Why is enterprise software becoming one of the strongest sectors in the market?

One of my favorite concepts to use during market corrections is relative strength. I’m specifically looking for stocks that are showing strength relative to the market. The theory is that there are strong growth companies looking to climb higher, but market tensions are holding them back. Once the selling pressure eases, these stocks tend to trade near their highs and have the potential to make significant gains.

Relative strength works during short-term market declines, but it really shines when we see larger corrections or bear markets. For example, after emerging from the 2008–2009 financial crisis, Netflix and Green Mountain Coffee were two of the top growth stocks on the 52-week top stocks list, and both posted huge profits.

A sector barely affected by the trade war

I bring this up now because we saw an ugly correction in the fourth quarter of 2018, but the enterprise software sector showed great relative strength during that time. It makes sense that the sector is doing well as many companies and government agencies are just starting to move their businesses to the cloud. Thanks to this ongoing transformation, plenty of software and cloud infrastructure companies are increasing their profits and sales by 30% or more year over year. Moreover, the profit margins of many companies are increasing, and the trade war in China hardly affects this sector.

One way to play this group is with ETF software (IGV). This gives you broad exposure to one of the market’s leading growth sectors. For those who like single-company stocks, I recommend putting the effort into finding companies that have strong technical and fundamental characteristics and also have large markets to reach.

Another thing that stuck in my mind in the fourth quarter of 2018 were acquisitions in this sector. In particular, the buyout of Mindbody (MB) by Vista Equity Partners at a premium of 68% and the buyout of Luxoft Holding (LXFT) by DXC Technology (DXC) at a premium of 83%. Not only were these deals made at impressive premiums, but they also took place during a difficult time for the market. This shows that many private equity firms and larger software companies (i.e. Microsoft, Salesforce.com, IBM and Oracle) are willing to put money into action when they see declines or find value in smaller software names.

On August 20, 2011, influential investor and software guru Marc Andreessen wrote an article in the Wall Street Journal with the now famous title: “Why software is eating the world.” In this article, Andreessen discussed how “we are in the midst of a dramatic and sweeping technological and economic shift in which software companies are poised to take over large swathes of the economy.” He then adds, “I expect software to disrupt many other industries in the next 10 years.” We’ve seen this happen in telecommunications, video streaming, healthcare, retail, transportation, job recruiting, and the endless list of industries where software is disrupting development.

There is currently a big debate about whether the stock market is in a bear market or whether we started a new bull market at the end of December 2018. In my opinion it doesn’t matter for the software. If this is a new growth trend, you can already see that the number of software companies are trading at or near all-time highs, and these stocks should continue to do well over the next 3-5 years. If this is a bear market, my guess is that these stocks will correct with the market, but will still hold up well and show relative strength. Once again, the market is simply tension keeping these stocks from devouring the world.

What to expect from the markets in the first quarter of 2019

The market moves because of 2 main factors

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