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John Kinsellagh
John Kinsellagh
Articles (155) 

Software Stocks as a Defensive Tech Sector Play

Software companies have better resilience than hardware companies due to scalability, no supply chains and immunity from tariffs

January 30, 2019 | About:

The tech sector has taken a beating recently, particularly among smartphone makers and video graphic card/chip companies.

Apple (NASDAQ:AAPL) and Samsung both have reported dramatically reduced sales, particularly in China's market. Samsung’s presence in China's handset market has virtually disappeared. Five years ago, the South Korean company was a colossus in the Chinese market, selling one out of every five devices in that market. Today, Samsung controls less than 1% of that market. The company was outmaneuvered by competitors from China that sold comparable handsets at substantially reduced prices.

Apple’s fortunes have followed a similar trajectory. First-quarter smart phone sales, which account for two-thirds of its total revenue, dropped to $51.98 billion from $61.1 billion a year earlier. The decline in iPhone sales in one of the company’s most lucrative markets was particularly pronounced. Apple’s total sales in China fell 27% to $13.17 billion.

Both Samsung and Apple have felt the sting of a slowing Chinese economy as well as the effect of tariffs.

Software companies face none of these challenges. What was true since the era of the first IBM PC of the early 1980s is still true today. Without a software operating system, a PC by itself makes a nice bookend holder. Software stocks provide a number of distinct and unique advantages for investors.

Software is constantly evolving and is always going to have built-in demand among corporations, which need to upgrade legacy systems with the latest operating systems as well as productivity software for their employees and customers. Software continues to make strides in facilitating business productivity and if clear productivity or revenue gains can be demonstrated, then more enhanced versions of a software company’s product could be a source of additional and potentially recurring revenue.

In a recent phone interview, Morgan Stanley analyst Keith Weiss told Barron’s, “Companies are going to invest in software even in a weaker economic environment.” Weiss added that the need for software, “is no longer a choice. It’s a must-have. Software has very durable demand trends.” In terms of sustained revenue, software that provides both back office efficiencies and lower overall IT costs is an easy product to sell.

Software companies are also well-positioned to take advantage of the burgeoning cloud computing services market. What makes cloud server software such a compelling product for customers is that software situated on the cloud offers better reliability, more flexibility for meeting a company’s specific IT needs, and demonstrably greater cost savings than traditional software running in-house computing equipment.

Additionally, investors should take note that the revenue model for many software companies is now evolving away from a paid-up license one-time sale to a model of recurring income. Subscription services software offerings will be the future of corporate IT computing. Currently, on average, approximately 80% of software sales are recurring, compared with just 50% recurring sales in 2008.

The phenomenal success of Microsoft (NASDAQ:MSFT)'s, subscription-based Azure cloud computing unit is an indication of the potential for the cloud software market. The meteoric rise in Microsoft’s stock price is ample evidence of the success and revenue potential of a recurring income business software model.

What is the potential for growth in the cloud database software services market? According to Wedbush Securities, approximately 30% of technology workloads are currently on the cloud, a share that will rise to 55% by 2022.

As the recent depressed fortunes of hardware tech companies Nvidia and Intel indicate, software companies are not immune from the effects an overall reduction in cloud spending due to a recession. However, despite economic blips, corporate customers will continue to move towards a cloud platform because of its efficiencies, flexibilities and demonstrable cost savings.

Those investors who prefer hardware tech companies would be well advised to explore the software sector. Astute investors who have previously established positions in software stocks have been amply rewarded with gains for some time. It is also interesting to note that the software sector has beaten the S&P 500 by 14% per annum on average since 2009.

Disclosure: I have no position in any of the securities referenced.

About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

He is the author of "The Mainstream Media Democratic Party Complex" and "Election 2016," both available on Amazon. Follow him on Twitter @jkinsellagh.

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