Software As A Safe Haven

With the dismal retail numbers, high home foreclosure rates, continued bankruptcies of major companies, profit warnings from international banks thought to have dodged the credit crisis, and request for more bailout funds from Bank of America and Citigroup, it is becoming apparent that 2009 is shaping up to be as bad or worse than 2008. With that in mind, if investors are looking for a safe place to invest outside of cash and Treasuries, I think software stocks are a safe bet.

I never thought I would suggest Tech stocks as defensive plays, but I believe that the dynamics of the software space make them an attractive investment in a depressed economic cycle. Software stocks should perform better relative to other tech sectors other than the Internet stocks, which are more volatile.

The main reason is that maintenance revenues, which constitutes over 50% of enterprise software company revenues is stable and continues in spite of economic conditions. Those revenues are also highly profitable with 80-90% margins. Moreover, as license revenues come under pressure, the high margin maintenance revenues should become a bigger part of the revenue mix, helping those companies report stable or growing profits and cash flow.

Maintenance fees are paid by corporations for supplemental services such as product updates, bug fixes, and technical support. And unless the corporation goes out of business, which is a risk particularly for retail and finance companies, then those maintenance payments continue to the software company. In addition, most enterprise companies report maintenance renewal rates close to 100% due to the high switching costs.

So in choosing companies to buy, investors should look to companies with (1) high maintenance revenues as a percent of total revenues; (2) high corporate exposure relative to consumer exposure; and (3) higher enterprise exposure relative to small business exposure. Further, infrastructure companies are more favorable compared to applications companies due to the fact that infrastructure sales are based on CPUs, while application sales are based on total heads. With the latter, as layoffs continue revenues are eliminated.

With that in mind, the most attractive companies in the space are Oracle, Symantec, TIBCO, and McAfee. Although Microsoft doesn't necessarily fit the criteria because of the high consumer exposure, I like its current competitive position and I am adding it to the investment mix. I will report occasionally on picks within the space.