What are we looking for?
U.S. tech companies that are growing their earnings but trading near or below their historical valuations.
The U.S. tech sector has been a blazing hot topic of late. FANG stocks (Facebook Inc., Amazon.com Inc., Netflix Inc. and Alphabet Inc. subsidiary Google) and blockchain technology is likely top of mind for many. It can be difficult though to justify paying fundamentally high valuations compared with other sectors. This week, I look for companies in this sector (today, this universe consists of 357 tech companies) by ranking on the following metrics:
- Five-year earnings-per-share growth rate (on average, how much earnings have grown in each year over the past five years);
- Quarterly EPS momentum (trailing four quarters of operating EPS versus the same figure one quarter ago);
- Debt-to-equity ratio (lower figures preferred to find companies that are less leveraged);
- Percentage of analysts that have revised their forward EPS estimates upward versus downward in the trailing 90 days, higher figures preferred (formula is number of analysts revising up minus analysts revising down, divided by total number of analysts);
- Historical variability of reported operating earnings per share (a statistical measure showing how volatile a companies reported earnings have been, lower figures preferred).
To qualify, companies must have at least three analysts actively covering the stock, and must have at least one of three core valuation metrics trading near their historical median values over the past 10 years (in the accompanying table, a historical relative price-to-book ratio of 0.9 would imply that the company has a P/B ratio that is 10 per cent lower than its own historical median P/B ratio).
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back-test this strategy from December, 1996, to April, 2018. During this process, a maximum of 10 stocks were purchased and equally weighted. Once a month, stocks were sold if their rank fell below the top 25 per cent of the ranked universe, or if a company’s price-to-sales, price-to-earnings and P/B ratios are all more than 30 per cent higher than their historical medians. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 13.9 per cent while the S&P 500 Technology Total Return Index advanced 9.1 per cent.
The stocks that meet our requirements for purchase and are listed in the table below. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.