It has been difficult to ignore the renewed sense of optimism creeping into stock markets this year. Misery has been replaced by a watchful brightness, and nowhere has this sheen reflected better than among software growth stocks.

After tumbling more than a third in 2022, the US-listed iShares Expanded Tech-Software Sector ETF (IGV:BATS), comprised of many of the major enterprise software players, was up 16% this year as of 2 February. It remains about 11% ahead as we write this feature (2 March).

That compares to the Nasdaq Composite’s 10.4% gain and the 4.1% advance of the S&P 500. The FTSE 100 is about 5% ahead.

The macroeconomic and geopolitical anxieties of the past few years – soaring inflation, rising interest rates, war, recession, etc. – are still rampant and feed investor worries about weakening business spending that are dampening forward expectations.

SOFTWARE IS IN LOCKSTEP WITH INFLATION, RATES AND EARNINGS

Software is a sector that walks in lockstep with what happens with inflation, rate hikes (particularly by the US Federal Reserve) and 2023 earnings guidance.

‘Investors remain focused on macro commentary and IT spending patterns,’ said an RBC Capital report. Market research firm Gartner in January cut its forecast for growth in 2023 global information technology spending by more than half to 2.4%, adding up to $4.49 trillion.

‘In January, we saw higher scrutiny on budgets compared to December, resulting in additional delays in large deals,’ said Jay Chaudhry, chairman and chief executive of cloud security business Zscaler (ZS:NASDAQ), at the beginning of March 2023.

But there is optimism too. Cowen analyst Derrick Wood recently surveyed tech departments on enterprise software spending priorities. ‘Our survey projects 7.3% budget growth in 2023, a modest deceleration from 8.3% in 2022,’ he said.

As has been the case with many software vendors during the latest earnings season, businesses are taking more time to scrutinise deal lengths or subscriptions, and software companies are streamlining their own operations, a worry for the pace of growth through 2023.

Yet software penetrates virtually every aspect of our lives in the digital information age and both individuals and businesses rely on operating systems and applications that makes software as crucial as oil, glass and steel.

For example, virtually every company in every industry is now looking to use software to get closer to its customers, innovate more quickly, and operate more efficiently. Many firms are embarking on multi-year digital transformation, cloud distribution, e-commerce and data analytics projects, are at least investigating the potential of artificial intelligence and machine learning, and this seems likely to accelerate as companies and government organisations adapt to hybrid work environments.

Companies that provide vital applications to power these transitions could be potential beneficiaries of these trends. Examples include Microsoft (MSFT:NASDAQ), Salesforce (CRM:NYSE), Workday (WDAY:NASDAQ), Oracle (ORCL:NYSE) and SAP (SAP:ETR).

SOFTWARE’S KEY METRICS

Recurring or subscription-based revenues is a major financial data point for studying the merits of software stocks. Industry businesses are increasingly trying to tie customers into a software ecosystem, offering better value through tools and applications that become mission critical, creating a network effect from which it becomes prohibitively complex and expensive to switch away.

Think about how Microsoft uses Windows and its Office 365 package of tools to clients, with Teams, PowerPoint, Excel and Word providing a gateway into its Azure Cloud applications suite of data storage, distribution and analytics.

‘Should we switch away from Microsoft?’ is a boardroom conversation starter as rare as hen’s teeth.

Other important metrics include overall growth, gross margins, returns on investment, alongside free cash flow. This is an industry that tends to throw off huge amounts of cash as successful software companies progress from start-up to maturity, providing enormous financial firepower to invest in new markets, make acquisitions and, eventually, pay dividends to shareholders.

Microsoft handed nearly $19 billion (£15.8 billion) back to shareholders in 2022.

It is this cash flow quality and faster-than-average growth that tends to see software companies trade on higher-than-average valuations than many other types of stock.

WHICH COMPANIES CAN I INVEST IN?

The UK software sector has been decimated over the years by overseas buyers and private equity investors. In the past year or so we have lost £9 billion engineering software firm Aveva (at the time the UK’s largest listed software company), consumer cybersecurity firm Avast, infrastructure IT business Micro Focus and EMIS, a software provider to the NHS.

That’s about £21 billion of software market value that generated roughly £5.5 billion of annual software revenues.

This has left the UK-listed software sector subscale when compared to the US, for example. Take £7.8 billion accounting software firm Sage (SGE), now the UK sector’s largest, compared to US peer Intuit’s (INTU:NASDAQ) $114 billion, or approximately £95 billion on a pound-for-pound basis.

According to Sharepad data, the UK market has only eight software companies worth more than £1 billion, and that’s only if we include three that have no place in the software sector at all. Auto Trader (AUTO), Baltic Classifieds (BCG), Moneysupermarket (MONY) are media businesses at their core.

Of those remaining, IT managed services supplier Softcat (SCT) and Belfast-based digital transformation company Kainos (KNOS) have impressed investors with their consistent growth and quality over the years but finding software companies with above-average growth potential otherwise requires investors to embrace the junior AIM market, and not everyone is comfortable doing that.

