Big technology companies are powering stocks higher on Wall Street this week, adding to the market’s gains after a three-week winning streak. Gains by technology and communication stocks and companies that rely on consumer spending are driving the increase. This week’s rally drove the technology-heavy Nasdaq composite to an all-time high. Technology and communication stocks and big e-commerce retailers have benefited this year as the pandemic has forced people to largely stay home and rely increasingly on the internet for shopping, work and entertainment.

As of June 30, the largest sector weighting in the S&P 500 Pure Growth index was information technology at 38.6%, according to S&P Dow Jones Indices. The largest sector weighting in the S&P 500 Pure Value index was financials at 33.6%. Looking at the returns of these two sectors as weighted in the S&P 500 index lends some perspective. In the first half of 2020, the S&P 500 Information Technology index posted a total return of 15.0%, compared to a decline of 23.7% for the S&P 500 Financials index, according to Bloomberg.

The Murphy Technology low price-to-growth-flow approach seeks technology stocks with high research and development spending, strong margins, a solid return on equity and high revenue growth, but selling at an attractive valuation level. The value-priced technology screen follows AAII’s interpretation of long-time technology investor Michael Murphy’s philosophy. Murphy provides a solid approach for individuals who want to invest in technology stocks, combining elements of both the growth and value styles of investing.

Identifying Good Quality Technology Companies

Murphy regards technology not so much as a sector, but rather as the growth driver of the U.S. economy, covering a relatively diversified group of companies. His approach seeks to identify technology stocks that are most likely to be the future leaders, and then buy those stocks when they become undervalued relative to their growth potential.

The Murphy Technology screen attempts to isolate technology stocks with high research and development (R&D) expenditures as a percentage of sales, high pretax margins and return on equity and strong top-line sales growth, but that are also selling at attractive values as measured by “growth flow.”

Murphy does not believe in buying growth at any price. Instead, he prefers to follow companies and purchase them only when valuations reach attractive levels. However, traditional valuation techniques are misleading for technology companies. R&D spending cuts into a company’s bottom line; as a firm spends more on R&D, its current reported earnings fall proportionately. As a result, a company that spends more on R&D will have a relatively higher price-earnings ratio. To counter this, Murphy adds per-share R&D spending to earnings per share (EPS) to determine what he calls a company’s growth flow. Murphy uses the ratio of price to growth flow to measure the underlying investment value of a technology stock.

Initial Application of the Murphy Technology Screen

Real growth is a critical test for a company. Sales growth, or top-line growth, drives the company’s bottom line. Murphy requires that a company exhibit annual sales growth of at least 15% over the last three years. Growth at this level helps indicate that R&D efforts are proving worthwhile. It also indicates that the company is participating in a rapidly expanding market or taking sales away from a competitor.

As with any screen that deals with a growth rate, it is important to study the sales figures on an individual year-by-year basis to confirm the strength of the growth figure.

Murphy looks for pretax profit margin of at least 15% to measure the profitability of a firm. The test helps to reveal a company that may have a proprietary edge because it is able to deliver its products at a substantial profit.

A high profit margin validates the strength of the sales growth rate. A firm may be able to boost its sales by “giving away” its products, but this can only be sustained for a short period of time. In fact, this strategy can hurt the company in the long run if it does not produce enough profits to reinvest in research and development, provide for expansion and reward the shareholders.

AAII’s next screen looks for companies with a return on equity of at least 15%. With high margins, it is not surprising to also see high levels of return on equity for the high growth-flow companies. When screening for high return on equity, it is also a good idea to carefully study the level of debt carried by the company. Any final company analysis should include an examination of the financial structure of the company.

Reinvesting for the Future

Murphy feels that the success of a technology company depends upon its commitment to R&D. A company’s ability to apply its research is critical to its success. A company must be willing to sacrifice a portion of its current earnings to fund research and create new products or variations of old products. Good management must be willing to make its own products obsolete, rather than waiting for a competitor to do the same.

Dividing the company’s R&D spending by its sales for the same time period tells you in percentage terms how much the company is spending. As a test of significant R&D spending, Murphy only looks at companies spending at least 7% of sales on R&D. At less than 7% investment in R&D, Murphy feels that the company is not committed to growth.

Beyond looking at the absolute dollars spent on R&D, the company’s track record in successfully bringing out new or improved products must be examined. Annual reports will provide some qualitative feel in this regard. Research discussed one year that turns into a product launch the following year and a success the third year is a good indication that the company is able to turn out a steady stream of new products. It is also helpful to understand what percentage of revenues today come from products introduced in the last three years.

The Growth-Flow Model

For a valuation approach that is appropriate for technology firms, Murphy adds per-share R&D spending (R&D spending divided by the number of shares outstanding) to earnings per share to determine a company’s growth flow. Dividing the current price of a stock by the growth flow per share provides the price-to-growth-flow ratio. Murphy uses this ratio to measure the underlying investment value of a technology stock.

The price-to-growth-flow ratio is calculated as:

Per-share R&D + EPS = Growth flow

Price ÷ growth flow = Price-to-growth-flow ratio

Murphy feels that the price-to-growth-flow ratio identifies cheap stocks both earlier and more accurately: R&D spending is usually stable and does not drop when earnings suffer. Thus, when share prices drop due to disappointing earnings, the price-earnings ratio will tend to change a little, whereas the stock will immediately look cheaper on a price-to-growth-flow basis.

As a guideline, Murphy views technology stocks as fairly priced when price-to-growth-flow ratios are around 10 to 14; anything under eight is cheap and below five is a real bargain; 16 and over is too expensive. The AAII Murphy Technology screen filters for price-to-growth-flow ratios at or below 8.

For example, Ebix (EBIX) is a tech company that provides on-demand software and e-commerce services and solutions to insurance, financial, health care and e-learning industries in the U.S. and internationally. The company develops and deploys insurance and reinsurance exchanges; provides software-as-a-service (SaaS) enterprise solutions in the area of customer relationship management, and front-end and back-end systems; and offers outsourced administrative and risk compliance solutions. Its price-to-growth-flow ratio is 4.9.

Three Technology Stocks Passing the Murphy Screen (Ranked by Price to Growth Flow)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence

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