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Why This “Quiet Zone” Is Now Tech’s Biggest Profit Sector

5 | By Michael A. Robinson

One of my favorite truisms of investing is that you’ll make the most money on the biggest innovations.

That sounds obvious. However, it also calls to mind Rule No. 2 in my five-part Tech Wealth Secrets system – “Separate the signals from the noise.”

The noisemakers in the mainstream tech media are obsessed with the latest mobile gadgets and the smallest memory storage devices. However, the biggest innovations – our “signals” -are happening in software.

And software remains among the most profitable industries anywhere – with gross margins exceeding 70%.

So today I’m going to show you how software has quietly become so visionary – and so lucrative.

And then I’m going to introduce you to an investment that takes advantage of this entire software revolution – and it’s also primed to double…

Bet Hard on Software

Before I share that investment with you, here’s how inventive software has become.

Through a technology known as an accelerated processing unit” (APU), software can now perform functions that once required pricey hardware upgrades.

Designers, multimedia specialists and video game makers can now substantially boost their PCs’ graphics capabilities with a push of the button instead of replacing their desktops.

And that’s just a start to what APU will be able to do.

Speed junkies looking for “hot-rod” levels of performance will be able to get what they need with affordable software upgrades instead of spending big at the body shop.

From there, just consider what military and airline techs will be capable of.

Then there’s software-defined networking (SDN). With SDN, software can now perform many of more complicated functions of network hardware – the gateways and routers that make all of an office’s PCs smoothly communicate with each other.

This innovation basically started a war among Cisco Systems Inc. (Nasdaq: CSCO), which owns half the SDN market, VMware Inc. (NYSE: VMW), Google Inc. (Nasdaq: GOOGL) and various startups.

Why? Corporations may still need network hardware, but SDN means they need a lot less of it. And so they’re piling into this new software technology – and spending plenty with the vendors who make the best, most affordable options.

According to Infonetics Research, the SDN market grew 192% in 2013, and it’s ready to grow more than six times to reach $18 billion by 2018.

Despite these innovations, I can understand why investors sometimes seem to forget about software.

The mainstream financial media likes to tout the importance of cloud computing, in which data and applications are delivered to clients via the Web. Theoretically, that frees companies from the need to buy expensive software.

I’m a big believer in the need for the cloud and its profit opportunities. But when you get down to it, software is the lodestone that makes all the hot tech inventions possible – and remunerative.

Just look at the roughly 1.48 billion mobile devices that the forecasters at IDG estimate will ship this year. Without operating-system (OS) software, those units are nothing more than expensive bricks.

And think about the billions of applications that consumers download every year to use on all those smartphones and tablets. Those apps are nothing more than software coded to perform very specific tasks.

According to Gartner, we’ll be downloading 268 billion apps a year by 2017 – generating $77 billion in revenue.

Software runs even deeper than that. Without software, none of those red-hot Big Data centers, online video devices, digital music platforms, Internet browsers, connected cars and personal computers would work.

Here’s proof of how essential software remains.

Last year, Wall Street predicted a decline in software sales in 2015, but so far we’ve seen a nearly 5% increase. Gartner says the industry hit $407.3 billion in sales in 2013.

A “Behind the Scenes” Signal

Let’s go back to Rule No. 2 for a moment. There’s a key point in there that many folks miss.

You can’t just ignore the noise – you have to find the right signal.

See, when Renaissance Capital recently noted that the number of tech IPOs in the third quarter fell by 50% to just seven, a lot of people saw that as a “signal” of an impending tech-stock sell-off.

There were only two software IPOs in the quarter, as well, so you can see why investors might want to avoid the sector altogether.

However, that interpretation misses a huge detail. Tech companies, particularly software firms, stayed on the sidelines because they feared the $25 billion Alibaba Group Holding Ltd. (NYSE: BABA) IPO would suck all the oxygen out of the market for new issues.

Behind the scenes, however, the big software firms went on a buying spree in the quarter. The investment bankers at Berkery Noyes note that there were 437 software mergers and acquisitions in the period.

That’s only a 3% increase from the year before. However, it’s a 12% increase from just the quarter before.

So, here’s the “secret” signal – supply and demand.

