The time has come to take profits in super-pricey software stocks like Zoom Video Communications, Okta, and DocuSign—and to find bargains elsewhere. That’s the key conclusion of this morning’s big call on the software industry by J.P. Morgan analyst Sterling Auty.
In a 151-page report, Auty lays out a case for shifting strategies on the sector heading into a post-pandemic economic recovery in 2021. He suggests moving into cyclically sensitive software shares—those that do better when the economy is expanding—and out of the premium-priced stocks that have thrived in the Covid-19 era. He notes that J.P. Morgan economists see the economy starting to turn around in the second quarter.
“Last year at this time, we were saying that the economic outlook really hinged on the outcome of China trade negotiations and that we wanted to stay cautious on cyclical names,” he writes in this morning’s report. “That turned out beneficial because of Covid 19. Now we believe that the economic outlook hinges on Covid-19 vaccine efficacy and availability, but we are turning bullish on cyclically sensitive software.”
Auty notes that the stocks he covers rallied on average 62% for the year through the end of November, versus a 12% gain for the S&P 500.
“It has been another tremendous year for software, as demand held strong throughout the pandemic and valuations expanded significantly with capital coming in from other sectors,” he writes. “Looking ahead, there is a scenario where improving economic expansion could motivate capital to rotate back out of software in favor of lower valuation cyclical segments that will benefit from economic improvement. Much of that will hinge on the success of vaccines to effectively open up the economy more broadly.”
Auty advises investors to snap up cyclically sensitive software stocks, and upgraded seven stocks on that basis, including Altair Engineering (ticker: ALTR), Autodesk (ADSK), Cadence Design Systems (CDNS), PTC (PTC), VeriSign (VRSN), Wix. com (WIX), and Intuit (INTU).
“The economic expansion is expected to be driven by the manufacturing sector, and that should favor the design software names in our coverage,” like Altair, Autodesk, Cadence and PTC, he says. “On the SMB front, we have already started to see increasing business starts that could continue into 2021 on the back of favorable interest rates and the potential for a more open economy post COVID-19,” and he sees that boosting stocks like VeriSign, Wix and Intuit.
His top two picks, meanwhile, are Varonis (VRNS), a data security and threat detection company, and RingCentral (RNG), which provides cloud-based unified communications services. “Both companies have the potential to show accelerating revenue growth, Varonis on the back of its subscription transition and healthy demand for data protection solutions and Ring from the increasing contribution of the partnership agreements signed over the last 12 to 15 months,” he writes.
On the other hand, Auty is downgrading an assortment of high-valuation stocks. He writes that in 2009-2010, coming out of the economic downturn, “the highest-multiple names as a group underperformed the software industry.” He contends that happened because “the good news on performance had already been factored into premium valuation stocks, while an improving economy offered potential to boost fundamentals and create a reversion to the mean trade.”
Citing their high current valuations, Auty today cut his ratings on CrowdStrike (CRWD), Okta (OKTA), Cloudflare (NET), Zoom Video (ZM), DocuSign (DOCU), Avalara (AVLR), and Veeva (VEEV).
He also cut ratings on Check Point Software (CHKP), Palo Alto Networks (PANW), and Fortinet (FTNT), reflecting his view that “[an] increasing percentage of cybersecurity budgets will likely shift to cloud security at the expense of on-premise network security and messaging security.”
And he also reduced his ratings on SecureWorks (SCWX), Pluralsight (PS), Model N (MODN), and SS&C Technologies (SSNC). “These names are likely to have 1-2 or more quarters of revenue deceleration that could hinder stock price performance,” he writes.
Write to Eric J. Savitz at email@example.com