This is a major reason why UK investors really need to look beyond their own stock market backyard and embrace overseas’ listed companies, especially on Wall Street, where the S&P 500 index is littered with software giants, some of which have been already mentioned, but you can also make a case for Apple (AAPL:NASDAQ), Google-owner Alphabet (GOOG:NASDAQ), Meta Platforms (META:NASDAQ), Amazon (AMZN:NASDAQ), Visa (V:NYSE) and Adobe (ADBE:NASDAQ) as software companies, even if they are not necessarily classified as such.

CAN I PLAY THE THEME THROUGH FUNDS?

Funds are a way to tap into the software space, and not only specialist tech vehicles. Given the influence of wider tech businesses on the S&P 500 (worth around 25% of its entire market cap), a low-cost ETF tracking this index will provide plenty of exposure for investors who prefer more diversification that a specialist tech fund.

An inexpensive Nasdaq Composite ETF is another way to get broad software company exposure. The Invesco Nasdaq 100 ETF (EQQQ) or the iShares Nasdaq 100 ETF (CNX1) both track the 100 largest Nasdaq companies.

For greater software and technology focus, both Polar Capital and Allianz run tech investment trusts and UCITS funds and, the past couple of years aside, have impressive track records. Their respective investment trusts – Polar Capital Technology Trust (PCT) and Allianz Technology Trust (ATT) – have averaged 17% a year and 20.5% respectively over the past decade.

Alternatively, there are several thematic ETFs that might appeal to investors. Cloud computing has been one of the most successful investment themes over the past decade, and it promises to create wealth for investors long into the future, we believe. First Trust Cloud Computing ETF (FSKY) aims to tap into this theme.

Or perhaps cybersecurity interests you. The L&G Cyber Security ETF (ISPY) is an option here. With assets of more than £2 billion, it’s large enough so that liquidity is no problem, broad enough for reasonable diversification, and has scale to lower costs, which it did in 2021. It’s still not the cheapest, with ongoing costs of 0.69%, but it does have a five-year total returns track record of 10.5% a year when most of its peers have only been around for a year or two, such as the WisdomTree Cybersecurity ETF (CYSE) and the Global X Cybersecurity ETF (BUGG).

TWO STOCKS TO BUY

MICROSOFT (MSFT:NASDAQ) $255.29

Years ago, it was said that no fund manager got sacked for buying IBM (IBM:NYSE), and while things have changed a lot since, the same could be said today of Microsoft, given its performance.

Microsoft has never been afraid to take risks with big acquisitions but its $68.7 billion pitch to buy Call of Duty, World of Warcraft and Candy Crush-owner Activision Blizzard (ATVI:NASDAQ) represents its biggest gamble yet.

The tie-up is far from guaranteed, with regulators in the US, EU and UK scrutinising the small print, but if it does, there is plenty of outstanding engineering talent at Microsoft capable of bringing extra value to the gaming space.

With its own expertise in the fledgling metaverse, Microsoft would be able to create a ‘multi-faceted metaverse of gaming and wider entertainment with a good chance of becoming a leader in this new field,’ says Gerrit Smit, manager of the Stonehage Fleming Global Best Ideas Equity Fund (BCLYMF3), where Microsoft is its second largest stake.

Microsoft has not been immune to slower economic activity, reporting its slowest revenue growth in five years in October 2022, while rising energy costs and the strength of the US dollar cut away profits. Sales growth in its Azure cloud business – one of the company’s bright spots in recent years – was lower than analysts had hoped at 35%, but as Azure revenues are largely driven by consumption, as the global economy picks up, so should Azure’s growth too.

Despite an extreme 2022 Microsoft was still able to push through Office 365 subscription price hikes of about 15% to 20%, illustrating how robust this company is. Enterprises simply can’t run without Outlook, PowerPoint, Excel, Teams and more, and it’s almost unthinkable to consider alternatives, believes Blue Whale Growth Fund’s (BD6PG78) Stephen Yiu. We agree. Over the last decade Microsoft’s earnings have increased 272.3% but its shares have delivered a total return of more than 800% as perception around the stock has moved away from seeing it as tied to a structurally declining desktop PC market.

KAINOS (KNOS) £13.76

In the eight years since listing in London, the Belfast University spin-out has seen its market value surge from £161 million to £1.7 billion, a 956% gain. It has also been one of those rarities – a tech company that has been raising 2023 guidance, not chipping away at revenue and earnings expectations.

September 2022 half-year results saw management upgraded its earnings forecast for next year on the back of ‘strong’ results across the board, saying demand ‘has never been higher.’ First-half profits rose 16% to £34 million.

‘The strong revenue performance and backlog growth encourage us to raise our sales estimates by 5% with the implied 19% year-on-year growth in the second half well underpinned by backlog,’ said analysts at Canaccord Genuity.

The shares aren’t cheap, on a March 2024 price to earnings of 28, reflecting its above-average growth and returns potential.

DISCLAIMER: The author of this article Steven Frazer owns shares in Polar Capital Technology Trust and Allianz Technology Trust, and units in Blue Whale Growth Fund.

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