Small-Cap Cloud Software Stocks Are Rallying. Here’s Why

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Software stocks were one of the strongest performing sub-sectors through the first three quarters of 2018. The strength was largely due to underlying secular growth trends stemming from an increasingly digital global economy.

While this high-growth group of stocks took a hit in late 2018 – along with just about every other group of stocks out there – I expect the big picture trend for software, and especially cloud-based software, to continue.

Why?

It’s simple. Digital strategies aren’t getting crossed off the to-do list of CIOs across the world. They are just too important to the future health and competitive positioning of their organizations. While this doesn’t mean every single company hawking a cloud-based software solution is a slam-dunk investment, it does mean the best-of-breed companies are likely to flourish.

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Cloud Software Still A Major Growth Market

Many software sector analysts see IT spending up in the 4.5% to 4.8% range in 2019 (just a hair below 4.9% growth in 2018), with software-specific spending up around 5.2% (as compared to 5.3% last year).

That backdrop should sustain another year of healthy growth for the stronger cloud-based software companies. Many of these companies are also maturing, have strong recurring revenue models, high renewal rates, a broader set of customers, a lower tax rate, and improving profitability.

This maturation of the group, and the SaaS-based delivery model, bodes well for the long-term financial health of companies that deliver software-based functionalities that partners and customers are increasingly dependent upon.

Thus far, earnings season suggests bullish trends are intact too. There haven’t been any of the huge negative surprises that share price performance in Q4 seemed to be forecasting. While growth rates in some business units might be slowing, results from the big boys of cloud, including Microsoft (MSFT), Amazon (AMZN), Apple (AAPL), and ServiceNow (NOW), show that cloud and service-related areas of their businesses are doing better than fine.

At the smaller end of the spectrum, it’s still a little early in earnings season to pull out major takeaways from small- and mid-cap software stocks. But a smattering of early reports from players, including Zendesk (ZEN), suggest positive trends continue here too.

One potential wildcard for the group: there is lurking potential for software companies to expand in Asia if trade negotiations with China around intellectual property (IP) enforcement advance. While any perceived progress won’t result in overnight success for U.S. software companies, there is a huge long-term opportunity for software companies to grow into a massive market that they’ve essentially been shut out of.

Keep this in mind as you read headlines about the U.S. working on a China trade deal that enforces IP protection.

Strategic Value of Software Stocks Remains High

There is another potential catalyst that could help small-cap cloud software stocks this year. After the market pullback in late 2018 the software group was back to trading near EV/Sales multiples that were in line with their historical averages at the beginning of 2019.

That’s despite the data showing the strategic value (i.e. takeover value) of software companies appears relatively high.

Data from Morgan Stanley shows that in 2018 there were just over 120 publicly announced software M&A deals, well ahead of the 84 disclosed in 2017 and 71 disclosed in 2016. The dollar value of deals was at an 18-year high as well.

The implication here is that, with many small-cap software stocks trading with an EV/TTM Sales multiple below the average acquisition multiple (around 8x EV/TTM Sales) from the last six years, there is potential for deals to be done well above current market prices.

That’s especially true in cases where there is strategic and/or scarcity value in the target company, technology, customer base and/or dataset.

This year a few deals have already been announced. Ultimate Software Group (ULTI) is one. The stock surged to an all-time high last week after the cloud-based HR application developer agreed to be acquired by an investor group led by a private equity firm.

The Best Small-Cap Cloud Software Stocks

This all said, the opportunity in cloud software stocks hasn’t gone unnoticed. Many of the stronger stocks in the space have recovered swiftly over the past six weeks. And there are still potential issues, such as slowing global growth and rising corporate costs.

I think we’ll see a narrower group of software stocks outperform in 2019 than we did in 2018 as the higher quality names attract investor dollars at the expense of the so-so, and lower quality, names.

In other words, stock selection will play a greater role in small-cap cloud software portfolios in the year ahead.

It will be particularly important to focus on small-cap software stocks that have ultra-compelling secular growth stories, durable business models, attractive M&A potential, reasonable valuations relative to growth, and some insulation from cyclical trends, rising interest rates and trade disruption.

No stock will check all of these boxes. But it’s a good idea to try and come close.

In my mind, small- and mid-cap software stocks with pure-play exposure to digital payments and banking, cybersecurity, various areas of compliance, and customer relationship management (CRM) are in the sweet spot.

You’re not on your own to uncover these stocks, of course. That’s my job.

I cover the best ideas I have in Cabot Small-Cap Confidential, an advisory service designed specifically for self-directed investors that want exposure to high-growth small-cap stocks. You can sign up for a subscription here.

Tyler Laundon

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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!

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