10 high-quality tech shares that might be on sale

After a grim first half of 2022, the tech sector received a massive boost in July. Stock screening expert Ben Hobson has scanned the market for the UK shares most likely to benefit if the recovery continues.

UK technology stocks were some of the big winners in the bull run that followed the Covid crash in 2020. Yet it wasn’t to last. The sector went on to be one of the worst performers in the first half of this year as economic woes and rising interest rates forced investors onto the back foot.

But after a bruising few months, technology was back in favour in July, with a number of previously beaten down shares enjoying solid momentum. If this trend continues, it could be an interesting place to find stocks with the potential to re-rate. So what should you be looking for?

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A roller coaster two years for tech shares

Back in the surreal days of 2020, when we were all getting to grips with lockdowns, tech-centric shares led the market recovery. A number were well placed to benefit as people’s lives changed, with internet retail, work-from-home (WFH) technologies and gaming companies all doing well.

In the US, of course, mega-cap technology stocks have played a major role in the phenomenal bull run over the past decade. Across the pond, tech is home to hugely influential global businesses such as Alphabet (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Meta Platforms (NASDAQ:META) and Microsoft (NASDAQ:MSFT).

While the sector doesn’t have the same influence in the UK, it’s an undeniably attractive area for investors looking for innovative, fast-growing businesses. But given that these firms can be unpredictable, especially at the smaller end of the market, they’re often the first to suffer when investors get spooked by a gloomy economic outlook. That’s exactly what we’ve seen in 2022.

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High inflation and the prospect of rising interest rates and recession have stifled appetite in riskier sectors. But some now believe that central banks have done enough to ensure we get a soft landing rather than a hard recession. That’s in part why the market turned positive in July, which translated into a very noticeable upturn for tech.

According to Trustnet, the IA Technology & Technology Innovations sector saw an 8.5% gain in July, making it the best-performing industry sector and second-best performing theme, just behind IA North America Smaller Companies.

High-quality shares that might be on sale

Looking for ideas at a time of heightened uncertainty needs careful research. After a spell in the doldrums, a number of tech stocks have seen their price-to-earnings (PE) ratios (a key valuation measure) fall this year. A focus on those that are profitable, with solid financial quality characteristics should help to reduce the risk of being too speculative.

With that in mind, this screen looks for:

• Stocks in the Information Technology sector
• A Return on Equity of more than 10% (a measure of a firm’s profitability and efficiency at generating a return from shareholder equity)
• A Return on Invested Capital of more than 10% (a profitability measure that tells you the return being achieved from the capital in a business)
• Generating positive unlevered free cash flow (indicating that a business is generating cash to cover its financial obligations)
• EBITDA Margin of more than 10% (this represents a company’s operating profit as a percentage of its revenue. Earnings before interest, taxes, amortisation and depreciation (EBITDA) strips out the costs of doing business, which makes it a fairer way of comparing different companies)

The main thrust of these screening rules is to find companies that are profitable and efficient at generating a return. There are several ways of doing that, but solid return measures, strong margins and positive cash flow (that can be used to grow), are a good start.

These results are sorted by one-month price return, and the table shows both the expected PE Ratio and the five-year average PE for comparison.

Seven of the 10 companies here have seen their share prices lose ground in 2022. But all saw positive gains over the past month as the wider market (and tech in particular) rallied.

Despite that upturn, some are still significantly down on the year, including online marketing specialist dotDigital Group (LSE:DOTD), down 52.3%, business IT system firm Kainos Group (LSE:KNOS), down 29.3%, and hazard detection group Halma (LSE:HLMA), down 28.8%.

Of the few that have managed a positive return this year, Cerillion (LSE:CER) and Concurrent Technologies (LSE:CNC)lead with gains of 20.9% and 16.3% respectively.

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Tech sector PE ratios are often higher on average than other sectors, and can also vary depending on specific industries. But you can see from this table that the forward PE ratios for a number of these firms are currently below (in some cases well below) their five-year averages. This isn’t always because share prices have fallen. A change in earnings can also influence PE ratios. But nonetheless it could be a clue in the search for improved valuations in the sector.

Faced with a range of uncertain factors, the challenge for investors is to balance the risk of further price pressure and economic woe, with the possibility that some shares have been unfairly sold off.

July’s eye-catching gains in the technology sector may well reflect a sense that riskier sectors like this have been beaten up quite badly this year. Once confidence genuinely flows back into the market, it’s a sector that may well be among the first to benefit.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.