Software stocks have a reputation for experiencing a downturn in the second half of the year, only to bounce back and outperform the S&P 500. As investors face the recent decline in software shares, it's important to consider the historical patterns while also adopting a more discerning approach.
Embracing the Short-Term Challenges
According to Evercore ISI analyst Kirk Materne, those with a longer-term perspective of six to nine months should be prepared to "embrace the suck." In other words, they should acknowledge and weather the temporary setbacks. However, Materne suggests that a level of selectivity is necessary, deviating slightly from what past trends would indicate.
Understanding the Current Pullback
The iShares Expanded Tech-Software Sector ETF (IGV) has experienced a 7% decline since its peak in mid-July. Materne believes that this pullback follows a familiar pattern seen in previous second-half declines, where investors take profits due to macro uncertainty. He notes that it will take another 30-60 days to gain clarity on IT spending budgets.
Factors Setting This Pullback Apart
While similarities can be drawn between the current selloff and past occurrences, there are notable distinctions. Materne points out that the dynamic has shifted due to the 10-year Treasury yield sitting at approximately 4.7%. This change makes profitability and positive cash flow imperative, unlike before when growth at any cost was favored. Moreover, larger "platforms" now enjoy a significant advantage over smaller vendors as they offer a free cash flow backstop.
As the software sector experiences this dip, investors must approach it strategically, taking into account previous trends while considering the unique elements at play.
Key Software Stocks to Watch
Software stocks have seen a recent decline, but some analysts believe that certain larger software companies may be poised for a rebound. These companies include Adobe Inc., Microsoft Corp., Intuit Inc., and Palo Alto Networks Inc. According to Materne, these well-established names have the potential to outperform when the software industry recovers.
In addition to these larger companies, Materne identifies a select group of growth names that are already at scale and generating positive free cash flow. Included in this group are CrowdStrike Holdings Inc., Snowflake Inc., and HubSpot Inc.
However, it is important to consider whether the decline in software stocks has truly come to an end. Materne suggests that while this year's pullback may not be as severe as in previous years, there is still some uncertainty. Nevertheless, profitability within the industry remains higher overall, and valuations for many software stocks are still below pre-COVID levels.
Industry conversations with partners also suggest a stable spending environment, even if there hasn't been significant improvement yet. Looking ahead, Materne predicts that software companies will begin to capitalize on generative artificial intelligence in the second half of next year and beyond.