How To Pick Top Momentum Stocks In Technology

by: Andres Cardenal, CFA

Momentum investing can be risky, but also very profitable in the long term.

Introducing a quantitative strategy focused on momentum stocks in the technology sector.

The strategy includes a market trend filter to control for risks in bear markets.

Volatility is elevated, and returns are fluctuating in the short term, but a strategy such as this one can be a valuable source of ideas with attractive upside potential.

Momentum is the tendency for assets that are performing well in the recent past to continue performing well in the middle term, and vice versa. There is plenty of statistical evidence showing that investors can obtain superior returns by capitalizing on momentum over the long term.

Even Professor Eugene Fama himself, the father of the efficient-market hypothesis, has said that momentum is "the biggest embarrassment to the theory". According to the research data, momentum can produce market-beating return across different assets, countries, and timeframes.

The following paragraphs will be presenting a quantitative strategy to select momentum stocks in the technology sector. Tech stocks tend to move in strong trends, either up or down, so the technology sector can be fertile ground for investors looking to capitalize on momentum opportunities.

Momentum stocks tend to be volatile and risky, and returns are also hard to predict in the short term. Nevertheless, investing in momentum stocks can also produce superior returns over the long term.

Momentum At The Stock Picking Level

The Stocks on Fire system is a quantitative algorithm that ranks stocks in a particular universe based on a combination of two main factors: fundamental momentum and price momentum.

Fundamental momentum evaluates how earnings and sales expectations are evolving for the company. This factor is basically a combination of five different variables:

  • The percentage increase in earnings expectations for the current quarter.
  • The percentage increase in earnings expectations for the current year.
  • The percentage increase in earnings expectations for next year.
  • The percentage increase in sales expectations for the current year.
  • The percentage increase in sales expectations for next year.

The price performance component in the ranking system measures price changes over the past 4 quarters. This factor is looking for stocks that are consistently outperforming the market over recent time periods, as measured by variables such as:

  • Return over the past 3 months.
  • Return over 3 months 3 months ago.
  • Return over 3 months 6 months ago.
  • Return over 3 months 9 months ago.

Leaving the mathematical details aside, the main idea behind the Stocks on Fire algorithm is actually quite easy to understand, the algorithm is looking for stocks with vigorous momentum, both in terms of fundamental expectations and in terms of market price performance.

Looking at the long-term backtested data, there is a direct correlation between the Stocks on Fire ranking and annualized returns. Companies in the top quintile, meaning those with a Stocks on Fire ranking above 80 tend to materially outperform the market.

Data from S&P Global via Portfolio123

The following backtest eliminates over the counter stocks, and it considers only companies with a market capitalization value above $500 million in the technology sector. This is to guarantee a minimum size and liquidity level for the companies in the portfolio.

The strategy picks the top 50 stocks with the highest Stocks on Fire ranking among such universe, and it builds an equally weighted portfolio with those names. The portfolio is rebalanced monthly, and trading expenses are assumed to be 0.2% per trade. The benchmark is the Technology Select Sector SPDR ETF (XLK).

The strategy substantially outperformed the benchmark. Since January of 1999, the quantitative strategy gained 1,031% versus a cumulative gain of 179.6% for the benchmark in the same period. Alpha for the quantitative strategy amounts to 8.9% annually. Data from S&P Global via Portfolio123

However, both the momentum strategy and the benchmark suffered massive losses during the explosion of the tech bubble in 2001, losing more than 80% from their peaks. This risk exposure is arguably too much for most investors, and it exposes an important consideration: momentum stocks tend to outperform over the long term, but in a bear market environment, momentum stocks can fall particularly hard.

Including A Market Trend Filter

When investing in momentum stocks in a cyclical sector such as technology, it makes a lot of sense to consider applying a market trend filter to reduce portfolio drawdowns.

This modified version of the strategy above picks the same 50 stocks, but it also takes a short position in the benchmark when such a benchmark is trading below the 200-day moving average. As we can see in the chart, the 200-day moving average has done a solid job in terms of signaling the main market trends in Technology Select Sector SPDR ETF over the long term.

Chart Data by YCharts

By applying this trend following system for capital protection, the maximum drawdown for the strategy falls to 54.3% versus 82.05%. The cumulative return also increases to over 1,500% versus almost 180% for the benchmark, and strategy alpha reaches an impressive 13.4% per year.

Data from S&P Global via Portfolio123

The strategy is still very volatile, but the market trend filter works well in terms of optimizing the risk and reward tradeoff, and the strategy substantially outperforms the benchmark in terms of return, risk, and risk-adjusted returns.

