A Value Investor and a Growth Investor Walk into a Tech Company…

In the fast-paced tech sector, traditional value metrics often struggle to find attractive stocks. Three characteristics of tech companies stand out for their tendency to blur the lens of conventional value screens:

• Technology companies tend to invest heavily in intangible assets, such as research and development, software and intellectual property. 
• Tech companies are more likely to reinvest profits into growth opportunities rather than distributing them as dividends, which makes dividend yield a less relevant metric. 
• A tech company’s book value is often misleading, because the rapid pace of innovation can quickly render physical and technological assets obsolete.

As a result, value strategies tend to underweight the technology sector or, worse, rely on these traditional metrics and then stumble into the dreaded “value trap.” Is there a better way?

Our value strategy uses an investment framework that emphasizes a proprietary Voya measure called excess capital yield. (See methodology below¹ ). We apply ECY to evaluate how effectively a company uses and deploys its “dry powder,” typically in the form of dividend growth, share repurchases, accretive M&A and organic investment.

We have found that this approach provides deeper insights into a company’s strategic financial health and its potential to sustain growth and generate returns. This makes it a more relevant and insightful tool for assessing true value in the fast-paced world of technology.

Historically, ECY has proven to be more effective than traditional value screens. Looking at the period January 2008 through December 2022, an analysis of the U.S. large cap software universe showed that stocks screened in the top quartile based on ECY generated higher excess returns, compared with stocks identified through book yield, dividend yield and earnings yield factors (Exhibit 1). Moreover, ECY’s quartile rankings offered successful indications of future returns, whereas other metrics were highly inconsistent, often ranking good stocks bad and bad stocks good.

We’re off to a good start, but that’s not the end of the story. Our equity platform is designed with the goal of generating an information advantage supported by a culture we call “collaborative alpha.” Working with the fundamental analytics team, our software sector analyst found an even better way to assess value opportunities in the tech sector

The “Rule of 40” is a staple for growth-oriented investors in the tech space. The rule states that a company’s combined revenue growth and free cash flow margin should add up to at least 40%. The metric provides a quick litmus test of a company's operational efficiency, profitability and market competitiveness.

Looking at the same universe of software companies and time period used in Exhibit 1, stocks that screened well with both ECY and the Rule of 40 produced even higher excess returns than those screened with the ECY metric alone (Exhibit 2).

The combination of Voya’s ECY with the Rule of 40 provides a powerful lens to not only avoid the pitfalls of outdated value strategies but also uncover compelling investment opportunities that other value investors might overlook.

This combined framework is a prime example of Voya’s “collaborative alpha,” an organizational mindset that encourages the sharing of information across teams while preserving the unique strengths of each.