For intrepid investors, the technology sector holds untapped sources of value.
This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
With stock indexes hitting all-time highs, the bad taste left in our mouths by the Internet bubble in the early 2000s may persuade investors to stray away from the famed gyrations of the technology sector rather than sift it for relatively untapped sources of value. The industry is characterized by rapid innovation and constant disruption, attributes that allow businesses to grow from upstarts to household names seemingly overnight.
That being said, these attributes have also provided fertile ground for select companies to sow deep roots. In this stock screen, we search for technology companies in Morningstar’s coverage universe that have been identified as holding durable competitive advantages that can produce considerable returns for shareholders.
We assign a firm a Morningstar Economic Moat Rating based on two primary attributes: its prospects of earning returns in excess of its cost of capital and a competitive advantage that prevents these returns from quickly eroding. Wide economic moats are earned through high switching costs, a cost advantage, intangible assets, a network effect, or efficient scale.
These facets are exhibited in a variety of forms in the technology space. Strong network effects are often created through the tendency of the industry to coalesce around a single platform such as Windows from Microsoft MSFT. Meanwhile, standardized systems such as complex data storage benefit from high switching costs that deter customers from turning to other vendors, while patents and brand names sustain excess returns for the likes of IBM IBM.
Cost advantages are also to be had in the semiconductor market, where Intel INTC dominates the computer-processor industry with its ability to invest in state-of-the-art chip-fabrication plants to maintain its product-cost leadership. We set our screen for either a narrow or wide moat to identify companies that display these traits and that we think are able to generate sustainable economic profits.
And PCF <= 15
While a firm may tout a strong competitive advantage, we still want to ensure that the market has not overpriced the stock. As such, we set the cutoff for companies trading at less than 15 times their current price/ cash flow.