Investing in “new” technology stocks could be especially rewarding as we shift from “up-market” to “bull market.” My previous article described why.
The challenge of investing in new technology companies is that they often are not well known plus they look overpriced. Moreover, risk is high. We have seen competition or failure to implement kill many a promising company.
However, the rewards can be high, so new technology stocks are a potentially a good investment area. How to select holdings? I mentioned three sources:
Personal choice – Select stock(s) you understand and in which you have confidence
Technology/growth funds – Use professional managers (with extensive research departments) to select and create a diversified portfolio
Screening – Identify attractive-looking companies (this approach needs follow-up analysis to select desirable investments)
Today, I want to address that third choice. Screening can help identify potential winning new technology investments. In order to do so, though, we must alter our typical screening approach – the search for value.
Last year we had a special opportunity to screen for value stocks. Stock prices then climbed with investors picking up the bargains. See this article
for a list of my write-ups about value screening.
Some Screening Basics
Before we start, let’s discuss the important basics of doing effective screening.
First, pick good screening software. Use a screening program with reliable U.S. stock data and the ability to conduct the testing you deem important. During my career, I used Compustat – it is outstanding, but expensive. Now I use Financial Visualizations (finviz.com). This free online service has a large data set with very good screening capabilities. Results can be exported to a spreadsheet program. Lists, screens and portfolios can be saved for future use.
Second, plan out the screening process. Like when traveling, it’s important to have an itinerary. This means thinking through what’s important and the order of its importance. Hate the idea of a highly leveraged company in today’s economy? Then put a low debt test toward the beginning of your search.
A common mistake is to jump in, then add, change and remove criteria depending on the results that fall out. There is a time for that, but it’s at the end of the planned screening – not at the beginning. Otherwise, you will likely turn off the computer with a head full of confusing results, no real knowledge gained and, worse, no attractive investments in hand.
Third, make the screening process abundant. Picking only one or two measures, especially if set at extreme levels, guarantees finding oddball stocks that happen to have wildly desirable characteristics. However, any in-depth analysis quickly shows the underlying problems and the investment’s undesirability.
Screening for "New" Technology Stocks
Now, let’s discuss how to identify potential new technology winners. Here’s where we need to ignore our value screen thinking. We’re no longer looking for bargains because growth stocks that are cheap mean something is not going right. We want success.
Note: Some screens may seem somewhat low (or easy). I prefer not to set the criteria too high. There can be companies that pass all the screens except one, narrowly missing a high cut-off. The screening will remove that stock, even though we might have been interested. By dropping the hurdles, we may get some weaker companies, but we can always delete those from consideration afterwards.
Starting with the FinViz.com database of 5,051 issues (excluding exchange-traded and closed-end funds), here is how the screening progressed (bold numbers show the number of companies that met the requirements).
First, here are some “non-screens” – criteria that are not necessary to finding successful new technology companies:
The company’s location – Technology skills and innovation are not limited to the US. Requirement: Country = any
The company’s size – Market capitalization is not a criterion of success. Requirement: Market Cap = any
The company’s inclusion in the Standard & Poor’s 500 Stock Index – Up and coming companies are often not yet in the market index. Requirement: Index = any
Now, let’s narrow down the stock universe.
The company is in the technology field – Requirement: Sector = technology. 924
The company’s capital is mainly equity – New technology companies rarely use long-term debt. Requirement: LT Debt/Equity < 0.1 (meaning long-term debt is under 10% of total capital). 557
The company pays no dividend – A new technology company should be retaining all of its earnings to reinvest in its profitable growth area. Requirement: Dividend yield = 0%. 488
Next, let’s bring in success measurements.
