Value And Quality In Technology Stocks

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Includes: AAPL, ACLS, ADS, AEIS, AMAT, AVGO, CIEN, CMCM, COHR, CRUS, CYOU, DQ, DXC, ESIO, EVTC, FDC, FORM, HCKT, HOLI, ICHR, IDCC, IMMR, INTC, JCOM, KLAC, LITE, LRCX, LXFT, MKSI, MOMO, MU, NANO, NVMI, NXPI, ON, PRGS, QIWI, QTNA, SEDG, SGH, STX, SWKS, SYMC, TER, TSEM, TSM, UCTT, UEPS, WEB, XCRA, XLK
by: Andres Cardenal, CFA
Summary

Simplicity is the ultimate sophistication in the stock market, it all comes down to buying solid businesses for a convenient valuation.

Introducing a quantitative system focused on financial quality and valuation in the tech sector.

Backtested performance is quite encouraging.

Past performance does not guarantee future returns, but it makes sense to pick technology stocks based on hard data as opposed to subjective opinions.

Successful investing does not need to be too sophisticated. On the contrary, a simple and straightforward investing strategy can many times produce superior returns in comparison to a more complex approach. At the end of the day, it all comes down to buying solid businesses for an attractive valuation.

In that spirit, the following paragraphs will be introducing a quantitative system based on finding stocks with strong financial quality and convenient valuations in the technology sector.

The numbers alone don't really tell you everything you need to know to make an investment decision, it's important to understand the business behind those numbers in order to build a complete investment thesis. That notwithstanding, quantitative systems such as this one can be enormously valuable tools to make solid and consistent investing decisions supported by hard data.

System Design

The quantitative system is not too different in its essence to the main concept behind Joel Greenblatt’s excellent book: The Little Book That Beats The Market. The main point is relying on financial ratios and indicators to pick stocks based on a combination of financial quality and valuation metrics.

The system is based on a ranking algorithm that ranks stocks in a particular universe according to the quantitative variables considered. This algorithm is basically an average of two main factors: quality and value.

The quality factor is a combination of metrics that includes long term growth expectations, gross profit margin, free cash flow margin, return on investment and return on equity. A stock is basically a share in an ownership of a business, so the value of the stock ultimately depends on the value of the business. All else the same, companies with superior profitability levels and growth expectations tend to create more economic value for investors.

On the other hand, even the best companies can be mediocre investments when the entry price is unrealistically high. It’s important to check the price tag when buying stocks, and the value component of the ranking system includes ratios such as price to earnings, price to earnings growth, price to free cash flow, and enterprise value to EBITDA.

Summing up, the ranking system uses a combination of indicators to measure both quality and value, and then it builds a final “quality and value” ranking which is an average of those two factors. The theoretical portfolio is allocated to the companies that have the best “quality and value” ranking in a particular selection universe.

Leaving the mathematical details aside, it’s important to understand the simple rationality behind this quantitative system. In the words of Warren Buffett: “Price is what you pay and value is what you get”. The system uses different metrics to select companies based on quality and valuation together. In other words, we are trying to get as much value as possible for a comparatively low price.

Backtested Performance And Recommended Portfolio

The following backtest considers only companies in the technology sector, and it excludes over the counter stocks and companies with a market capitalization below $250 million to guarantee a minimum liquidity level. The simulated portfolio is allocated to the 50 stocks with the highest quality and value ranking, equally weighted and monthly rebalanced. The portfolio has an assumed annual expense ratio of 1% to account for trading commissions, and the benchmark is the Technology Select Sector SPDR ETF (XLK).

The backtested performance numbers are quite encouraging. Since January of 1999, the system gained 17.48% per year, more than tripling the 5.23% per year produced by the benchmark in the same period. The system also significantly outperformed in terms of risk-adjusted returns, the Sharpe ratio stands at 0.66 for the system versus 0.23 for the benchmark. System alpha over the backetesting period was 13.08%.

Data from S&P Global via Portfolio123

To put the numbers in perspective, a 100,000 investment in the Technology Select Sector SPDR ETF in January of 1999 would currently be worth around $271,500, and the same amount of capital allocated to the portfolio of tech stocks with strong financial quality and valuation metrics would have a much larger value of $2.26 million.

