Despite the heightened regulatory and valuation risks currently facing technology stocks, Goldman Sachs has found a group of software companies whose shares may give investors the benefit of high growth without all the downside risk. They are not as big as the tech behemoths—Alphabet Inc. (GOOGL), Facebook Inc. (FB), Apple Inc. (AAPL) and Amazon.com Inc. (AMZN)—that are currently facing antitrust investigations, nor are their stocks suffering from elevated valuation premiums typical of fast-growing software stocks.
“High-growth technology stocks face two key risks: regulation and valuation,” wrote Goldman’s analysts in their most recent Weekly Kickstart report.
Given those risks, the analysts screened the Russell 3000 index for stocks with: 1) more than $1 billion in market capitalization; 2) positive sales growth averaging at least 10% in each of the last 3 years; 3) consensus estimates of at least 10% sales growth in each of next 2 years; 4) consensus estimates of 2019 net profit margins greater than 10%; 5) and forward enterprise value (EV)-to-sales (EV/Sales) ratios below 6x. The screen produced four software stocks, listed below.
4 High-Growth Software Stocks
(Company/Index: 12-month forward sales growth)
- Palo Alto Networks Inc. (PANW): +20%
- Ebix Inc. (EBIX): +19%
- Fortinet Inc. (FTNT): +15%
- RealPage Inc. (RP): +13%
- Russell 3000 Median: +5%
Source: Goldman Sachs
What it Means for Investors
The first major risk concerns the rise in concentration of the U.S. equity market within the current political landscape. The decline in the number of publicly listed U.S. companies from 8,000 in 1996 to approximately 4,000 today has pushed the level of concentration in the equity market above its long-term average, which has not gone unnoticed by regulators concerned about maintaining a competitive environment.
“Rising market concentration and the political landscape suggest that regulatory risk will persist and could eventually weigh on company fundamentals,” write the analysts.
But while the major tech giants are facing regulatory scrutiny from the U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) that could result in antitrust lawsuits and the eventual breaking up of their businesses, smaller tech firms should be able to keep growing with little concern for now. Alphabet, Facebook, Apple and Amazon, which are all currently subject to antitrust investigations, all have market caps above $500 billion, whereas the market caps of Ebix, Fortinet, Palo Alto Networks and RealPage are all below $25 billion.
The other big risk is the currently elevated valuations within the tech sector and especially within the software industry. The S&P 500 Information Technology sector is carrying a valuation premium significantly above its 10-year average, and software stocks in particular are trading at a median EV/sales ratio of 6x, nearly the highest that multiple has been since the peaking of the Tech Bubble.
While stocks with the highest EV/sales valuations have historically underperformed their peers over the long term, Ebix, Fortinet, Palo Alto Networks and RealPage all have consensus forward EV/sales multiples below the software-industry median, at 3.5x, 5.2x, 5.3x and 5.6x, respectively.
With much lower valuation multiples than their industry peers and high growth prospects, these stocks are set to outperform. Goldman’s analysts note that growth stocks dramatically outperformed in 2019 as investors were willing to pay premiums for idiosyncratic growth amid slowing economic activity. “In addition to growth, investors have embraced software firms due to their above-average profit margins as well as their relative insulation from trade conflict,” they add.