Past earnings growth – Even though the previous five years have been challenging, we want companies that had positive earnings growth. (This criterion also removes companies with short histories. While these stocks can be desirable, they carry added risk and require more in-depth analysis.) Requirement: EPS Growth Past 5 Years >0%. 215
Short-term earnings growth forecast – Good growth seen for near-term. Requirement: EPS Growth Next Year >10%. 152
Long-term earnings growth outlook – Good growth seen for future. Requirement: EPS Growth Next five Years >10%. 132
Desirable profitability – We want companies that earn higher levels of profit from their sales. Requirement: Net Profit Margin >10%. 75
High shareholder return – We also want earnings to represent a good return for shareholders. Requirement: Return on Equity >15%. 45
Now we can bring in valuation. Here is where we flip value screening on its head. We don’t want an attractive valuation. In a successful, growing company. It is a sign of risk, not opportunity.
Current price/earnings (P/E) ratio is high – Investors are willing to pay up for successful companies. Requirement: P/E >15. 31
Forward price/earnings (P/E) ratio is high – Investors also are willing to pay up based on next 12 months earnings if they see even more growth after that. Requirement: Forward P/E >10. 31
The last item is a technical indicator. The stock should be exhibiting a positive trend.
Price above the 200-day moving average – This measure takes the last 200 daily closing prices and averages them. If the current price is above that average, it tends to confirm that the stock is rising. Requirement: 200-Day Simple Moving Average (SMA) – Price > SMA. 30
The Screening Results
Below are the 30 companies that passed the screens. Also included are the five technology stocks in the Dow Jones Industrial Average. The red numbers show where those DJIA stocks didn’t pass a screen.
Click to enlarge charts
In spite of their sizes, Apple (NASDAQ:AAPL
) and Google (NASDAQ:GOOG
) continue to pass these screens. What’s valuable is the screening can reveal smaller, less-known companies that share the same desirable characteristics. In addition, we get a database of comparisons for other technology companies.
Besides providing us with 30 stocks to examine, there are some interesting points in this list:
- While all are in the technology sector, they are scattered across many “industry” categories. (Some categories might seem too narrow – e.g., Apple’s “personal computer” – but that is not unusual in the technology field where companies and “industries” evolve.)
- By allowing all countries, we get six added companies: Three from China, two from Israel and one with a Bermuda registration.
- The wide spread of market cap size is typical of new technology companies, their industries and their product/market focus.
- Note that the companies with the highest EPS growth for the past five years have reduced forecast growth rates for the next five (still good, but less). This reduction is caused by two factors: (1) analysts typically use models that project a return to “normal” (i.e., lower) growth rates and profitability and (2) analysts cannot forecast new products and markets that produce new growth (think Apple).
Two observations about the five DJIA technology companies:
- The numbers aren’t “bad,” but their projected growth rates are about one-half of the 30 screened stocks. This difference helps explain why the Dow stocks’ valuations look attractive.
- Their ROEs look great – better than the 30 screened stocks. However, for leveraged companies, ROEs can be misleading. Unlike the screened companies, four of the five Dow stocks (not Intel (NASDAQ:INTC)) use a significant amount of long-term debt (especially IBM (NYSE:IBM)) that inflates the ROE numbers. For those, we need to look also at return on assets (ROA). The picture of these companies changes significantly by doing so:
Cisco (NASDAQ:CSCO) – ROE = 17% ROA = 10%
HP (NYSE:HPQ) – ROE = 22% ROA = 8%
IBM (IBM) – ROE = 65% ROA = 13%
Intel (INTC) – ROE = 25% ROA = 20%
Microsoft (NASDAQ:MSFT) – ROE = 44% ROA = 24%
Next Step: Analysis and Selection
Next comes the analysis of the screened stocks with the objective of identifying those that look especially desirable. This analytical step involves reading research reports, company information and insights from others (like write-ups at Seeking Alpha). Each investor then uses his/her knowledge and experience to match a company with his/her goals and comfort level.
An additional approach I find especially helpful is technical analysis. No, not looking for patterns, but trying to understand a growth stock’s “personality” in order to evaluate potential return and risk. That will be the subject of my next technology growth article.
So, screening can be fruitful in identifying growth companies. The key is to search for those characteristics that typically accompany such stocks and not expect to find bargains.
Disclosure: I am long AAPL, INTC.
Additional disclosure: Intel position is for income. Apple position is for new technology growth. None of other screened stocks has been selected for purchase yet. (I am in analytical process.)