The big sell-off in software stocks has eased up since March 15. But it’s still unclear whether valuations have bottomed out for software growth stocks.
“Software stocks have seen two straight weeks of positive performance after growth adjusted software multiples hit levels not seen since late March 2020,” said Morgan Stanley analyst Keith Weiss in a report.
Software companies remain one of the sectors that offers the best revenue growth in technology. Increased corporate spending on cloud computing, digital transformation, big data analytics and artificial intelligence all drive revenue growth for software stocks.
Further, software companies with the highest percentage of subscription-based, recurring revenue stand out. They’re known as software-as-a-service, or SaaS, companies.
On the other hand, the valuations of software stocks have contracted significantly since November. Software growth stocks that traded at the highest multiples of forward-looking revenue also have been the hardest hit.
Software Stocks: Worries Over Interest Rates
Meanwhile, a closely watched software benchmark — the iShares Expanded Tech-Software ETF (IGV) has contracted 15% in 2022. That’s an improvement from being down 24% in early March.
Also, the IBD Computer-Software Enterprise group has retreated 37% from its all-time high set on Nov. 16, 2021.
Worries over rising interest rates emerged as a headwind to software and other tech stocks. In addition, software makers involved in e-commerce were pressured by concern over supply chain constraints.
Further, companies that benefited from work-at-home trends during the Covid pandemic, such as Zoom Video Communications (ZM) and DocuSign (DOCU), are experiencing slower growth as the economy normalizes.
Software Growth Stocks Soared In 2020
The pullback in software stocks followed stellar gains. For all of 2021, the IGV software index gained 12.3% vs. the S&P 500’s nearly 27% advance. In 2020, the software index soared nearly 52% vs. the S&P 500’s gain of 16.3%. Software stocks also outperformed in 2019 and 2018.
The big question for software growth stocks: what companies will gain favor during volatility in the Nasdaq and longer term.
Investors should monitor the IBD Stock of the Day, which gives readers a close look at a company’s technical and fundamental performance.
MSFT stock has dropped 10% in 2022. In addition, Microsoft has pivoted to cloud computing and software-as-a-service.
No software growth stocks currently belong to the IBD 50 roster of fast-growing companies. Software companies that at one-time joined the IBD 50 included Adobe Systems (ADBE), ServiceNow (NOW), Workday (WDAY) and Atlassian (TEAM).
Adobe sells digital media and marketing software. ServiceNow’s self-service tech portal enables company employees to access administrative and workflow tools. Founded in Sydney in 2002, Atlassian sells project management and collaborative software for software developers and information technology engineering teams.
Software Stocks: Key Technical Ratings
Also, investors should look for software stocks with Composite Ratings above 90. IBD’s Composite Rating looks at technical and fundamental factors. Those factors include relative price performance, earnings growth and return on equity.
Amid the shake-out in software growth stocks, some analysts have steered away from companies with higher exposure to stock-based compensation. According to a Baird report, software companies with “more options underwater” amid falling stock prices have a higher risk of employee turnover.
Some analyst favor software stocks that generate more free cash flow. “We do believe there is greater valuation support with higher FCF multiples in a rising interest rate environment,” said an RBC Capital report.
Growing Free Cash Flow A Plus?
Salesforce.com has been a leader in subscription-as-a-service. The customers of SaaS companies purchase renewable subscriptions, rather than one-time software licenses. Further, customers receive automatic software updates via the web.
Among the big losers so far in 2022 is Twilio (TWLO). Twilio’s tools enable app developers to embed voice, text messaging and video into their products. Other laggards include HubSpot, Shopify (SHOP), Asana (ASAN) and Coupa Software (COUP).
Amid Covid-19, demand for next-generation collaboration and productivity tools increased as companies shifted to work-from-home arrangements. Also, the pandemic forced some companies to digitize customer-facing functions for the first time.
IBD groups software companies as enterprise stocks as well as in vertical markets such as financial and medical. Also, some companies belong to product groups, such as database software and computer security.
Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.