my math background to select high-return, low-volatility investments. I also love teaching so I... More
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  • Selecting The Best Technology Stocks 0 comments
    Feb 24, 2014 8:40 AM | about stocks: AAPL, AMZN, CSCO, GOOG, IBM, INTC, MSFT, ORCL, QCOM, XLK, YHOO

    Technology has been an exciting but volatile sector over the past three decades. In the 1980's, the mainframe computer was replaced by the personal computer and Microsoft (NASDAQ:MSFT) began to dominate the operating system market with the introduction of Windows. The 1990's were the "go-go" years as the internet became of age and all "dot com" companies flourished. The bubble finally burst shortly after the beginning of the millennium and hundreds of companies went out of business. However, some of the strongest, like Amazon (NASDAQ:AMZN), not only survived but thrived and have become dominant players over the more traditional "brick and mortar" businesses. New products such as cloud computing, mobile phones, and social networking are changing the way we work and communicate. Today, technology is one of the largest segments of the economy and technology companies make up the largest sector of the S&P 500, weighing in at 20.7%.

    Most people love new technology but has it been a good investment? In this article I explore the risks and rewards associated with some of largest technology companies. The technology segment is huge so I have limited my analysis to a few of the largest players that have become household names. I apologize in advance if I did not include your favorite company.

    Most investors focus only on the returns associated with these companies. However, as a retiree, risks are as important to me as returns. So I will define the "best" technology stock as the company that provides the most reward for a given level of risk, with risk being measured by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.

    The companies that I included in my analysis are as follows.

