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How to capture quality technology stocks

Arian Neiron  |  08 Aug 2017Text size  Decrease  Increase  |  

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The technology sector has presented a wealth of opportunities to investors, though market euphoria has pushed many US technology companies to stretched valuations which may not stand the test of time.

 

Importantly, not all technology companies are desirable from an investment perspective. Smart investors understand they should be seeking investments that can survive the downturns, as well as ride the upturns.

At the moment, the high levels of debt among many US technology companies make them more vulnerable to a market correction than less encumbered companies.

The Nasdaq 100, of which around 60 per cent is technology stocks, has surged well through its previous 2001 high, as the chart below indicates. Many observers argue that valuations are justified based on still relatively low price-earnings (P/E) ratios and ongoing growth in underlying earnings.

 

Nasdaq 100 Index price


chart

Source: Bloomberg, 27 June 1987 to 27 June 2017. Past performance is not a reliable indicator of future performance.

 

Nasdaq 100 average P/Es since dot com


chart

Source: Bloomberg, Nasdaq 100 average P/E data is only available from 2001. Past performance is not a reliable indicator of future performance.

 

However, some companies are trading at very high P/E ratios, such as Amazon which was trading at a P/E of around 184 at 7 July, which may not be able to be sustained over the medium to long term.

Investors also need to consider the high level of debt some of these tech companies are accumulating.

The cost to service corporate debt in the US has never been cheaper given record low interest rates. This is in direct contrast to 2000 when debt was expensive.

However, the danger is that if growth and inflation accelerate and the US Federal Reserve is forced to increase rates faster than expected, companies with overly leveraged balance sheets may struggle to service their debts.

Take, for example, telecommunications company Comcast and video streaming business Netflix.

Comcast, which is a top 10 constituent of the Nasdaq 100 with a weighting of 2.8 per cent and a P/E of 21.5, has a net debt/equity ratio of 112 per cent. Netflix, with a 0.89 per cent weighting in the Nasdaq 100 and a P/E of 207, has net debt/equity of 113 per cent.

These are huge debt burdens which make these companies vulnerable to higher interest rates.

 

Comcast performance and debt to equity


chart

Source: Factset, Bloomberg

 

Netflix performance and debt to equity


chart

Source: Factset, Bloomberg

 

Only quality companies

While the technology space continues to be a potential investment opportunity, it is prudent for investors to separate those technology stocks that will weather downturns from those that may fail.

The MSCI World ex Australia Quality Index does the work for investors. The MSCI Quality Index includes companies with high-quality scores based on three fundamental factors: high return on equity; stable year-on-year earnings growth; and low financial leverage.

Technology companies excluded by MSCI include: stocks that have no ROE, such as Twitter; companies that lack stable earnings growth such as Tesla and Facebook; and those that are heavily indebted, such as Comcast and Netflix.

MSCI's quality approach has demonstrated significant outperformance during market downturns with outperformance and less volatility over the long term relative to the market benchmark index, the MSCI World ex Australia Index, as the charts below indicate.

 chart

(click image to enlarge)

Source: Morningstar Direct, VanEck. 30 November 1994 to 30 June 2017

 

VanEck Vectors MSCI World ex Australia Quality ETF (ASX: QUAL) tracks the MSCI Quality Index. As a result, it is limited to companies that meet quality criteria including low debt, and its underlying index demonstrates outperformance across market cycles.

QUAL has a 33 per cent exposure to quality international technology companies. Hence, it provides investors with ease of access to international technology companies.

 

Top 5 Tech companies in QUAL

table

Source: Factset, 27 June 2017

 

QUAL has returned 14.90 per cent since its inception in 2014 to the end of 30 June 2017, outperforming the MSCI World ex Australia Index by 1.51 per cent.

For investors, QUAL is an effective way of getting exposure to quality US technology companies and not missing out on the boom, while taking some insurance against a bust.

 

Trailing performance QUAL versus MSCI World ex Australia Index

table

(*QUAL Inception Date is 29 October 2014. Performance results are calculated to the last business day of the month and assume immediate reinvestment of distributions. You cannot invest in an index. QUAL results are net of fees and costs excluding brokerage fees or bid/ask spreads incurred when investors buy/sell on the ASX. Returns for periods longer than one year are annualised. Past performance is not a reliable indicator of future performance.

 

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Arian Neiron is the managing director of VanEck Australia. VanEck is a leading global provider of exchange traded funds (ETFs). This is a financial news article to be used for non-commercial purposes and is not intended to provide personal financial advice to any person.

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