Software Stocks Are Hot Again as Earnings Shows Resilience
The fast-growing software companies that took a pounding in this year’s technology stock selloff suddenly are stars of the market, and earnings are a big reason why.
Companies from Atlassian Corp. to Alteryx Inc. and Cloudflare Inc. have reported strong results, underlining tailwinds for the industry that bulls say remain intact even in a weaker economy.
At the same time, valuations have come down after the brutal first half and, just as importantly, sentiment toward the Federal Reserve has shifted and investors now are far less concerned that the central bank will go too far in raising interest rates.
“I’m optimistic about the ability of these stocks to outperform over the intermediate and long term, since they’re being fueled by underlying trends that remain quite strong,” said Hilary Frisch, senior research analyst at ClearBridge Investments. “Valuations are at multi-year lows in some cases, but the fundamental picture has only gotten more clear.”
While none of these stocks are household names like industry giants Microsoft Corp. or Oracle Corp., investors large and small flocked to them during the bull market of the past couple of years because of their rapid sales growth and, in many cases, their exposure to hot sectors such as cloud computing or cybersecurity. This year has been tough.
A Goldman Sachs Group Inc. basket of high-growth software has slumped 41% in 2022, more than twice the decline of the Nasdaq 100 Index, and steeper than the 23% drop of the iShares Expanded Tech-Software Sector ETF. The slump came as the Fed began aggressively raising rates to fight inflation, a headwind to high-valuation stocks that are priced on their prospects far out in the future.
Investors, however, looked optimistically at Fed Chair Jerome Powell’s comment last month that the central bank will slow the pace of increases at some point, suggesting a friendlier environment for growth stocks. The yield on the 10-year Treasury has gone from a recent peak near 3.5% to less than 2.7%, relieving some of the pressure on growth-stock multiples.
Since a June 16 closing low for the Nasdaq 100, Goldman’s software basket has easily outperformed, jumping about 30%.
“By and large, software weakness has been 100% about the macro environment, not fundamentals,” said Jordan Klein, a managing director and tech analyst at Mizuho Securities, who noted some exceptions such as pandemic beneficiaries like Zoom Video Communications Inc. Otherwise, he said, corporate results are illustrating the enduring strength of their businesses.
The Goldman basket trades at 7.8 times forward sales, about half its average going back to 2018. In early 2021, it was trading at nearly 25 times estimated sales. The Nasdaq 100 has a multiple of about 4 times estimated sales.
Among specific reports, ZoomInfo Technologies Inc. spiked more than 10% in the wake of its results, while Confluent Inc. rose 11% after hiking its forecast and Alteryx popped nearly 20% after its own bullish forecast. Atlassian, HubSpot Inc., and Cloudflare all gained after reports late Thursday, with Atlassian up 8.2% and Cloudflare climbing 14%.
The sector has not been uniformly strong, with ServiceNow Inc. and Datadog Inc. both falling after their reports. But of the 38 companies in the S&P 500 software & tech services sector that have reported, 28 exceeded earnings estimates, while seven have missed.
A key question for investors is how growth will hold up if the economy falls into a more protracted downturn. Mark Haefele, chief investment officer at UBS Global Wealth Management, wrote that it was too soon to move back into growth stocks, singling out unprofitable tech as an area that could be particularly vulnerable.
“The rising cost of capital, tightening financial conditions, and growing recession risks are likely to limit the upside for unprofitable tech companies given limited near-term scope for strong margin expansion,” he wrote.
Still, software companies are putting up the kind of growth that investors love. Wall Street expects earnings for the software and services sector will rise about 12% in 2023, compared with the 15% pace that had been expected in late February, according to Bloomberg Intelligence data. Revenue is expected to grow 11%, down from the 12% pace that had been expected in early July.
Tech Chart of the Day
While Uber Technologies Inc.’s stock is on track for the best week ever as a public company, shares of Lyft Inc. are on course of their biggest weekly gain in 20 months. Both ride-hailing firms announced better-than-expected quarterly results this week. Lyft was up 5.6% after the company reported the highest earnings in its history.
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