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Software Stocks Look Attractive, but Another Round of Pain May Await

Software stocks in the S&P 500 have been hit particularly hard this year. Investors could see more selling before gains take hold.

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Software stocks have tumbled, and they now look tempting to buy, though one more bout of selling could take hold first. 

Software stocks in the
S&P 500
have been hit particularly hard this year.
Salesforce
(ticker: CRM),
ServiceNow
(NOW), and
Microsoft
(MSFT) are all down 25% to 49% for the year. 

The reasons are aplenty. Many stocks are down this year as high inflation and the subsequent interest-rate hikes from the Federal Reserve have prompted markets to expect a hit to economic demand. Businesses could pull back on spending and reduce IT budgets, which would make it difficult for many software companies to meet sales expectations. Plus, demand spiked for cloud and digital software services in 2020 and 2021 as businesses pivoted to work-from-home policies, so earnings growth now will be down from that.

Also, higher rates hurt these names, too. Many software companies are still growing profits at a rate above that of the broader stock market in aggregate, which means the bulk of their profits are expected to come many years in the future—and higher rates make future earnings less valuable.

Now, these stocks look interesting at these levels. The S&P 500 software sector has posted a gain that is double the broader index’s rise since December 2016, according to Wells Fargo strategists. That’s down from a 300 percentage-point cumulative outperformance seen in late 2020, as other groups have been more in favor. The current lower level of cumulative outperformance was last seen in 2018, when buyers stepped in and sent these stocks higher. 

Such buying is entirely possible, given the current market backdrop. Investors hope for interest rates to stabilize, and that would support software valuation multiples. That would allow earnings-growth expectations to bring these stocks higher, at least for the companies that can execute and uphold profit forecasts. 

These are the core reasons why the Wells Fargo strategists upgraded the industry to Neutral from Underweight. The current aggregate forward price/earnings multiple for the S&P 500 software industry is around 24 times, a roughly 40% premium to the S&P 500’s multiple. That premium is down from the above 60% often seen since 2019, and it’s roughly where the premium tends to bottom. That confirms that these multiples may not fall much from here. 

“Valuations have retreated from five-year highs, improving the group’s risk/reward,” Christopher Harvey, chief U.S. equity strategist at Wells Fargo, wrote in a report. 

That reward could come to fruition if these companies execute, and uphold their earnings growth expectations. Currently, the group is expected to post just under 30% earnings-per-share growth in 2023, according to Wells Fargo. That’s down from nearly 40% in 2020, but still much higher than the broader market.

Enterprise cloud services continue to replace traditional ways of organizing and storing data, while providers of the new offerings are upselling existing customers new, complimentary products. That’s driving sales growth, while lesser increases in costs like marketing drive profit margin expansion, helping get the group to the expected earnings growth. The key for these stocks as 2023 progresses will be upholding 2024 earnings-per-share growth forecasts, which are about 24% on average for Salesforce, ServiceNow, and Microsoft, according to FactSet. 

That all sounds rosy, but the near term could bring one more bout of pain for these stocks.

Earnings in the near term could take a hit. Companies could reduce their IT budgets as the economy feels the pain of higher rates. The three previously mentioned companies have all seen analysts lower their 2023 earnings-per-share estimates from the peaks, but those estimates are still up for the entire year. Data from RBC strategists show that the majority of earnings-per-share revisions for the next two years for software has been upward, but historically, a majority of those revisions can be downward, especially during recessions.  

Software stocks may very well be a buy right now. Just don’t be surprised to experience some pain before enjoying a gain. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

Credit: marketwatch.com

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