Taking a deeper look at performance over different periods, it's important to note that the strategy outperforms both over the past 20 years and in the past 3 years. However, over a five-year time frame, the strategy is lagging the benchmark.

Strategy Benchmark
Annualized 14.71% 5.17%
One Year 1.53% 6.15%
Three Year 103.90% 73.62%
Five Year 100.50% 110.13%
Total 1,545.49% 179.60%
Sharpe Ratio 0.58 0.25
Sortino Ratio 0.85 0.33
Max Drawdown -54.30% -82.05%
Standard Deviation 25.83% 23.28%
Correlation 0.37 -
R-Squared 0.13 -
Beta 0.40 -
Alpha (annualized) 13.38% -

This is to be expected. No quantitative strategy can outperform the market in each and every year, and the statistical evidence is conclusive, even the most effective strategies can go through long periods of underperformance.

Practical Considerations And Portfolio

The strategy is concentrated in only one factor - momentum - and in a single sector - technology, so it clearly lacks diversification in order to be considered a complete portfolio solution. As opposed to that, a quantitative strategy such as this one should be considered a source of ideas for further research.

The strategy also gravitates toward relatively expensive and volatile stocks, since many times those kinds of stocks are the ones that exhibit superior momentum. Investors sourcing for ideas from this strategy may want to pay special attention to the stock's valuation levels and the degree of stability in the company's financial performance.

Importantly, momentum cuts both ways. The stocks that deliver the biggest gains on the way up are many times the ones that suffer the biggest losses on the way down. Momentum stocks generally carry higher downside risk than other kinds of investments.

Without further prologue, the table below shows the 50 stocks currently selected by the quantitative system, data in the table also includes the current market price and the Stocks on Fire algorithm value for the companies considered. As we can see, there is some variety among the companies included, but most of these names are relatively high-beta and volatile.

Ticker Name Price Rank
ACIA Acacia Communications Inc. 46.6 96.7
ACIW ACI Worldwide Inc. 31.46 98.39
AYX Alteryx Inc. 86.86 96.87
AVLR Avalara Inc. 67.64 99.39
BAH Booz Allen Hamilton Holding Corp. 63.17 98.35
CACI CACI International Inc. 203.52 98.46
CSGS CSG Systems International Inc. 44.85 96.6
CYBR CyberArk Software Ltd. 132.05 99.94
DOMO Domo Inc. 33.5 96.79
ENV Envestnet Inc. 66.91 96.72
EPAM EPAM Systems Inc. 172.59 98.66
EVBG Everbridge Inc. 78.64 98.12
FICO Fair Isaac Corp. 295.9 98.85
FLT FleetCor Technologies Inc. 258.21 98.62
G Genpact Ltd. 36.15 96.37
GLOB Globant SA 92.84 99
HUBS HubSpot Inc. 173.28 99.46
PI Impinj Inc. 24.79 97.39
JKS JinkoSolar Holding Co Ltd. 20.11 99.83
KBR KBR Inc. 22.22 97.39
LRCX Lam Research Corp. 174.61 95.95
LSCC Lattice Semiconductor Corp. 12.8 96.35
LDOS Leidos Holdings Inc. 75.33 97.91
MANH Manhattan Associates Inc. 65.47 97.85
MLNX Mellanox Technologies Ltd. 109.78 97.22
MDB MongoDB Inc. 140.34 99.58
OSIS OSI Systems Inc. 103.59 98.31
PAYC Paycom Software Inc. 212.1 98.71
PCTY Paylocity Holding Corp. 100.22 97.43
PRFT Perficient Inc. 30.43 98.81
PRGS Progress Software Corp. 40.96 97.58
PRO PROS Holdings Inc. 56.7 99.5
QCOM QUALCOMM Inc. 66.82 96.66
RNG RingCentral Inc. 119.85 98.79
SPNS Sapiens International Corp. NV 15.72 99.35
SHOP Shopify Inc. 274.9 98.2
SEDG SolarEdge Technologies Inc. 53.58 96.28
SNPS Synopsys Inc. 116.44 98.94
TER Teradyne Inc. 42.14 98.25
TTD Trade Desk Inc. 198.81 99.96
TWLO Twilio Inc. 131.99 99.06
OLED Universal Display Corp. 146.93 98.64
UPLD Upland Software Inc. 46.79 97.1
VRNT Verint Systems Inc. 56.75 98.83
VRSN Verisign Inc. 194.98 96.64
VSAT ViaSat Inc. 87.03 99.56
WDAY Workday Inc. 204.12 96.54
WK Workiva Inc. 55.64 98.75
WP Worldpay Inc. 121.64 97.79
ZS Zscaler Inc. 68.63 99.98

Disclosure: I am/we are long WDAY. 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.