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Software Growth Stocks To Buy As Digital Transformation Drives Growth| Investor’s Business Daily

The big sell-off in software stocks eased up in mid-March. But as April-May quarter earnings start to roll in, software growth stocks are tumbling again.

Meanwhile, a closely watched software benchmark — the iShares Expanded Tech-Software ETF (IGV) has contracted 26% in 2022. The IGV index fell 13% in April, marking the worst month since October 2008, noted a Cowen report.

This year’s big sell-off among technology stocks has left many software and internet companies grappling with stock-based compensation issues that could eventually affect earnings.

On the plus side, private equity firms have been active in buying public software companies in 2022. Companies purchased this year include Citrix, Anaplan, CDK and SailPoint.

Still, the valuations of software stocks have contracted significantly since November. Software growth stocks that traded at the highest multiples of forward-looking revenue  have been the hardest hit.

“While valuations may have bottomed out, an uncertain macroeconomic environment (higher inflation combined with war) could put the strong fundamentals at risk,” Jefferies analyst Brent Thill said in a note to clients.

In his note to clients, Morgan Stanley analyst Keith Weiss said: “Software-as-a-service valuations remain under pressure. The prospects of rising interest rates and geopolitical unrest create a challenging market backdrop, driving investors to find safety in supporting free cash flow.”

Software Growth Stocks Retreat

Also, the IBD Computer-Software Enterprise group has retreated 37% from its all-time high set on Nov. 16. 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 are experiencing slower growth as the economy normalizes.

The big question for software growth stocks: what companies will gain favor during volatility in the Nasdaq?

BMO Capital Markets analyst Keith Bachman says profit margins are key.

“We understand that isolating on any one variable to gauge stock performance is overly simplistic, as many factors play a role including valuation, expectations, billings and ARR performance, amongst others,” he said in a note. “Given rising interest rates, it is our contention that margins and free cash flow will maintain or grow in importance in influencing valuation for the balance of 2022. We do not see this as a fleeting trend. Over the past 5-10 years, the market has rewarded ‘land grab’ strategies in which growth was strongly favored over profits or FCF.”

Growing Free Cash Flow A Plus?

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.

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 stocks with the highest percentage of subscription-based, recurring revenue stand out. They’re known as software-as-a-service, or SaaS stocks.

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.

Investors should monitor the IBD Stock of the Day, which gives readers a close look at a company’s technical and fundamental performance.

Companies featured as the IBD Stock of the Day have included Datadog (DDOG), Paycom Holdings (PAYC) and HubSpot (HUBS).

As it stands, Microsoft (MSFT) has dropped off the IBD Leaderboard. The Leaderboard is IBD’s curated list of leading stocks that stand out on technical and fundamental metrics.

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, Workday (WDAY) and Atlassian.

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

When deciding whether the time is right to buy software stocks, Relative Strength Ratings are important. They’re available at IBD Stock Check-up.

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.

Salesforce.com (CRM) is among SaaS stocks that churn out free cash flow. One factor impacting CRM stock is the integration of recently acquired Slack Technologies.

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.

Further, cloud computing, digital transformation and artificial intelligence projects should remain corporate priorities, analysts say.

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.

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