Without further prologue, the table below shows the 50 stocks currently picked by the quantitative system, ordered by market capitalization. Data in the table also shows market capitalization, forward price to earnings ratio, and return on assets to provide a quick reference on size, valuation, and profitability for the companies in the list.

Name

MktCap (Millions)

Forward PE

ROA%TTM

Apple (AAPL)

$946,342

16.65

15.19

Intel (INTC)

$241,901

12.95

9.08

Taiwan Semiconductor Manufacturing (TSM)

$211,229

17.75

17.66

Broadcom (AVGO)

$91,704

10.62

20.95

Micron Technology (MU)

$63,823

4.69

32.43

Applied Materials (AMAT)

$47,136

10.18

17.26

NXP Semiconductors NV (NXPI)

$35,552

15.26

4.06

Lam Research Corp (LRCX)

$29,179

10.19

14.77

DXC Technology Company (DXC)

$24,839

10.78

8.22

First Data Corp. (FDC)

$21,154

15.61

3.8

Skyworks Solutions (SWKS)

$17,429

13.47

20.11

KLA-Tencor Corp (KLAC)

$16,666

13.49

12.99

Seagate Technology (STX)

$16,211

10.61

8.91

Symantec Corp (SYMC)

$13,173

13.6

6.78

Alliance Data Systems (ADS)

$12,936

10.25

3.24

ON Semiconductor (ON)

$10,276

13.53

12.55

Momo (MOMO)

$9,142

18.02

31.66

Teradyne (TER)

$7,795

21.02

8.89

MKS Instruments (MKSI)

$5,525

12.27

16.13

Coherent (COHR)

$4,199

11.85

10.77

j2 Global (JCOM)

$4,194

14.33

5.82

Ciena Corp (CIEN)

$3,705

20.77

24.21

Lumentum Holdings (LITE)

$3,405

15.44

11.49

InterDigital (IDCC)

$2,898

43.44

9.76

Cirrus Logic (CRUS)

$2,511

13.83

11.39

SolarEdge Technologies (SEDG)

$2,409

16.15

17.78

Advanced Energy Industries (AEIS)

$2,366

11.5

20.56

Tower Semiconductor (TSEM)

$2,245

12.17

17.71

Progress Software (PRGS)

$1,781

15.65

8.14

EVERTEC (EVTC)

$1,684

14.02

6.12

Hollysys Automation Technologies (HOLI)

$1,357

12.46

9.02

Cheetah Mobile (CMCM)

$1,319

16.78

21.33

Luxoft Holding (LXFT)

$1,289

15.98

9.91

Web.com Group (WEB)

$1,145

9.04

3.41

FormFactor (FORM)

$1,022

13.68

5.92

QIWI (QIWI)

$979

14.85

8.1

Nanometrics Inc (NANO)

$893

16.76

13.4

Xcerra Corp (XCRA)

$792

13.97

11.59

Nova Measuring Instruments (NVMI)

$790

14.64

17.73

Changyou.com (CYOU)

$778

10.66

3.5

SMART Global Holdings (SGH)

$713

5.09

14.62

Axcelis Technologies (ACLS)

$691

13.71

31.74

Ultra Clean Holdings (UCTT)

$617

7.25

15.48

Electro Scientific Industries (ESIO)

$616

8.54

38.89

Quantenna Communications (QTNA)

$592

38.59

17.04

Ichor Holdings (ICHR)

$540

5.95

13.39

Net 1 Ueps Technologies (UEPS)

$529

5.78

3.19

Hackett Group (HCKT)

$494

15.34

15.26

Immersion (IMMR)

$461

7.45

31.41

Daqo New Energy (DQ)

$399

7.43

13.59

Backtested performance does not guarantee future returns, and only because a company is selected by the system, that doesn't mean that it will necessarily outperform the market going forward. Nevertheless, it makes sense to expect attractive returns when investing in technology stocks with solid fundamentals and attractive valuation levels.

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