By The Numbers: Tech Stocks With Big Cash Distributions

The technology sector offers many attractive characteristics for investors. Technology is a fertile ground for disruptive innovation, and companies with superior technologies tend to generate market-beating returns over time. In fact, many of the most profitable stocks in the market over the past several years have been innovative business benefiting from technological innovation.

On the other hand, finding the right stocks in the technology sector can be particularly challenging. Comparing different companies and their technological strength is no easy task at all, even for those with a deep understanding of the sector. Besides, the sector is particularly dynamic, so staying ahead of the curve can require lots of hard work in an always changing environment.

There's no perfect or infallible formula to picking winning stocks, but the statistical evidence indicates that companies with big cash distributions tend to deliver above-average returns over the long term, and this makes perfect sense from a fundamental point of view. With this in mind, the following article will be introducing a quantitative system to pick technology stocks based on their capital distributions.

Cash Distributions As A Return Driver

When talking about cash distributions, most people tend to think about dividends, which are arguably the most transparent and straightforward way to return capital to investors. On the other hand, shareholder yield can be a more holistic approach to cash distributions. In a nutshell, shareholder yield is a cash distribution metric that includes not only dividends but also share buybacks and debt cancellations.

Buybacks are a much-discussed topic among investors, and the convenience of buybacks over dividends ultimately depends on the particular case. If the stock is undervalued and business prospects are good, then buybacks can create a lot of value for shareholders, because the company is investing its capital in an undervalued asset, meaning its own stock. On the other hand, when the business is deteriorating or the stock is excessively priced, then buybacks have a negative impact on shareholder value.

By including debt paydown in the equation, shareholder yield avoids situations in which companies finance their dividends and buybacks with borrowed money. Opportunistically issuing debt to finance cash distributions is not necessarily a bad thing, and it can even be a smart move under the right conditions. Nevertheless, money coming from internally generated funds as opposed to debt is a more sustainable source of capital distributions over the long term.

Importantly, these different venues of cash distributions are intimately related. Many companies tend to first cancel their debt when they have excess cash flow, then repurchase stock, and ultimately allocate those excess cash flows to dividend payments as the business matures over time. This means that companies making big debt cancellations and share buybacks today are many times the big dividend payers of tomorrow.

The main point is that cash distributions say a lot about a company and its financial strength, and shareholder yield can offer a broad perspective on cash distributions that is more comprehensive than dividends alone. Besides, different statistical research studies have proven that investing in stocks with high shareholder yield can be an effective strategy to outperform the market in the long term.

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 level below $250 million to guarantee a minimum size and liquidity level for stocks in the investable universe.

The system then picks the 50 stocks with the highest shareholder yield in that universe and it builds an equally weighted portfolio with those names. The portfolio is rebalanced every four weeks, and it has an assumed trading expense ratio of 0.2% per transaction. The benchmark is the Technology Select Sector SPDR ETF (XLK).

Backtested performance numbers are remarkable. Since January of 1999 the system gained 14.94% per year, far surpassing the 5.47% per year generated by the Technology Select Sector SPDR ETF in the same period.

In other words, a $100,000 investment in the sector-tracking ETF in January of 1999 would currently be worth around $285,900, and the same amount of capital allocated to the system would have an exponentially larger value of over $1.56 million.

Data from S&P Global via Portfolio123

It’s important to note that the period under analysis includes two massive bear markets for tech stocks during both the explosion of the tech bubble in the year 2000 and the Great Recession in 2008.

Companies with elevated cash distributions not only outperformed the market in terms of cumulative returns, but these stocks also showed a smaller downside risk. The maximum drawdown over the backtesting period was 58.27% for the high shareholder yield portfolio versus 82.05% for the benchmark during the backtesting period.

This is to be expected. Companies making big cash distributions tend to be relatively big and more stable than the average, so they are generally more resilient during challenging market environments.

It’s important to keep in mind that stocks with elevated shareholder yields should not be expected to outperform in every single year. No quantitative return driver or investment strategy outperforms all the time, even the ones with the best track records over the long term go through periods of underperformance from time to time.

In times of elevated risk appetite, when investors are gravitating towards high-growth stocks with little or no cash distributions, stocks with high shareholder yields will most probably deliver below-average returns.

Also, when interest rates are on the rise, high-dividend stocks and companies with elevated cash distributions tend to be negatively affected, as many investors go hunting for higher yields in the fixed income market. This is particularly relevant since interest rates have been increasing lately.

The quantitative system is concentrated in one particular return driver in a single sector of the market, so the main idea is not that investors should replicate the portfolio of tech stocks with elevated shareholder yields since such an approach would fail to provide enough diversification. The main idea is that a system such as this one can be a valuable source of investment ideas for further research.

When implementing the quantitative system, it's particularly important to pay close attention to the sustainability of cash distributions. You want to buy the companies that can continue making big cash payments over time, not the ones that made exceptionally high distributions in a particular year.

Without further prologue, the table below shows the 50 stocks currently picked by the system, in alphabetical order. Data in the table also includes market capitalization (in millions), forward price to earnings ratio, price to free cash flow, and shareholder yield.

Past performance does not guarantee future returns, and the numbers alone don't tell you everything you need to know to make a well-informed investment decision. It's important to understand the business behind such numbers in order to tell if the numbers are sustainable or not.

Nevertheless, cash distributions can be a powerful return driver for stocks over the long term, and investing in tech stocks with big cash distributions makes a lot of sense from a fundamental perspective.

Disclosure: I am/we are long AAPL, AUDC, 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.