Investing in Software Stocks

Copyright 2009 by Morris Rosenthal - All Rights Reserved

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Trading Notes

Copyright 2009 by Morris Rosenthal

All Rights Reserved

Trading the Software Stocks that Run Businesses

It would be nice to be able to divide software stocks up into business infrastructure, consumer and support, but the three areas are so intermingled that it would turn into one long apology. For starters, we included three serious market cap companies on our short-list that most people probably wouldn't identify as software plays: IBM, Amazon and E-bay. IBM, under Gerstner, made the transition from being the world's largest computer hardware company to the world's largest software services company. Most purists were skeptical at the time, but the commoditization of computer hardware may have proved Gerstner right, and the stock has been a long term winner. IBM does retain some excellent R&D facilities in the semiconductor business, but the main thrust of the company is getting their consultants in the door of Fortune 1000 companies and billing hours. Lot's of hours, lots of earnings. The "product" is complicated solutions with excellent job security for the team:-)

Amazon (AMZN), of course, is a story unto itself. AMZN is traded as a growth stock, a high-growth stock, with a P/E of just under 40. It's currently trading near a high thanks to news it is acquiring eInk, makers of the Kindle display for eBook readers. Institutional ownership is nearly 70%, and only time will tell if those investors deserve to work at institutions or be committed to them. Amazon cannot generate the growth it needs to justify it's valuation (in my opinion), but they are growing the online retail sector worldwide, and if their brand holds up, who knows.

E-bay is know to all as the world's biggest online auctioneer, but the truth is, they're really a software or financial services play. We're including them in the the software sector because their entire business is essentially a custom software product and a lot of good will. Their days of rapid revenue growth are long behind them, and are beginning to experiment with other ways of increasing the bottom line. Unlike Amazon, who actually derives the majority of their revenue from traditional retail (ie, shipping and receiving), E-bay derives all of their revenue through brokering 3rd party transactions, selling product placements and ad enhancements, etc. Are they vulnerable to a well financed start-up doing exactly the same thing? EBAY once had the highest P/E in our group, a dubious distinction.

Microsoft stock has languished for some time at around a quarter of its peak value, and despite the record one-time dividend they paid out last year, it's hard to see them doing much more they oscillating about a fixed price. While MSFT is one of the greatest cash generating machines of our time, it suffers from being fully valued and having limited prospects for growth. They can create a new, successful franchise, like the X-box, and barely see an impact on the bottom line or the stock valuation. Despite this, Microsoft is no longer valued as a growth company, and institutional ownership has climbed to around 60% as it has lost popularity with individual investors over recent years.

Oracle is the pure-play database company that has shown a Microsoft-like capacity for guarding its space through aggressive acquisition of competitors. The stock has been remarkably stable since the bubble burst, which may just mean that it's fairly valued. Oracle is a back-room product, the name means nothing outside of IT departments and investing circles. At a P/E of 18, ORCL is practically a value play for a pure software company that is still growing. Volume is traditionally strong in relation to the market cap, but institutional investment has grown by 33% in the last few year to nearly 60%, the same level as Microsoft.

SAP is the German owned enterprise software company that dominates the corporate reengineering space with hugely complex and expensive solutions that truly force the customer to remake their workflow in the software's image. The stock trades as an ADR on the NYSE, with a P/E just over 29 and a market cap of around 50 billion. Institutional investment is only 10%, but keep in mind we're talking about an ADR and the institutions probably buy it direct on the German exchange.

Symantec is our software security play, with their popular corporate and home anti-virus products. They are also a takeover candidate for one of the big boys looking for more vertical integration. The P/E is AWOL and their shares have the highest institutional investment percentage in the group at just under 94%. Apparently, fund managers are forced to buy SYMC as a software security play to show they have exposure, and there aren't any pure-play options.

The closest stock to a pure consumer play in our group (we'll have to add a game company or two) is Intuit, maker of the hugely successful Quicken financial software for home and small business use. INTU has been volatile in the past, but seems to be settling and has become quite popular with institutional investors, just behind SYMC in our group. The P/E of 22 reflects that fact that they are seen as a growth play compared to their larger cap bretheren.