How To Outperform The Market With Growth Leaders In Technology

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Includes: ADBE, ALRM, ANET, ATTU, AVGO, CIEN, CRM, CYBR, EEFT, EPAM, FLT, FTNT, GLOB, KEYS, MA, MLAB, MLNX, PANW, PAYC, PCTY, SSNC, UBNT, ULTI, UPLD, XLK, ZBRA
by: Andres Cardenal, CFA
Summary

Investing in high-growth technology companies can be a powerful strategy over the long term.

However, identifying consistent growth leaders is easier said than done.

Introducing a quantitative strategy that invests in tech stocks with consistently superior growth metrics and strong quantitative attributes on a broad scale.

The strategy also incorporates a trend-following mechanism to protect the portfolio and reduce downside risk.

Backtested performance is quite solid in terms of both potential for gains and downside risk.

The technology sector is fertile ground for growth and innovation. Investors who pick the right stocks in technology can often be rewarded with spectacular gains over the long term.

But risk and reward are two sides of the same coin. The best tech companies generally trade at elevated valuations, and they operate in a very dynamic and competitive environment. Besides, the technology sector generally carries higher beta and price volatility than other areas of the market.

With this in mind, the following paragraphs will be presenting a quantitative strategy focused on technology companies with above-average growth over multiple time frames and strong quantitative attributes in different areas. The strategy also incorporates a trend-following mechanism to control market risk.

The backtested numbers show that a strategy such as this one can generate impressive performance in terms of both the potential for gains and downside risk reduction.

Past performance does not guarantee future returns, and these quantitative strategies offer both advantages and disadvantages for investors. Nevertheless, these quantitative models can be remarkably valuable tools to identify promising investment ideas based on cold, hard data as opposed to opinions and speculation.

Looking For Consistent Growth Leaders In The Numbers

Like Warren Buffett said, "If a business does well, the stock eventually follows". Shares in companies with superior growth rates tend to deliver market-beating returns over the long term.

However, growth sustainability is a major factor to consider. Success attracts competition in the business world, and increasing competitive pressure can have a negative impact on growth levels over time.

High-growth companies generally trade at higher valuations, and this can be problematic for investors. If growth rates decelerate more abruptly than is expected, high-growth stocks trading at demanding valuations are vulnerable to the downside. This means that consistency and sustainability are crucial considerations when investing in growth stocks.

The quantitative strategy looks for tech companies with superior growth rates over different time periods. Companies must have revenue growth rates above 50% of companies in the industry over three different time frames: the most recent quarter, a trailing twelve-month period, and the past five years. If the company is consistently outgrowing the competition, this probably indicates that it has superior fundamental qualities, such as better technologies, a more innovative management team, or superior brand power.

Among the companies that meet the consistent growth criteria, the system invests in the 25 stocks with the strongest quantitative ranking based on the PowerFactors ranking system. This ranking system is a proprietary algorithm available in real time to members in "The Data-Driven Investor". The algorithm ranks companies in a particular universe based on a combination of factors that includes: financial quality, valuation, fundamental momentum, and relative strength.

In simple terms, the PowerFactors system is looking to buy good businesses (quality) for a reasonable price (valuation) when the company is doing well (fundamental momentum) and the stock is outperforming (relative strength).

The algorithm has delivered market-beating performance over the long term. The chart below shows backtested performance numbers for companies in 5 different PowerFactors buckets over the years.

Data from S&P Global via Portfolio123

Stocks with higher rankings tend to outperform those in the lower rankings, which shows that the system is consistent and robust. Besides, stocks in the strongest bucket materially outperform the market in the long term.

In order to protect the portfolio from market volatility, the quantitive strategy also takes a short position of 100% of the portfolio capital in times when the benchmark is in a downtrend. The trend is measured by evaluating the 10-day slope in the 200-day moving average in the Technology Select Sector SPDR ETF (XLK).

Summing up the quantitative strategy:

  • We consider only companies in the tech sector, and we eliminate over the counter stocks and stocks with a market capitalization value below $250 million for liquidity reasons.
  • Stocks in the system are required to have revenue growth rates above the industry average over the past quarter, the past 12 months, and the past 5 years.
  • Among the companies that meet the criteria above, the strategy selects the 25 stocks with the highest PowerFactors ranking.
  • The portfolio is hedged 100% with a short position in the benchmark when the benchmark is in a downtrend, as measured by the slope of the 200-day moving average.
  • The backtest assumes that the portfolio is equally weighted and monthly rebalanced. Trading expenses are assumed to be 0.2% per transaction.

Backtested Performance Data

Since January 1999, the quantitative strategy gained 14.14% per year, almost triple the 4.97% annual return produced by XLK in the same period. Alpha for the quantitative strategy amounts to 12.58% per year.

