Quant Concepts: U.S. Tech Cos

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Phil Dabo: Welcome to Quant Concepts working from home edition. A lot has been said about the U.S. tech sector because of how well it's performed. Last year, U.S. tech was the strongest performing sector with a return of 44%. Some of the most well-known companies such as Nvidia and Apple have generated a great 12 month return of 94% and 45% respectively. Some of the less well-known companies in the U.S. tech sector have performed even better with mid cap stocks such as MicroVision and MicroStrategy, generating well over 1,300% and 300% respectively.

Today, let's take a look at a strategy that focuses on U.S. tech stocks and includes popular companies such as Microsoft and Adobe, as well as less well-known companies such as Arista Networks, and IHS Markit. As always, we're going to start by selecting our universe of stocks, which includes all 300 tech stocks in our U.S. database. We're going to rank our stocks from 1 to 300 according to five key factors. The first factor is our Morningstar quantitative moat score. An economic moat is a structural feature that allows the firm to sustain excess profits over a long period of time. Companies with a wide moat are expected to have a strong competitive advantage that protects its profitability.

Next is our Morningstar quantitative health score. Morningstar developed this score to make it easier for clients to determine whether a company is having solvency or liquidity issues. The methodology ranks companies on the likelihood that they will fall into financial distress by using measures of leverage to estimate a firm's distance to default. The next factor is one that I like a lot called the price change to 12-month high. We found that stocks that are trading close to their 12-month high tend to perform well. This is a momentum factor that has shown really good downside protection. Next, we have our price to sales ratio, which is a good measure of a company's market value relative to the amount of revenue the company generates. Our last factor is the forward reinvestment rate, which is a measure of a company's profitability, and is the rate at which a company is expected to reinvest earnings back into the business in order to generate growth.

Now that we have our stocks ranked from 1 to 300, we're going to screen out the stocks that we don't want. We're only going to buy stocks that are ranked in the top 15th percentile of our list. We only want to purchase companies with a market cap that is greater than $500 million, which essentially eliminates micro-cap stocks. We're only going to buy stocks that are ranked in the top third of our list based on the price change to 12-month high. And we want to eliminate stocks that don't have an economic moat based on the Morningstar quantitative economic moat score. Now when it comes to financial health, we only want to buy stocks that are ranked in the top third of our list based on the Morningstar quantitative financial health score. Now let's take a look at our sell rules. And our sell rules are very simple. We're going to sell stocks if they fall out of the top 20th percentile of our list. And we're also going to sell stocks if the financial health deteriorates and drops to the bottom third of our list.

Now let's take a look at performance. The benchmark that we use is the S&P 500 Total Return Index. And we tested the strategy from January 2005 to May 2021. Over this time period, the strategy has generated a very strong 15% return which is 4.6% higher than the S&P 500 and it only had a 30% annualised turnover. We can see by looking at the annualised returns, that this is a strategy that has outperformed the S&P 500 over every significant time period. And it's done that with market like price risk as you can see by the standard deviation. Although the standard deviation was similar to the benchmark, the strategy still has stronger risk adjusted returns as you can see by the Sharpe ratio. Now when looking at the beta we can see similar market risk, however slightly lower over the one and three-year period. When looking at this performance chart, we can see very good performance over time, especially over the past year, which is no surprise for the tech sector.

When looking at the up and downside capture ratios, we can see that this is a strategy that has performed well in down markets and still participated very nicely in up markets. Together, those two factors have contributed to a very nice overall market capture ratio, showing that this is a strategy that has performed well in different market environments. This is a great strategy to consider if you're looking for companies in the tech sector that have more downside protection. It's not obvious when looking at the performance charts, but this strategy has identified stocks in the tech sector that have less market risk. An additional benefit of this strategy is that it doesn't have a single negative calendar year over the past 15 years, except for the great recession in 2008. On average, 50% of the stocks in the portfolio, beat the index over each calendar year. You can find the buy list along with a transcript of this video.

From Morningstar I'm Phil Dabo.