Software stocks outperformed the market for the fourth straight year during the coronavirus pandemic. Can this sector make it five in a row in 2021 with the likes of Snowflake stock, Zoom Video stock and Shopify stock trading at high multiples?
Heading into 2021, some analysts are cautious. They say investors should be picky about software stocks, rather than diving into the sector across the board.
One reason is that on average, software stocks trade at a higher multiple of forward-looking revenue than before the coronavirus pandemic hit. Bullish analysts expect spending on so-called digital transformation projects to stay strong in 2021.
Those initiatives work to automate business workflows and digitize customer-facing functions amid the corporate shift to remote work. At many companies, digital transformation involves speeding up internal software development.
Goldman Sachs analyst Heather Bellini expects spending on cloud computing software to be prioritized in 2021. In addition, she says increased demand for next-generation collaboration and productivity tools will persist.
Top Performing Software Stocks
“We believe the upward pressure on multiples is a result of an improved fundamental outlook for the pace (of) digital transformations in a post-Covid world,” she said in a report to clients. Bellini added that a sustained low interest rate environment has boosted software stocks. Low rates make borrowing money cheaper.
Also, individual investors have been big buyers of software stocks.
“We don’t think any of these three factors are likely to change in the near-to-medium term, and therefore remain bullish on the group despite record high valuations,” she added.
Zoom Video stock has retreated from its all-time high amid positive vaccine news. The initial public offering of Snowflake stock raised $3.4 billion. That set a record as the largest U.S. software IPO ever.
Software Stocks: Recurring Revenue Models
One reason for the four-year run of the software sector is that it sees recurring revenue streams, produced by subscription-based services.
RBC Capital, in its 2021 outlook for software stocks, said: “2020 was a year in which the defensiveness, durability, and long-term opportunity of software-as-a-service became fully appreciated in the public markets, both in terms of growth and valuations.”
“Most companies enter 2021 with more efficient go-to-market strategies, favorable bookings comparisons, and larger pipelines than a year ago,” RBC analyst Alex Zukin said in a report to clients.
He added: “We believe that while general IT budgets for next year are likely to be flat to down across many industries, budgets for digital and security transformation are likely to rise.”
Will 2021 Returns Be More Moderate?
But Morgan Stanley analyst Keith Weiss is cautious on the outlook for software growth stocks. He says interest rates could rise. Also, if the U.S. economy rebounds, he says investors could shift to more cyclical sectors of the stock market.
Further, he expects software companies to ramp up investments. That would pressure operating margins of software growth stocks.
“Given often conflicting headwinds and tailwinds to assess for software stocks heading into 2021, finding broad themes across the group appears exceedingly difficult,” he said in his note to clients.
Mizuho Securities analyst Gregg Moskowitz also is cautious on software stocks. “Following another year of meaningful software outperformance, valuations are near peak levels,” he said in a note. Moskowitz added, “We believe 2021 returns will be more moderate.”
Software Stocks An Expensive Space
One lingering concern is that software firms with direct sales models will see large deals delayed if in-person meetings and conferences continue to be canceled.
At Canaccord Genuity, analyst David Hynes said investors will need to “navigate an expensive space in 2021.”
“Table stakes for consideration is leadership standing in a big TAM (total addressable market),” he said in a note. “You can’t create a big business without a big opportunity. The second thing we look for is a defensible moat.”
Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.
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