By The Numbers: Best Stocks In Internet And Software

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Includes: ADBE, BCOR, CARB, CDNS, CHKP, CRCM, CRM, CTXS, CYBR, ETSY, FTNT, GOOG, GOOGL, GRUB, IAC, IWF, JCOM, MEET, MOMO, MSFT, MTCH, SPSC, STMP, TEAM, TTD, TTGT, UPLD
by: Andres Cardenal, CFA
Summary

The internet services and software industries offer many of the most profitable growth companies in the market.

On the other hand, technological disruption and demanding valuations can make these industries particularly challenging for investors.

The following article is introducing a quantitative system to select stocks based on four time-proven return drivers: financial quality, valuation, business momentum, and relative strength.

No quantitative system is perfect or infallible, and past performance does not guarantee future returns. However, making investment decisions based on objective data is a sounder approach than relying entirely on opinions and speculations.

The internet services and software industries are home to many of the most profitable growth stories in the stock market over the past several years. Picking the right names in these industries can generate outstanding returns for investors, because winning players in internet and software tend to enjoy booming revenue growth and superior profitability.

On the other hand, selecting stocks in the internet and software industries is no easy task at all. These areas of the market are particularly dynamic and prone to technological disruption, so the winner of today can easily turn out to be the loser of tomorrow.

Making things even more complicated, companies in these industries tend to trade at aggressive valuation levels, which has important implications when it comes to risk. Paying an expensive price for a high growth stock, only to see it losing ground to the competition in the following years, can be a remarkably expensive mistake, and an easy one to make when investing in internet services and software.

There is no infallible formula to picking winning stocks. However, quantitative indicators can be enormously valuable when making investing decisions based on hard quantified data as opposed to subjective opinions or speculation.

In that spirit, the following paragraphs will introduce a quantitative system aimed at selecting stocks with superior potential returns in the internet services and software industries. In particular, the system is based on four time-proven return drivers: financial quality, valuation, business momentum, and relative strength.

System Design

The PowerFactors System is a quantitative system exclusively available to members in my research service:The Data Driven Investor. The system ranks companies in a particular universe according to a combination of 4 key quantitative attributes: financial quality, valuation, business momentum, and relative strength.

Some brief explanations about these factors:

  • Financial quality: This factor includes variables such as long-term growth expectations, profit margins on sales, and return on capital. All else the same, a more profitable business with superior growth rates should generate higher returns for investors over time.
  • Valuation: A high-quality business deserves an above-average valuation. However, overpaying for high-quality stocks is a very common mistake, and even the best companies can turn out to be mediocre investments when the stock price is excessively high. For this reason, the PowerFactors system includes valuation ratios such as price to earnings, price to earnings growth, and price to free cash flow.
  • Momentum: Stock prices don't just reflect fundamentals, but expectations about those fundamentals can be even more important. When expectations about the company’s financial performance are on the rise, this generally means that the stock price is on the rise too.
  • Relative Strength: Winners tend to keep on winning in the market, when a stock is outperforming the market, it tends to continue doing so more often than not over the middle term. For this reason, the PowerFactors system looks for stocks delivering above-average returns.

The PowerFactors system basically considers multiple ratios and quantitative indicators across these four dimensions, quality, value, momentum, and relative strength. Then it incorporates those numbers into a final PowerFactors ranking for each stock in the investable universe.

Leaving the numerical considerations aside, the main rationale behind the system is actually quite simple. The algorithm is basically looking to buy solid companies (quality) at a reasonable price (value), when the business is doing well (momentum) and the stock is outperforming (relative strength)

Backtested Performance And Portfolio

The following backtest considers only companies in the internet and software industries with a market capitalization of more than $250 million and excluding over the counter stocks. This is to guarantee a minimum size and liquidity level for companies in the investable universe.

The system picks the 25 stocks with the highest PowerFactors ranking among such universe, and it builds an equally weighted portfolio with those names. The portfolio is monthly rebalanced, and it has an assumed annual expense ratio of 1% to account for trading expenses. The benchmark is the Shares Russell 1000 Growth ETF (IWF)

Since January of 1999 the system more than tripled the benchmark, with annual returns of 16.57% per year versus an annual return of 5.4% for the ETF in the same period. In cumulative terms, the system gained 1,885.81% versus 178.58% for the benchmark.

Data from S&P Global via Portfolio123

The system is more concentrated than the benchmark, and this makes it also more volatile. Nevertheless, the system still outperformed on a risk-adjusted basis, as expressed by a Sharpe ratio of 0.62 for the system versus 0.28 for the benchmark. System Alpha amounts to 11.09% according to the backtest .

Offering more details, the table below shows the return numbers for the system and the benchmark over different time periods.

Return

System

Benchmark

Annualized

16.57%

5.40%

One Month

-1.80%

3.67%

Three Month

11.69%

8.55%

One Year

41.76%

22.88%

Three Year

108.92%

52.68%

Five Year

280.82%

107.86%

Total

1885.81%

178.58%

Without further prologue, the table below shows the 25 stocks currently selected by the quantitative system. Data in the table also includes market capitalization (in millions), forward price to earnings and long term growth expectations for the companies in the list. This is to provide a quick reference about size, valuation, and growth potential for the companies included.

Name

Mkt. Cap

Fwd PE

Growth E%

Adobe Systems (ADBE)

$124,968

37.76

18.94

Alphabet (GOOG) (GOOGL)

$871,944

28.11

20.46

Atlassian (TEAM)

$17,280

96.15

27.14

Blucora (BCOR)

$1,705

19.72

20

Cadence Design Systems (CDNS)

$12,794

26.89

10

Carbonite (CARB)

$1,009

22.59

27.5

Care.com (CRCM)

$640

30.52

13.93

Check Point Software (CHKP)

$18,063

20.04

9.33

Citrix Systems (CTXS)

$15,367

20.79

10.59

CyberArk Software (CYBR)

$2,255

47.33

20.51

Etsy Inc (ETSY)

$5,035

61.49

12.5

Fortinet (FTNT)

$11,056

42.98

24.25

GrubHub (GRUB)

$11,435

69.03

29.6

IAC/InterActiveCorp (IAC)

$12,574

23.27

20.05

j2 Global (JCOM)

$4,129

14.11

12

Match Group (MTCH)

$10,292

27.82

12.68

Microsoft (MSFT)

$826,659

25.23

14

Momo (MOMO)

$8,421

16.6

31.71

salesforce.com (CRM)

$105,616

62.27

25.86

SPS Commerce (SPSC)

$1,471

51.69

22.5

Stamps.com (STMP)

$4,867

27.08

22

TechTarget (TTGT)

$874

43.75

20

The Meet Group (MEET)

$296

17.08

20

Trade Desk (TTD)

$3,765

45.19

25.67

Upland Software (UPLD)

$721

21.61

20

Backtested performance does not guarantee future returns. However, buying stocks based on quantified factors such as financial quality, value, momentum and relative strength makes a lot of sense from a fundamental investing point of view, and statistical evidence indicates that these kinds of companies tend to deliver superior returns over the long term.

Disclosure: I am/we are long goog, googl, CRM. 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.