The technology industry is fertile ground for innovation and growth, and many of the most profitable stocks in the market come precisely from the tech sector. On the other hand, tech stocks also are quite volatile, and they operate in an always changing environment. This means that the sector also is more risky and unpredictable than other areas of the market.
You can’t just build a complete investment thesis about a company by looking at the numbers, you need to understand the main business drivers behind those numbers in order to fully evaluate the risks and potential returns in a particular investment. However, a welt-built quantitative system can be enormously valuable in terms of providing a solid framework for decision making based on cold-hard quantitative data.
3 Key Return Drivers To Consider
The following quantitative system applies the PowerFactors ranking algorithm to companies in the technology sector. PowerFactors is a stock picking algorithm exclusively available to members in my research service: The Data Driven Investor. The system basically selects companies based on three main factors: Quality, value and momentum.
The PowerFactors algorithm compares a wide variety of ratios and indicators across these three main dimensions, and then it averages those numbers to reach a final PowerFactors ranking for a particular stock.
Here’s a quick overview of the variables considered by the algorithm:
Quality includes profit margins such as gross profit margin and free cash flow margin. The system also includes long-term growth expectations for the company and profitability ratios like return on equity and return on assets. All else the same, the more profitable the business, the more value it creates for investors over time.
A high quality company deserves an above average valuation. However, it’s important to keep valuation at reasonable levels and avoid companies with unrealistically high price tags. For this reason, the system includes traditional valuation ratios such as price to earnings, price to earnings growth, and price to free cash flow. Cheaper companies obviously get a higher ranking in the algorithm.
Momentum is about both financial performance for the company and market performance for the stock. The system measures a stock’s relative strength in comparison to other names in the market, looking for companies that are doing better than average. In addition, the system looks for companies that are reporting better than expected sales and earnings, as well as driving increasing expectations about future performance.
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