The IGV ETF: Because Software Is Not Dead – It’s Thriving (BATS:IGV)

The iShares Expanded Tech-Software Sector ETF (BATS:IGV) is down ~28% from its high of $448 set last November (see chart below) as the high-valued software sector has suffered a wicked correction. That said, note that over the past year IGV shares are down only 10.5% – demonstrating that much of the pull-back was simply giving back gains made earlier in 2021. Regardless, for investors who yet to have direct exposure to some of the best software companies on the planet, the time looks ripe to start scaling into the IGV ETF, which I rate a BUY.

Investment Thesis

As you know, the global pandemic greatly accelerated technology trends that were already firmly in place: the digital transformation of businesses and migration to the cloud. These two trends (among others) highlighted high-margin software-as-a-service, or SaaS-based business models. As a result of projected revenue growth rates, combined with the scaling-up of an already high-margin business, the valuation level of many software companies soared. That being the case, I am not at all surprised by the recent pull-back in the IGV Tech-Software ETF. However, I am certainly not selling my shares… in fact, I will now start nibbling and adding more shares over time. Here’s why.

The growth in big data continues to accelerate. Here are some stats for your consideration courtesy of research.aimultiple.com:

• IDC predicts that the “Global Datasphere” will grow from 45 Zetta bytes (“ZB”) in 2019 to 175 ZB by 2025. (data from IDC)
• It has been estimated that 1.7 MB of data will be created every second for every person on earth by 2020. (data from DOMO)
• Each minute in the world: (data from DOMO)
  • 500k tweets are shared on Twitter.
  • YouTube users watch over 4 million videos.
  • Netflix users stream 69k minutes of video.
  • Snapchat users share 527k photos with each other.
  • Over 100 million spam e-mails are sent.
  • Google conducts 3.6 million searches.
  • Users post 46k new posts on Instagram and 250k stories are shared.
  • 15 million text messages are sent.
  • Americans use 2.6 million GB of internet data.

Software not only makes all this creation and movement of data possible, it is also a critical factor in efficiently storing, managing, and analyzing all the “big data” being aggregated. Indeed, in a recent survey of what is the “first business function” driving the use of big data management software, the results were broad-based.

As can be seen, and not too surprisingly, Customer & Market Analysis ranks #1 on the list. Companies are mining big data in order to figure out how best to retain customers, grow revenue, and decrease costs. Meantime, the diversity of big data usage across multiple business functions (IT, eCommerce, cybersecurity, etc.) bodes well for viable long-term growth in the overall sector. Software makes it all possible: from the creation of data, to the movement of data, to the storage of data, and eventually to the critical analysis of that data.

With that as background, let’s take a look at the iShares Tech-Software ETF to see how it has positioned investors to benefit from these trends.

Top-10 Holdings

The top-10 holdings in the IGV Tech-Software ETF are shown below and equate to what I consider to be a relatively concentrated 52% of the entire 127 company portfolio.

Not surprisingly, Microsoft (MSFT) holds the top-spot with an 8.4% allocation. As most of you know, Microsoft is a strong #2 when it comes to the cloud, trailing only Amazon’s (AMZN) AWS business. But of course Microsoft also offers investors a great SaaS-based business model with its Office 360 product line while LinkedIn is demonstrating strong revenue growth.

Microsoft’s Q2 FY22 EPS report was bullish:

• Q2 revenue of $51.7 billion was +20% YOY.
• Q2 operating income was $22.2 billion, +24% YOY.
• Diluted EPS was $2.48, +22% YOY.
• LinkedIn revenue was +37%.
• Microsoft Cloud (Azure) revenue was $22.1 billion, up 32% YOY.

Softie ended calendar year 2021 with $125.4 billion in cash. That’s after returning $10.9 billion to shareholders in the form of share repurchases and dividends during Q2. That was a +9% return of capital as compared to the Q2 FY21.

Microsoft is expected to earn $9.44/share this year and currently trades at a 30x forward multiple. The stock is up 12.4% over the past year.

