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They call it the stock market, but it’s actually a market of stocks. While the broad indexes have been struggling in recent months, the software sector remains in a strong bull market. As a reference, the iShares Expanded Tech-Software Sector ETF (IGV) has gained over 20% in the past year, while the SPDR S&P 500 ETF (SPY) is up by a far more modest 7% in the same period.
Past performance does not guarantee future returns, but the software sector offers exposure to many high-growth companies with attractive fundamentals, and the iShares Expanded Tech-Software Sector ETF is displaying impressive momentum levels.
The Fundamentals
IGV is highly concentrated, with the top 10 positions accounting for more than 56% of the portfolio. When looking at these names, there are some important characteristics to highlight.
Source: Seeking Alpha
First and foremost, companies in the software sector tend to have solid competitive strengths due to high switching costs in the industry. High-quality players such as ServiceNow (NOW), for example, have customer retention rates of around 98%.
Switching suppliers can be remarkably problematic for users in the software industry. Time and money are obvious considerations, but there are also indirect costs related to lost productivity during the transition. More importantly, the operational risk related to the possible loss of data and business disruption is a major factor to consider.
Once a software provider is well ingrained into a client, chances are that this relationship will be maintained and even enlarged over the long term. This creates plenty of opportunities for sustained revenue growth among the top players in the market.
The chart below shows how revenue for the top 10 stocks in the iShares Expanded Tech-Software Sector ETF has evolved over the past three years.
Big and stable corporations such as Microsoft (MSFT) and Oracle (ORCL) can’t be expected to grow at the same speed as younger and more dynamic players like ServiceNow and Workday (WDAY). However, most of the big players in the industry are delivering impressive performance at the top line.
The business model in software offers remarkably attractive characteristics. Most of the operating costs are relatively fixed, adding a new customer generates more revenue, while the cost impact of servicing such a customer increases at a much slower rate than revenue. For this reason, profit margins tend to expand as revenue grows over the years.
In a nutshell, many of the companies in the iShares Expanded Tech-Software Sector ETF benefit from solid competitive advantages, rapid revenue growth, and expanding profitability. This is clearly an attractive combination for investors.
The Timing Looks Good
Winners tend to keep on winning in the stock market. Rising prices attract more buyers and vice-versa. When a particular sector is doing well, it tends to continue doing well more often than not, as investors gravitate towards the sectors that are delivering superior performance. In fact, there is plenty of statistical research proving that investors can obtain market-beating by investing in securities with strong momentum over the long term.
IGV is substantially outperforming the SPDR S&P 500 over the past year. Not only that, but also while the ETF that tracks the S&P 500 is still below its highs from 2018, the software ETF is in a much stronger uptrend and trading above such a critical level.
Source: Koyfin
The Global Rotation System is a quantitative system available to members in The Data-Driven Investor. This system rotates among a wide variety of ETFs that represent different asset classes and sectors based on risk-adjusted momentum.
The system is basically buying the ETFs with superior risk-adjusted returns over three and six months, so it’s basically buying strength and selling weakness, as simple as that.
Since January of 2007, the Global Rotation System produced a cumulative gain of 548.7% versus 161% for the SPDR S&P 500 in the same period. In annual terms, the system gained 16.3% versus 8.1% for the SPDR S&P 500.
Source: ETFreplay
The system substantially outperformed the SPDR S&P 500 in terms of downside risk too. The maximum drawdown was 18.4% for the Global Rotation System versus 55.2% for the SPDR S&P 500 in the same period. Drawdown is calculated as the greatest percentage drop from the high.
Source: ETFreplay
This strategy does not beat the market in each and every year, and momentum can be a double-edged sword, meaning that the sectors that are delivering superior returns on the way up can many times suffer the biggest losses when markets turn around. However, the data shows that following the main trends in momentum can be an effective way to increase returns and control for downside risk in the market.
As of the most recent update, the iShares Expanded Tech-Software Sector ETF is one of the three portfolio holdings in the Global Rotation System, meaning that the ETF is ranked as one of the top 3 alternatives in the investable universe based on risk-adjusted return metrics. If the statistical evidence is any valid guide for the future, this bodes well for investors in the software ETF going forward.
The Bottom Line
Software is a high-growth sector, as such, companies in the industry generally trade at demanding valuation levels. Besides, software demand is highly related to corporate spending and hence to economic growth. If there is an economic slowdown or a recession in the US over the middle term, the iShares Expanded Tech-Software Sector ETF could be vulnerable to the downside from current valuation levels.
That risk being acknowledged, the software sector offers attractive opportunities to profit from consistent revenue growth and expanding profitability. Besides, the timing looks right for a position in IGV over the middle term.
Statistical research has proven that stocks and ETFs showing certain quantitative attributes tend to outperform the market over the long term. A subscription to The Data Driven Investor provides you access to profitable screeners and live portfolios based on these effective and time-proven return drivers. Forget about opinions and speculation, investing decisions based on cold hard quantitative data can provide you superior returns with lower risk. Click here to get your free trial now.
Disclosure: I am/we are long CRM, WDAY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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