Software stocks, especially those on the smaller side, really took it on the chin when the Fed started hiking rates a few years ago.
They were already trading at elevated valuations, and the aggressive rate hiking cycle added a dose of uncertainty to the economy.
This prompted a lot of their customers, primarily small and mid-sized businesses (SMBs) to cut their software spending.
The early days of AI hype didn’t help matters either, as the initial beneficiaries were hardware and semiconductor stocks and AI-focused headlines highlighted results that threatened the product offerings of these pure-play software stocks.
All of this led to an extended downgrade cycle through 2022 and 2023. In many cases that extended into Q1 of this year.
Now, after a prolonged period of underperformance, smaller software stocks have stabilized and valuations look reasonable once again, as this recent chart from Morgan Stanley shows.
There are a number of reasons that, in the aggregate, suggest much brighter days ahead.
First, despite the Fed’s aggressive rate hike cycle (which is now over), the economy has held up and survived without the recession so many feared. It’s reasonable to think businesses that purchase software, including SMBs, will get a boost from the Fed’s policy shift.
Second, it seems the initial concern that AI would destroy many software company business models has faded. Examples where AI represents a real competitive threat are now better known. I think investors have begun looking at software companies on a more individual basis. And in many cases, AI represents a growth opportunity, not imminent destruction.
Lastly, Q2 earnings season was incrementally positive for software. There were more upward revisions than guidance cuts. Sure, that was partly because of how management teams lowered expectations in Q1, but still. The market loves a bad to better story, especially when there are other tailwinds.
Speaking of tailwinds, lower interest rates are a significant tailwind for software stocks. Lower rates help growth stocks, like software, trade at higher valuations.
Five Small & Mid-Cap Software Stocks Set to Rebound
Because software ETFs like the WisdomTree Cloud Computing ETF (WCLD) and Global X Cloud Computing ETF (CLOU) are heavily invested in large caps (around 38%), you’re better off targeting promising small- and mid-cap names individually.
Here are five names that I think are worth your attention.
Docebo (DCBO): A Canadian software company disrupting the Learning Management market with a modern, easy-to-use cloud-based learning platform. The platform helps organizations work with internal workers, but also in more complicated external partner and customer scenarios. That core competency is something Docebo’s platform is increasingly recognized for. Revenue should grow by around 19% this year and EPS should be up about 50%, to $0.95. Docebo has a market cap of $1.4 billion.
Clear (YOU): Clear has a market cap of $5.2 billion. It’s a security identity platform that most people recognize when traveling. Its Clear Plus subscription product uses biometrics to speed things up when going through airport security. Analysts see full-year revenue growth of about 24% with EPS growing by about 120% to $1.27. That’s an impressive growth and profit profile for a software company this size.
Klaviyo (KVYO): A $9.9 billion market cap marketing automation company with a platform that helps customers generate returns from marketing investments. The company is also a data specialist, which feeds into its AI strategy. Klaviyo posted an impressive Q2 beat on August 7, reporting revenue growth of 35% to $222 million and EPS growth of 67% to $0.15. That puts the company on track to grow both the top and bottom line in the 30% to 35% range this year, with upside potential.
Semrush (SEMR): Semrush, like Klaviyo, is a marketing technology company. It is a $1.9 billion market cap company with an online marketing software platform that’s known as having one of the better search engine optimization (SEO) toolsets in the industry. The company recently expanded through M&A (it bought Brand24 in Q2 and Ryte in July) and launched an enterprise-focused SEO product in May. This movement deeper into the enterprise market has been welcomed by analysts, who have seen Semrush’s exposure to the small and mid-sized business (SMB) market as a potential weakness (even though SMB seems stable to improving now). The company should grow 2024 revenue by 22% to $374 million and EPS by 126%, to $0.26.
Unity (U): Unity, which has a market cap of $8.4 billion, offers a software platform for developing, running and monetizing video games in both 2D and 3D formats. It works on mobile devices, tablets, consoles and virtual reality devices. It’s known as the best “picks and shovels” stock to play gaming and interactive content. The company recently announced it was ditching its runtime fee, which was implemented last year and caused a ruckus among customers. Unity will simply increase subscription fees instead. Analysts like the move, which they see helping to turn around a negative trend in revenue and earnings that began in 2024. While revenue is seen down 19% this year, it should be up around 1% in 2025. Unity is still profitable, with EPS of $0.86 expected this year (down 20% versus 2023). It’s a turnaround story.