    • Apple (NASDAQ:AAPL). Apple has a sterling reputation for innovation and has invented products like the iMac, IPad, IPod, iTunes, and iPhone. Apple operates over 400 retail outlets, with 254 in the U.S. and the rest in international markets. It still has a robust product pipeline but the rate of innovation may have slowed. Pressure from Android based devices is continuing to grow. Apple initiated a $60 billion stock buyback program, which barely dents its estimated $170 billion in cash. Apple yields 2.2%.
    • Google (NASDAQ:GOOG). Google had an Initial Public Offering in 2004 at a price of $85. Since then it has exploded upward, with a current price north of $1100 per share. Google operates the world's leading internet search engine, which is so ubiquitous that "google" is the common phase when someone wants to search the web. Each day Google processes more than a billion search requests from around world (181 countries and 146 languages). In 2005, Google purchased YouTube, which has become the premier video-sharing website. Each month, YouTube has more than a billion unique visits that watch over 6 billion hours of video. With such high traffic, strong advertising revenue will likely persist for the foreseeable future. Google also is the developer of the Android operating system, which is a direct competitor to Apple's iOS on smartphones and tablets. Google offers free email accounts (called "gmail"), which have over 400 million active users, making this the world's largest email service. Google stock does not pay a dividend.
    • Amazon. Amazon is the largest online retailer, selling virtually every consumer item that can be shipped. Competitive pricing coupled with fast two-day fulfillment of orders has been Amazon's claim to fame. Amazon has been an innovator of online retailing and moved the country away from brick-and-mortar stores. As an example, Amazon was selling over 400 items per second in the run up to Christmas last year. With the development of the Kindle line of tablets, Amazon now provides competition to Apple's iPads. Amazon's growth has been phenomenal but the profit margins have remained small as volume soared. The company does not pay a dividend.
    • Intel (NASDAQ:INTC). Intel is the dominant force in the semiconductor market and has an 80% share of the microprocessor market. It provides the famous "Pentium" chips for PCs as well controllers and memory chips. The proliferation of personal computers has greatly benefited Intel. Intel spends a massive amount on Research and Development (19% of sales), which keeps it ahead in processor performance. This provides an advantage in both the server and PC market. Recently Intel has begun penetrating the tablet and smartphone markets by developing an "Atom" chip, which uses cutting-edge technology to providing more computing power with lower power consumption. Intel has a nice dividend yield of 3.6%.
    • Oracle (NYSE:ORCL). Oracle is the world's largest enterprise software company and is a major developer of databases, software applications, and hardware servers and storage devices. It is dominant in the database and middleware business which provides dashboards and analytic programs to businesses. Once an Oracle database is installed, there is a high cost of switching to competing products, which provides Oracle with a competitive advantage over newer cloud based technologies. Oracle purchased Sun Microsystems in 2010, which provided Oracle with the rights to Java, a programming language designed for the distributed environment of the internet. It is estimated that up to 3 billion devices run versions of Java. Oracle has a dividend yield of about 1%.
    • Yahoo (NASDAQ:YHOO). Yahoo is globally known for its web portal that provides consumers with a multitude of data and services including a financial information, news, search engine, and email accounts. Yahoo has more than 800 million active users per month. Yahoo's main source of revenue is online advertising, including both display and search engine advertising. Yahoo also owns 24% of the Alibaba Group, the leading e-commerce company in China that operates a number of marketplace platforms. Alibaba is currently not a public company but could launch an IPO sometime in the future. Yahoo does not pay dividends.
    • International Business Machine (NYSE:IBM). IBM is a worldwide supplier of advanced information technology, communication systems, and business services. IBM is a leader in high-end mainframe computers and servers, infrastructure-management software for data centers, and long-term information technology services. IBM owns the Rational Rose product family of software tools that provide a popular integrated development environment for large scale software development. IBM operates in more than 170 countries and about 65% of its revenue is generated abroad. IBM pays a 2% dividend.
    • Microsoft. Microsoft is the largest independent maker of software. It develops the Windows Operating System used on almost all personal computers (except for Apple Computers) and is the developer of the industry leading Office suite of tools including a word processor (Word),a spreadsheet program (Excel) and a presentation program (PowerPoint). Over a billion people currently use office and over 200 million Windows 8 licenses have been sold. Microsoft has also sold over 3 million Xbox game consoles in 13 different countries. Microsoft pays a 2.7% dividend.
    • Cisco Systems (NASDAQ:CSCO). Cisco is a leading provider of switches and routers used to transport data across networks, including the internet. Cisco's Ethernet switches are ubiquitous in corporate data hubs. The explosion of cloud services has cut into Cisco's profits but the company is fighting back by entering new arenas like wireless enterprise networking and video conferencing. Cisco currently has $47 billion in cash and yields a respectable 3.1%.
    • Qualcomm (NASDAQ:QCOM). Qualcomm is not a household name like some of the other tech companies but every time you use a smartphone, you are likely using Qualcomm technology. Qualcomm has two main business segments. The first is licensing its Code Division Multiple Access (OTCPK:CDMA), which is the backbone of every 3G network. When a smartphone uses 3G, it must pay Qualcomm a royalty. The second business is developing the advanced "Snapdragon" processors used in high-end smartphones, like those from Apple and Samsung. The licensing account for about 71% of revenue and the rest is from the sale of Snapdragon processors. Qualcomm pays a 1.9% dividend.

    For reference, I have also included:

    • SPDR Technology Select (XLK). This ETF is a good proxy for the large-cap technology sector. It has 71 holdings, with the top constituents coming from the computer and peripherals subsector (25%) followed by IT services (17%) and software (15%). The top 5 holdings are Apple at 14%, Google at 9%, Microsoft at 8%, International Business Machine at 6%, and AT&T (NYSE:T) at 5%. The fund has an expense ratio of 0.18% and yields 1.7%.
    • SPDR S&P 500 (NYSEARCA:SPY). This ETF is a proxy for the overall stock market and contains all 500 stocks in the S&P 500. It has and expense ratio of only 0.09% and yields 1.8%.

    To begin the analysis, I wanted to assess performance over an entire market cycle so I chose a look-back period that began on 12 October, 2007 (the start of the 2008 bear market) and extended to the present. I utilized the Smartfolio 3 program (www.smartfolio.com) to plot the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each stock. The results are shown in Figure 1.

    (click to enlarge)

    Figure 1: Reward and Risk over bear-bull cycle

    The figure indicates that there has been a wide range of returns and volatilities associated with tech stocks. For example, Amazon generated a high rate of return but at the expense of increased volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each stock.

