Over the past year, many investors have been asking whether the party is over for American technology and software. US software companies thrived during the Covid-19 pandemic as working from home became the norm and services underpinned by technology flourished. With a return towards normality, however, the sector has experienced a sharp downturn.
The tech-laden Nasdaq index is down almost 30% since the start of 2022. Investors could be forgiven for questioning whether this reversal in fortunes, coupled with a backdrop of rising inflation and interest rate hikes, means they should give software companies a wide berth.
The truth is that the US software and technology sector is huge and diverse. Although it does contain overleveraged and (until recently) overvalued stocks with too little (or no) revenue, we believe there are still a number of solid growth stocks in the space. In our view, some of these names, which have strong revenue streams and good prospects over the medium to long term, are being unfairly penalised by bearish market sentiment.
The fact is that many software products and services companies have only scratched the surface when it comes to serving their potential client base. In many ways it is still ‘early days’ for these companies, even if it feels as though many are established names. Companies offering products and services software that enable their clients to save money and enhance productivity is something businesses are willing pay for – and pay more for – during inflationary times.
A few of the key names in this space may be familiar: Intuit, Oracle and Microsoft. Intuit is a technology platform specialising in financial software such as tax preparation (TurboTax), accounting (QuickBooks) and credit monitoring (Credit Karma). Oracle, which originally provided relational databases to clients with a 34% market share in this $40bn market, is now the world’s third biggest software company by revenue and market capitalisation.
The company has transitioned to an infrastructure and software as a service (IaaS and SaaS) model which has enabled it to branch out into a number of service areas, including the provision of cloud storage services to healthcare firms. Microsoft arguably needs no introduction, but the company continues to innovate and stay abreast of the latest industry trends.
All of these companies are large and software is an area in which it generally pays to be big. Market share leaders are better equipped to navigate challenging economic environments since they tend to have more robust supply chains and can gain further market share by providing consistency of service to their customers. In addition, smaller challengers typically don’t have first access to supplies as they aren’t bulk buyers. Software and services revenues are now far less cyclical than the market and companies in the space usually possess defensive traits.
Microsoft, Oracle and Intuit, as well as similar companies, have long-term structural tailwinds in their favour. For example, Intuit is the market leader when it comes to providing financial software services to small and medium enterprises (SMEs). Yet with more than 200 million SMEs in the world, Intuit QuickBooks currently serves fewer than 10 million of these. Oracle enjoys a similar market advantage and, although some consider it a value stock, the company’s revenue is growing at more than 10% per year.
The enterprise resource planning (ERP) market – which helps organisations manage day-to-day business activities such as accounting, procurement, project management, risk management and compliance – offers great growth potential and Oracle is already becoming a leader in cloud ERP. As the ERP applications market is larger than Oracle’s core database market, their transition to the cloud is likely to accelerate company growth while effective cost management could offset any margin pressure associated with transition costs.
More broadly, the percentage of the world’s population with access to the internet is still just 60%. As more people move online, the demand for the services provided by companies such as Microsoft, Oracle and Intuit should only increase.
It is important to differentiate between profitable and unprofitable technology companies. The former are cash generative and have the potential for further growth from untapped markets. Stocks that sold off most sharply in the first half of 2022 relied too much on sentiment with a lack of profits to support stretched valuations.
Given the uniqueness of the crisis, ‘pandemic winners’ should be distinguished from companies whose products were rendered temporarily more useful and profitable versus those who have benefited from a sustainable step-up in product penetration. Using the example of Microsoft Teams, the platform was certainly used more during Covid-19 for virtual meetings, but it is also a cornerstone of Microsoft’s enterprise go-to-market strategy.
Software serves as a deflationary force since it enables businesses to enhance their productivity. This means in a world of rising prices and input costs for labour and materials, any product or service that allows a company to save on time and labour in business activities can be both extremely useful and of enormous value. Companies get more bang for their buck.
This gives companies like Microsoft, Oracle and Intuit not only protection against inflationary pressure, but also significant pricing power. For long-term investors seeking a safe haven from a volatile market, these types of quality growth companies could offer sustainable opportunities.
Justin Streeter is portfolio manager of the Comgest Growth America fund. The views expressed above should not be taken as investment advice.