Software has been among the hardest-hit segments in 2022. As one of the fastest growing areas of technology, it has been particularly vulnerable to a shift in the monetary policy environment. However, it remains around one-third of the Allianz Technology Trust portfolio and one of the most exciting sectors within the portfolio. Why has it become so important?
At its heart, software is simply computer code that tells a computer how to perform a specific task. There are many kinds of software, including operating systems, applications, and malware. In aggregate, the software market is now edging towards $1 trillion in size, with around half of that in cloud computing. It has become pervasive, with software companies embedded in many of the major long-term technology themes, including digital transformation, cybersecurity and big data analytics.
Done right, software can make an excellent investment. It can attach itself to fast-growing industries, it is highly scalable and, in specific segments, has high customer demand. After the initial development stage, margins are high and ongoing support costs are relatively low. Increasingly, software is delivered on a subscription basis, thereby delivering long-term sustainable cash flows for investors. As such, the right software company can be a powerful boost for portfolio returns.
It is also a fertile area for M&A activity. In 2022, there were a number of multi-billion dollar deals in the software space and activity thrived even as the economic environment weakened: enterprise SaaS company SandboxAQ, confirmed its acquisition of cybersecurity and encryption analysis software company, Cryptosense, while Oracle finally closed its deal for electronic health records company Cerner. Broadcom acquired VMware for $61bn. This gives long-term support for share prices.
Software is a vast market and touches multiple industries. We see three areas of particular interest within the software space: digital transformation, cloud software and security software. These three areas are intertwined - digital transformation involves a move to the cloud, which brings in cloud analytics and the requirement for better security – which means the growth of one area feeds the others, creating a virtuous circle.
Digital transformation is the integration of digital technologies into all areas of a business. It can be used to improve operational efficiency, increase employee productivity by managing workflows, or improve interactions with customers. The pandemic accelerated digital adoption by many companies and it has proved an enduring theme even after the pandemic, with many CEOs saying it remains a priority.
Software is at the heart of these digital transformation. In October 2022, for example, oil services giant Schlumberger, rebranded itself SLB, as part of its reinvention as a digital services provider and supporter of cleaner energies. Rather than providing traditional oil services, it now creates and deploys technology solutions to help its customers decarbonise. This includes data analytics, carbon reduction and carbon capture solutions, all enabled by software.
It is a pattern replicated across many industries. John Deere, for example, is an agricultural manufacturing company that now provides its customers with digital services. These include ‘smart farming’ solutions, allowing for the more efficient use of fertilizers, watering system and seeds. This is part of a new wave of precision agriculture. Electric vehicles only work if the software that controls power consumption and distribution works.
We see increasing requirements for digital solutions to help companies manage rising labour costs. Labour costs have been rising across the world. The latest data from the US shows labour costs rising at around 5% per year. with some sectors experiencing far higher rates of growth. Technology, and more specifically, specialist software, appears to offer a solution to this.
In hospitality, for example, software can be used to manage check in and check out, or ordering in restaurants and hotels. We own Paycom, which is a payroll and human resources solution. It reduces manual processing work and allows employees to focus on more value-added tasks. These types of solution are likely to be in greater demand as companies look for options to manage labour shortages.
Companies are increasingly embracing cloud solutions, moving company data off-premise to the cloud, rather than running expensive and inefficient servers themselves. Part of the appeal of moving away from on-premise data storage is the ability to hold far greater amounts of data at far lower cost. Companies are increasingly generating data from a wide range of sources, including websites, devices and financial software.
However, this data has no use if it cannot be organised and interrogated to provide actionable insights. This is where cloud software comes in. Companies can apply algorithms to large amounts of data to identify patterns, even predict outcomes, which can be used by the business for more effective decision-making.
This can provide granular data on a business’s operations. AspenTech, for example, works across a range of industries. It uses data to improve the reliability and efficiency of industrial assets. It can help companies with supply chain optimisation and planning, or improving the energy efficiency of their network. This can be an invaluable resource to help companies improve productivity and profitability.
Cloud analytics software companies are generally high growth businesses and, as such, have struggled over the past year as growth businesses have fallen out of favour. However, many have continued to deliver strong operational performance. Snowflake, for example, grew revenues 67% in the year to 31 October, having grown at 83% the previous year. There should be a long runway of growth for many cloud software businesses as companies recognise the competitive advantage in strong analytics.
CEOs are grimly aware of the threat cyber breaches can pose to the reputation of their company and its management team. Analysis demonstrates that it can have a serious impact on subsequent share price performance and it can cost companies millions of pounds to repair the damage. If customer data is involved, it can be impossible to regain trust. Against this backdrop, spending on cyber security software remains a significant priority for CEOs and looks unthreatened by the coming economic downturn.
Security software comes in multiple guises – it can be used to protect and secure hardware, such as mobile devices and laptops, but also to defend data, users and systems from incoming risks. Increasingly companies need to have multiple layers of software to protect themselves, with large companies operating as many as 50 different types of security software. This has led to a burgeoning industry in security platforms, which help manage these multiple products efficiently and improve the visibility of threats.
As with other types of software, this part of the market has been hard-hit in 2022 as investors have reappraised valuations. However, it should be less sensitive to the weakening economic environment expected in 2023, with cyber security now a necessity for all businesses.
Software companies may have had a difficult year, but they are embedded in some of the strongest growth themes of the next decade and beyond. These companies continue to deliver rapid growth in earnings, and are largely insensitive to the economic environment. Software continues to be a fertile hunting ground for the trust and a favoured area for growth.