Salesforce (CRM) is the #3 holding with a 7.8% weight. Salesforce famously replaced Exxon Mobil (XOM) in the DJIA in 2020, which in hindsight looks bad considering CRM is down 27% YTD while Exxon is up 38% YTD. Meantime, Salesforce – a cloud-based customer relationship management company – is expected to continue its impressive track record of revenue and earnings growth this year.

Despite the pullback in the stock this year, CRM still trades at a relatively rich forward P/E = 40x.

The #4 holding is financial management company Intuit (INTU) with a 6.5% weight. Intuit is up 19% over the past year, but is down 23% YTD. The company trades with a forward P/E = 41x and note that the upcoming Q3 FY22 report is its seasonally strongest quarter due to the popularity of its tax-preparation software – TurboTax. Intuit also provides the popular QuickBooks product line and also owns the Credit Karma franchise.

The #7 and #10 holdings in IGV are taken up by two of the leading cyber-security companies: Palo Alto Networks (PANW) and CrowdStrike (CRWD), which in aggregate equate to 5.1% of the total portfolio. PAN is up 73% over the past year while CrowdStrike is up only 7.7% following a big sell-off last November. I am very bullish on the future of cybersecurity providers – see my Seeking Alpha article Recent CyberSecurity Earnings Reports Are Why You Should Own The BUG ETF Now.

Activision Blizzard (ATVI) is the #8 holding with a 2.9% weight. If Microsoft is successful in its takeover attempt, IGV could see its weighting in Microsoft grow even larger. However, it is still unclear if this merger will be allowed to proceed and note that there is an on-going insider trading investigation about various stock transactions prior to the announcement of MSFT’s planned purchase of the company. In January, the stock jumped from $64 to $82 and it has kept most of that gain, indicating the market likely believes the deal will go through.

As for the portfolio as a whole, the sub-sector breakdown is shown below.

As can be seen, the vast majority of the portfolio is invested in applications & systems software.

Performance

As of the end of March, IGV has an excellent long-term performance track record of delivering an average annual return of 18.3% over the past decade.

The price performance of the IGV ETF over the past 5-years is shown in the graphic below as compared to the broad market indexes of the S&P500, DJIA, and Nasdaq-100 as represented by the (SPY), (DIA), and (QQQ) ETFs, respectively.

As can be seen, the IGV ETF had raced ahead of all the indexes post the pandemic sell-off in 2020 – even beating the QQQ by a significant margin. However, as can also be seen, the recent sell-off in the software sector has brought the fund back inline with the QQQ’s five year performance. Note that both the IGV and QQQ ETFs have significantly out-performed the S&P500 and DJIA over the past 5-years and in my opinion both will likely outperform over the next 5-years as well.

Risks

All the market risks of the current macro environment certainly apply to the IGV ETF: high inflation, rising interest rates, the global pandemic’s impact on factory shut-downs and supply-chains, and Putin’s horrific war-of-choice on Ukraine and the resulting sanctions placed on Russia by the United States, its free-Democratic NATO allies, and by many Asian countries as well. Any of these risks have the potential to slow global economic growth and combined they could easily tip the world into recession.

Despite the recent sell-off, note that the IGV portfolio is still relatively richly valued in comparison to the S&P500 (P/E = 22.7x).

However, also note that these software companies, many of which operate a SaaS-based business models, have very high-margins, are growing at a fast-clip, and are generating tons of FCF. Most all those metrics are significantly higher than the typical S&P500 company.

Summary & Conclusion

I certainly would agree that the software sector, as well as the IGV ETF, rose to valuation levels that were unsustainable. Without a doubt, the recent market correction proves that point. However, I don’t believe the leading software companies are going to be unduly troubled by rising interest rates – even if the 10-year Treasury were to rise to 3.5%, which as I showed in my recent Seeking Alpha article on the (SCHX) ETF, is still very low by historical standards. After all, many of them have strong balance sheets and are generating strong free-cash-flow.

In addition, the market’s recent rediscovery of the “value” sector has no way done anything to diminish the macro, secular, and long-term thesis of rising digitization, the migration to the cloud, and the software that helps create, move, store, and manage big data. That being the case, investors should consider taking advantage of current market volatility and start, or add to, a position in the IGV Tech-Software ETF.