    The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of XLK, which is the broad based reference technology fund. If an asset is above the line, it has a higher Sharpe Ratio than the XLK. Conversely, if an asset is below the line, the reward-to-risk is worse than the XLK.

    Some interesting observations are apparent from the plot. First off, XLK had about the same performance as the S&P 500, in both return and risk. Generally, stocks were more volatile than the reference technology fund, which supports the well-known belief that investing in a basket of stocks is less risky than buying individual companies. IBM was the least volatile stock and had performance about the same as XLK.

    Looking at the red line we see that Microsoft and Yahoo were more volatile than XLK but investors were adequately compensated for the increased risk (both stocks had about the same risk-adjusted performance as XLK). Oracle, Google, and Qualcomm were tightly bunched on the risk-reward plot and all had good risk-adjusted performance. Apple and Amazon were by far the best performers over the bear-bull cycle, generating outstanding returns without substantial increases in volatility. The performance of Intel lagged by a small amount, being just below the red line. Cisco booked the worst performance, barely making a positive return over the period. So for the 6+ year since 2007, the "best" award goes to Apple and Amazon. These stocks have completely different business models but both performed exceptionally well.

    Next I wanted to assess how much portfolio diversification I might receive by investing in these stocks. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected stocks. The results are provided as a correlation matrix in Figure 2.

    (click to enlarge)

    Figure 2. Correlation matrix over the bear-bull cycle

    This data indicates that technical stocks are only moderately correlated with XLK and SPY (correlations in the 60% to 80% range). Even more surprising (at least to me) was that the different tech stocks were not very correlated with one another. I did not expect that result! For example, Apple was less than 60% correlated with the other large-cap tech companies. This data suggests that you can receive significant diversification benefits by adding several technology stocks to your general market portfolio.

    We have seen that most of the technology stocks funds had outstanding performance over the entire bear-bull cycle. Did this outperformance continue during the recent bull market? To answer this, I analyzed the past 3 year period and the results are presented in Figure 3.

    (click to enlarge)

    Figure 3: Reward and Risk for past 3 years

    During the past 3 years, the S&P 500 has been in a strong bull market and in general, the technology stocks have kept pace, with XLK having almost exactly the same performance (in both reward and risk) as SPY. Many of the individual technology stocks had absolute returns that were comparable to those of XLK but have fallen behind in risk-adjusted performance due to increased volatility. This was true of Qualcomm, Intel, Cisco, and Oracle, all of which lagged XLK in terms of reward-to-risk. IBM posted the worst risk-adjusted performance during this period.

    The other tech companies continued to shine during the period. Amazon and Apple dropped slightly in relative performance but still book excellent results in terms of both absolute return and risk-adjusted return. Microsoft was near the red line, with performance matching XLK. Google and Yahoo had the best performance during this period, with great absolute and risk-adjusted returns.

    Finally I looked at the past 12 months when the S&P 500 was in a rip-roaring bull market. The results were similar to the 3 year look-back period and are shown in Figure 4. It is interesting to note that performance of XLK and SPY were exactly the same (the green diamonds on the chart are literally on top of each other). Google and Yahoo were the only companies to outperform the indexes on a risk-adjusted basis. Apple fell back as you might expect since it had a relatively rough year. IBM had the worst performance, with returns slipping below the line.

    (click to enlarge)

    Figure 4: Reward and Risk for past 12 months

    Bottom Line

    The performance of the selected tech stocks depended on the look-back period but in general, most tech companies generated excellent absolute returns over the past few years. However, volatility has been high, so on a risk-adjusted basis, the performance has not been as impressive. Yahoo and Google are the only two companies that have been above the red line for all time periods analyzed. Amazon and Microsoft have also turned in above average performance but have faltered slightly over the past 12 months. No one knows what the future will bring but based on the past, tech stocks should be considered if you want to add diversification and performance to your portfolio.

    Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XLK, YHOO, GOOG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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