Data from S&P Global via Portfolio123

The strategy also outperforms the benchmark by a wide margin when considering risk-adjusted returns. The maximum drawdown for the strategy is 51.17%, versus 82.05% for the benchmark. Offering a similar perspective, the strategy has a Sharpe ratio of 0.59, substantially above the 0.23 Sharpe ratio offered by XLK.

The performance numbers are clearly strong. However, looking at the data over the long term could hide some important characteristics in the performance metrics over shorter time frames. The table below shows some key performance metrics for the quantitative strategy and its benchmark in different periods.

Return Strategy Benchmark
Annualized 14.14% 4.97%
1-Month 4.88% 2.68%
1-Year 1.59% 2.34%
3-Year 91.80% 74.80%
5-Year 93.33% 108.58%
Total 1341.56% 166.12%
Risk-adjusted Return Strategy Benchmark
Sharpe Ratio 0.59 0.23
Sortino Ratio 0.84 0.3
Max Drawdown -51.17% -82.05%
Standard Deviation 23.63% 23.33%
Correlation 0.37 -
R-Squared 0.14 -
Beta 0.37 -
Alpha (annualized) 12.58% -

Even if the strategy still performed quite well on an absolute basis in the past five years, it also underperformed the benchmark in the period. The strategy gained 93.44%, versus 108.58% for the benchmark.

This is because the market portfolio protection mechanism had a negative impact on overall returns in recent years. Market pullbacks have been relatively shallow in the past five years, and those small retracements were ultimately buying opportunities as opposed to reasons to hedge the portfolio.

This is just the nature of trend-following, and when you get big down markets such as in 2001 and 2008, protecting the portfolio with a system such as this one can make a big difference in terms of reducing portfolio damage. On the other hand, when you get relatively shallow pullbacks such as in the past five years, hedging the portfolio has a negative impact on performance.

It's important to note that this quantitative strategy is concentrated in only one class of stocks - growth - and in a single sector - technology. This is obviously a risky proposition in terms of portfolio concentration, and the idea is by no means that investors should automatically buy all the stocks in the list. The point is showing how identifying consistent growth leaders in the tech sector through a quantitative strategy can lead to attractive performance over the long term. Investors may also want to consider some of the names in the list as interesting candidates for further research.

The table shows the 25 stocks currently selected by the quantitative strategy. Data in the table also shows revenue growth in the most recent quarter, in the trailing twelve-month period, and over the past five years.

Ticker Name Sales% Qtr Sales% TTM Sales5Yrs%
ADBE Adobe Inc. 22.83 23.67 17.36
ALRM Alarm.com Holdings Inc. 25.46 24.06 26.42
ANET Arista Networks Inc. 27.33 30.69 42.89
ATTU Attunity Ltd. 42.17 38.89 19.38
AVGO Broadcom Inc. 12.39 18.21 52.59
CIEN Ciena Corp. 20.49 14.17 8.24
CYBR CyberArk Software Ltd. 35.69 31.14 38.99
EPAM EPAM Systems Inc. 26.45 27.06 27.3
EEFT Euronet Worldwide Inc. 7.4 12.62 12.41
FLT FleetCor Technologies Inc. 5.48 8.18 22.14
FTNT Fortinet Inc. 21.68 20.49 23.96
GLOB Globant SA 21.4 26.33 26.96
KEYS Keysight Technologies Inc. 20.19 22.64 6.07
MA Mastercard Inc. 14.95 19.63 12.46
MLNX Mellanox Technologies Ltd. 22.09 26.03 22.77
MLAB Mesa Laboratories Inc. 12.72 10.66 15.68
PANW Palo Alto Networks Inc. 30.35 30.38 41.83
PAYC Paycom Software Inc. 31.84 30.78 39.4
PCTY Paylocity Holding Corp. 21.99 23.1 37.18
CRM salesforce.com Inc. 25.76 26.02 26.68
SSNC SS&C Technologies Holdings Inc. 153.44 104.21 36.85
UBNT Ubiquiti Networks Inc. 22.51 17.67 25.95
ULTI Ultimate Software Group 21.23 21.24 22.68
UPLD Upland Software Inc. 62.24 53.02 29.48
ZBRA Zebra Technologies Corp. 10.82 13.33 32.36

Bottom Line

The quantitative indicators alone don't tell you everything you need to know in order to build a complete investment thesis for a stock. It's important to evaluate the business behind those numbers in order to tell if the company is solid enough to sustain superior growth rates in the future.

That being acknowledged, a quantitative strategy such as this one can be an effective tool to identify promising candidates for further research. Information is power, and investment decisions supported by quantified data tend to produce superior performance over the long term.

Disclosure: I am/we are long ANET, 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.