As the number of mergers and acquisitions increases, the supply of software stocks falls. And that means investors can expect to see greater share-price appreciation for the industry as a whole.

The Top “Software Revolution” Play

So that’s why we’re going to cash in with the iShares North American Tech-Software ETF (NYSE: IGV).

With nearly 60 stocks in its portfolio, you can pick up a broad swath of the software sector’s leaders.

As such, IGV holds an interesting blend of stable big-caps like No. 1 software company Microsoft Corp. (Nasdaq: MSFT) and No. 2 Oracle Corp. (NYSE: ORCL), as well as smaller firms poised for big breakouts. That way you get power of combined investing and avoid the risk of possibly picking a laggard.

Let’s take a look:

  • Nuance Communications Inc. (Nasdaq: NUAN): This voice-recognition and imaging technology firm boasts 4,000 patents. Nuance services a dozen industries, including mobile, automotive, legal and medical. With a $4.96 billion market cap, this stock has lot of upside, but it’s too risky for most individual investors.
  • Splunk Inc. (Nasdaq: SPLK): This is a great play on the hot Big Data trend. Splunk is focused on data analytics generated by “machines.” That’s a loose term that covers the Web, computer servers, networks, mobile devices and the billions of sensors in use around the world. With a market cap of $7.81 billion, the company has weak profit margins but averaged a 60% annual growth rate over the last three years.
  • Adobe Systems Inc. (Nasdaq: ADBE): Most investors know of Adobe as the maker of software that creates PDF files. Adobe also is the world leader in software for designers, artists and illustrators. These are complex packages with millions of lines of code that take up a lot of computer space. The company recently rolled out a cloud model in which users rent apps by the month. With a $35.02 billion market cap, Adobe generated nearly $1 billion in free cash flow last year.
  • Cadence Design (Nasdaq: CDNS). This is a great double play. The firm is a leader in software for the booming semiconductor industry. Founded in 1988, the Silicon Valley firm has granted software licenses to roughly 200 firms and counts seven of the top 10 chipmakers as clients. With a market cap of $5.28 billion, Cadence has a three-year earnings growth rate of more than 44%.

And remember, when it comes to racking up high profit margins, it’s hard to beat the software sector’s 70%+ gross margins. Compare that to the hardware sector, where firms have to spend heavily on infrastructure and scrape for 40% margins.

At around $92 per share, IGV covers a lot of ground with a cost-effective price for an investment vehicle that also outperforms the broader market.

Over the last six months, this software sector play has gained nearly 16%. That would rank as a great annual return – and it blows away the Standard & Poor’s 500 Index’s 8% gains in the period.

The iShares North American Tech-Software ETF is a great foundational play that will continue to do well in the kind of volatile market we see today.

That means you can ignore the noise and instead invest in “quiet” innovations like SDL and APUs. And you can also ignore the market’s ups and downs as you steadily build your wealth through tech.

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5 Responses to Why This “Quiet Zone” Is Now Tech’s Biggest Profit Sector

  1. Hal Crosskno says:

    Michael, can you please tell me where to find the article you published recently on American Tower Corporation, and how I can log in to re-read the article, Thanks, please keep the great recommendations coming.
    Hal

    • Chris Skokna says:

      Hi, Hal. You can find it on the front page of this site, under the headline “A REIT to Avoid — And One to Buy Now.”

  2. TOM says:

    This looks good, but I have been in SKYY, the cloud ETF, since 9/28/11 & I am up over 67% & 23% in the last year. These two have many of the same holdings & you can get into SKYY for $28. Just seems like a better buy to me.

  3. M.K.Ramasubramanian says:

    Dear Mr.Robinson: I have enjoyed your incisive provocative analysis of tech sector stocks and I have benefitted from them. However I am intrigued by your recommendation of the ETF IGV.
    This stock has been on the rise for the past 6 months and now you are recommending it at its peak –perhaps you believe the stock has lots of traction . .Any particular reason WHY this was not in your radar back then ?Granted you are not expected to have acrystal ball I am curious to know if the activity on the stock that caused a the price rise was caused by extraordinary circumstances and not to be cynical,an attempt to boost up the stock so that the “early” investors could benefit?
    Thanks.

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