By The Numbers: High-Quality Stocks In Technology

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Includes: AAPL, ADBE, AEIS, AMAT, ANET, ANSS, ATHM, AVGO, BIDU, CDNS, CGNX, COHR, EA, ESIO, FB, FFIV, FISV, FNJN, IDCC, INTU, IPGP, ISNS, ITRN, JKHY, KLAC, LRCX, MA, MANH, MOMO, MTCH, MU, MXIM, NVDA, NVMI, OLED, ORBK, PAYC, PAYX, RHT, ROI, STMP, TSM, TTD, TXN, UBNT, V, VMW, VRSN, XLK, XLNX
by: Andres Cardenal, CFA

Summary

Investing in the tech sector can be a double-edged sword. Tech companies can produce massive returns for investors, but the sector is also particularly risky and volatile.

In order to find the right names in the sector, the following article is presenting a quantitative system based on selecting tech stocks with superior profitability levels.

Profitability is clear sign of fundamental quality and underlying strength at the business level.

Backtested performance for the quantitative system is quite attractive.

The numbers alone don't tell the whole story behind a stock, but making investing decisions based on quantified data is a far sounder approach than relying on opinions and speculations.

The technology sector is fertile ground for growth and innovation, and many of the most profitable stocks in the market come precisely from the tech sector. On the other hand, tech stocks also are quite volatile, and they operate in an always changing and aggressively competitive environment. This makes the tech sector more risky and unpredictable than other areas of the market. Selecting the right names is always important, but especially more in technology, where the dispersion in potential returns can be huge.

The following paragraphs are introducing a quantitative system focused on selecting high-quality stocks in the tech industry. The main idea is not that investors should build a complete investment thesis on a stock based solely on the quantitative indicators, you still need to analyze the business behind the numbers in order to understand the main risks and the key return drivers.

However, quantitative indicators can be enormously valuable tools to make better investment decisions by focusing on cold-hard objective data as opposed to subjective opinions and speculations.

Looking For Quality In The Numbers

Most investors would agree on the fact that high-quality stocks can be remarkably profitable investments in the long term. However, finding such stocks is easier said than done. Like beauty, quality is eye of the beholder to some degree, and the concept of quality includes many variables which are hard to measure or quantify.

That notwithstanding, quality can also be analyzed in numerical ways, and business profitability is one of the most important indicators of underlying quality. There is a clear and direct relationship between business profitability and shareholder returns. If all other variables are the same, the more profitable the business, the higher its ability to create value for investors over time.

Besides, consistent profitability says a lot about a business. In a free market economy, success attracts the competition, and competition erodes profitability levels over time. If a company is consistently making above-average profitability, this generally indicates that it has superior fundamental qualities such as differentiated brand, better technology, or a more innovative management team.

The quantitative system is based on a ranking algorithm; this is essentially different from a screener. A screening system will invest only in companies that meet a specific parameter - for example, the return on assets ratio is over 5% and the operating profit margin is above 10%.

A ranking system, on the other hand, will rank companies in a particular universe based on return on assets and operating margin and will invest in the companies with the higher ranking based on an average of those two indicators.

There are basically two ways to measure business profitability. Profitability on capital measures how much money the company makes on its assets, shareholder equity, or invested capital. Alternatively, profit margins measure how much money the company makes as a percentage of revenue at different levels, considering ratios such as gross profit margin, operating margin, and free cash flow margin.

The ranking algorithm includes both kinds of profitability indicators. In particular, it covers return on investment (ROI), return on assets (ROA), return on equity (ROE), gross profit margin, operating margin, and free cash flow margin.

Summing up, the ranking algorithm averages down six profitability metrics to reach an average profitability score for all companies in the investable universe. The system then invests in the companies with the highest combined profitability ranking.

Backtested Performance And Recommended Portfolio

The backtest portfolio builds an equally weighted and monthly rebalanced portfolio with the 50 stocks with the highest profitability scores in the tech sector. The portfolio is equal-weighted and monthly rebalanced, and it's assumed to have an annual expense ratio of 1% to account for trading expenses and similar considerations. The benchmark is the Technology Select Sector SPDR ETF (XLK).

The backtested performance numbers are quite encouraging. Since January of 1999, an investor following the portfolio recommendations from the quantitative system would have obtained an average annual return of 13.64%, far surpassing the 5.08% annual return produced by the benchmark in the same period. In cumulative terms, the system gained over 1,108% during the backtesting period, while the Technology Select Sector SPDR ETF gained a much smaller 162.8%.

