There’s one sector I like to include in the investments I make during a recession. But only in companies from that sector that have two important qualities, which I’ll tell you about in a moment.
This recession is no different. I’m investing in this sector right now, as there are companies I believe will deliver big profits when the market turns around. Now is the time to get in.
I’m talking about the software sector. As a whole it has outperformed the FTSE 100 over the past year. But looking deeper within it, we can see that certain software companies are much more recession resistant than others. That’s what I’m exploring today, as it helps you to narrow down the kind of company to go for.
Software companies invest in innovation through research and development (R&D) rather than capital investment (Capex) which is often larger than R&D for many conventional manufacturing businesses. In the latter, substantial Capex is needed for plant, production and test equipment and the buildings to put them in.
Differences in innovation investment and business model determine how companies respond to an upturn. A software company needs very little Capex and can greatly increase ‘production’ of a software package instantly and at almost zero cost. A manufacturing company in sectors like automotive or electronics , on the other hand, has a much more difficult task in expanding production when a line reaches full capacity.
Here’s what makes a good software stock to own in a recession
So what happens to the software company in a downturn or recession? There are two key factors to look out for. The first is the percentage of recurring revenues – revenues that do not depend on sales of new software packages. These may be maintenance revenues or licence fees from multi-year contracts. The second is whether the software package has ‘must have’ characteristics.
The current recession gives us the chance to see how the sector is doing compared to the market. Take a look at the chart of the software & computer services sector vs. the FTSE All-share over the past year.
So the best software companies need to have ‘must have’ products and substantial recurring revenues. Let us look at these two aspects.
In a recession customers must trim costs and it is not enough to be offering them ‘nice to have’ software. You need to be able to explain to your customer why your software is essential to him. It may be a crucial part of his business process and his competitive advantage, it may save costs with a payback period of a few months or it may open the door to new and profitable customers.
But the ‘must have’ software will only have pricing power if it has clear advantages over competitors’ products. After all, a car is a ‘must have’ product for many people but few car companies have pricing power! This is where the R&D investment is so important for a software company. Success goes to the company that develops software to be the leading application in a significant international niche and then maintains that lead with new developments and upgrades.
There are several UK software companies that have established leading positions of this kind. Examples include Fidessa (ticker: FDSA) in trading software and AVEVA (ticker: AVV) in engineering design and project lifecycle management. These two companies both have recurring revenues of 55% or more.
Here’s how to find the right software companies
There are also several smaller UK software companies that are aiming to establish leading international positions in their market niches. These companies offer the potential of large gains for investors if they go on to secure their aim of becoming leaders in their niches.
The average R&D investment for global software companies is of order of 10% of sales but leading UK software companies typically invest 15% or more of sales in R&D. This heavy investment is needed to develop ‘must have’ new products and to maintain the ‘edge’ of existing products. It is also directed at growing the proportion of recurring revenues and is accompanied by excellent marketing.
There are several large and smaller software companies that meet all these conditions. But it’s the companies that not only meet these conditions but also show features like strong balance sheets, a record of profitable growth and a high proportion of overseas sales that you should consider investing in.
Kind regards,
Dr Michael Tubbs
For The Right Side
Editor’s recommendation: Michael Tubbs is editor of Research Investments which identifies high quality R&D investing companies. He is a regular contributor to The Right Side and it’s well worth reading some of his previous articles. You can access these here.
MARKET NOTES
The surge in financial stocks is an artificial rally
BY SHIVVY ARORA
As I write, RBS is up 15%, Barclays has risen 12% and Lloyds Banking Group added 11%. Impressive, you say. Be cautious, we respond. These are artificial rises, and we’ll tell you why.
Take a look at the chart below. It shows the FTSE 350 Banks index (blue line) versus the FTSE100 (red line), from 3 March to date. The UK banks have rallied nearly 60% – their best spell in over three months, and it’s still going.
The banking sector’s ‘pseudo’ rally…
Source: Google Finance
Note the rampant outperformance of bank shares in this bear market rally. And this is exactly the problem.
You see, there’s a reason for this…
Previously, investors were short selling banking shares. That’s when you borrow shares from an institution or other big investor, then sell them, betting that they will fall. But you need to "close" the short position by buying back the same number of shares and returning them to the lender.
So when the price does fall, you buy back the stock at the lower price, return it, and make a profit on the difference. And this is what is driving that bear market rally.
Don’t forget that the slew of government programs to shore up the banks has also led investors to bid up financial shares. But the sector as a whole remains hugely unstable and we’ve yet to see any concrete turnaround in fundamentals.
So be careful. While currently in the green, bank shares aren’t likely to bring about a sustained market recovery.
Follow-up reading: Theo Casey of The Fleet Street Letter explained this phenomenon in a recent essay for The Right Side. Click here to access Short Sellers and How You Can Use Them for free.
The Daily Reckoning – The good new days
BY BILL BONNER
London, England
Thursday, 30 April 2009
Those were the good ol’ days!
The Wall Street Journal:
“US economic output tumbled in the first quarter as businesses cut back sharply, marking the nation’s worst six-month contraction in 51 years...
“The 6.1% annualized decline in gross domestic product came as the home-building sector continued to deteriorate, business investment in buildings and equipment plunged and firms drew down inventories at the fastest pace since the start of the decade.”
But wait... 51 years ago was the decline of ’57- ‘58. According to our sources, that recession – though frightening when it began – only took 3.2% off the nation’s GDP. And it ended after 6 months.
Perhaps we should look back and see what heroic acts on the part of Congress and the Fed cured that recession so quickly.
What’s this? The record shows that Fed did almost nothing. According to Jim Grant, though the Fed cut its key rate to 2.25%, the total monetary stimulus provided by the Fed during that period amounted to zero. On the fiscal side, however, Congress boosted spending, adding to the deficit the equivalent of 3.2% of GDP.
In other words, faced with an equivalent downturn, the feds of yesteryear cured the recession of ’57-’58 – or it cured itself – with a total exertion of barely one-tenth what they are doing today.
But it was a different world back then. To make a long story short, the great boom was just beginning, the empire was still rising, its currency was still backed by gold... and its books – both federal government registers and national trade accounts – were in balance.
That was also when Detroit’s invitation to “see the USA in a Chevrolet” still had advertising punch. We remember the ads on television... those sleek new automobiles (Detroit came out with brand new models every year)... with their big tailfins and their wide, comfy ride... tops down... roads open... no seat belts – those were the good old days.
General Motors was the biggest and most profitable automobile company on the planet... an icon of American capitalism and its industrial success.
But what’s this? Today’s news tells us that not only is GM to be nationalized, it and Chrysler are to be taken over by the UAW! Ah... at last... Marx’s dream has come true. The workers – at least those in the United Automobile Workers union – are taking over the means of production. Between the government and the unions, General Motors will be almost entirely in the hands of the sweating proletariat.
Along with the story – in the Financial Times – comes a photo of the UAW on strike in 1937. It’s a ‘sit down’ strike... so we see them sitting down in the factory... comfortably resting on Chevy seats while reading the paper. Except for one slob, they all look fairly respectable. Several are wearing neckties! Those were the good old days... when the working class still had class.
But these are the good new days.
Imagine if we’d had to write these Daily Reckonings during the Eisenhower years. What would we have said?
Read on…
To read the Daily Reckoning in full, click here.
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