A distinction of tech companies is that they are sources of innovation and growth. In addition, large-cap tech companies often rank among the highest quality in the market when evaluated by typical measures such as Return on Equity (ROE). That is why the tech weight in the quality ETF QUAL has grown to 43%. Furthermore, ROE has been the most effective driver of long-short stock returns within the tech sector of the S&P500, more than momentum or size.
The reward of investing in the innovation opportunity in tech stocks can be seen in the return to R&D spending, specifically R&D/Sales. The chart shows the tight connection between the direction of tech stock prices in the S&P500 as expressed by the XLK ETF (dashed red line) and the return to the R&D/Sales factor return (blue line). The vertical dashed line in the chart focuses on the change in the direction of the reward to the R&D/Sales factor return, which peaked on July 5, days before XLK peaked on July 10 (days before the S&P500 peaked on July 16).
On July 10, the tech sector's defensive Free Cash Flow (FCF) yield factor return (dark blue line) began an unusually sustained climb. And, as R&D/Sales and XLK dropped, the reward to ROE (green line) climbed.
The market has shifted from rewarding tech company stocks based on innovation to rewarding strong cash flow and ROE. If innovation opportunities no longer drive tech stocks, how will tech maintain high profitability and growth? What will drive tech stock performance?
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