Data from S&P Global via Portfolio123

Importantly, the system also outperforms the benchmark in terms of risk-adjusted returns. The Sharpe Ratio for the quantitative system is 0.54, more than double the 0.23 Sharpe Ratio offered by the Technology Select Sector SPDR ETF. Offering a similar perspective, the system has a Sortino Ratio of 0.77 versus 0.3 for the benchmark.

Past performance does not guarantee future returns, and investors should always do their own research before making any decisions in the markets. That acknowledged, a list of tech companies with superior profitability can be a valuable source of potential ideas for further research.

The table below shows the 50 stocks currently selected by the quantitative system. For illustrative purposes, data in the table also shows return on assets, return on investment, and operating profit margin for the companies in the quantitative portfolio.

Name

ROA%

ROI%

Operating M.

Adobe Systems (ADBE)

15.19

21.88

31.97

Advanced Energy Industries (AEIS)

20.56

29.08

29.93

ANSYS (ANSS)

9.74

12.13

36.03

Apple Inc (AAPL)

15.19

22.91

26.7

Applied Materials Inc. (AMAT)

17.26

25.49

28.19

Arista Networks Inc (ANET)

21.45

30.88

30.04

Autohome Inc (ATHM)

20.26

29

34.82

Baidu Inc (BIDU)

9.96

14.55

20.47

Broadcom Inc (AVGO)

20.95

27.44

N/A

Cadence Design Systems (CDNS)

8.92

13.41

17.86

Check Point Software Technologies (NASDAQ:CHKP)

15.13

22.61

49.88

Cognex Corp. (CGNX)

14.27

16.16

32.78

Coherent Inc. (COHR)

10.77

15.64

22.75

Electro Scientific Industries (ESIO)

38.89

53.07

25.37

Electronic Arts (EA)

12.8

20.15

27.84

F5 Networks (FFIV)

17.59

35.79

27.77

Facebook (FB)

22.65

25.55

50.12

Finjan Holdings (FNJN)

57.09

87.6

45.59

Fiserv Inc. (FISV)

14.18

20.83

26.7

Henry (Jack) & Associates (JKHY)

19.82

29.88

25.51

Image Sensing Systems (ISNS)

19.12

27.99

15.29

InterDigital (IDCC)

9.76

15.9

56.61

Intuit (INTU)

22.05

47.83

26.95

IPG Photonics (IPGP)

17.23

19.44

40.35

Ituran Location and Control (ITRN)

20.43

35.31

24.21

KLA-Tencor (KLAC)

12.99

19.8

37.61

Lam Research (LRCX)

14.77

19.8

27.92

Manhattan Associates (MANH)

37.31

74.99

30.03

Mastercard (MA)

20.84

38.51

54.15

Match Group (MTCH)

19.9

27.26

29.04

Maxim Integrated Products (MXIM)

10.1

14.13

33.77

Micron Technology (MU)

32.43

39.05

46.46

Momo (MOMO)

31.66

37.98

26.47

Nova Measuring Instruments (NVMI)

17.73

21.79

25.48

NVIDIA (NVDA)

36.26

42.34

35.99

Orbotech (ORBK)

12.09

15.72

15.49

Paychex (PAYX)

13.06

47.05

38.08

Paycom Software (PAYC)

5.83

30.58

19.46

Red Hat (RHT)

6.16

14.86

16.32

Skyworks Solutions (NASDAQ:SWKS)

19.61

22.23

34.29

Stamps.com (STMP)

24.45

28.36

35.44

Taiwan Semiconductor (TSM)

17.66

20.31

39.32

Texas Instruments (TXN)

24.2

28.59

41.61

Trade Desk Inc. (TTD)

9.2

24.31

22.71

Ubiquiti Networks (UBNT)

19.44

24.19

31.74

Universal Display (OLED)

13.72

16.47

42.86

VeriSign (VRSN)

18.2

61.6

61.06

Visa (V)

14.1

19.94

66.65

VMware (VMW)

7.08

12.12

23.43

Xilinx (XLNX)

10.46

13.55

30.66

The list includes many of the biggest and most recognized companies in the tech sector, covering names such as Apple, Facebook, and Visa, among others. This is to be expected since big and successful companies tend to generate superior profitability levels, and that's a major return driver for investors in high-quality stocks.

Disclosure: I am/we are long AAPL, MU, FB, LRCX, MA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.