Smooth Sailing for Software Stocks

S&P likes the Systems Software subindustry's stock-price momentum and positive fundamental outlook. Among its top picks: Microsoft and Oracle

While flipping through the rolling 52-month relative strength charts for the 138 subindustries in the Standard & Poor's Composite 1500 index (which consists of the large-cap S&P 500, MidCap 400, and Small Cap 600 indexes), I noticed six subindustries that I thought had encouraging-looking, longer-term relative strength trends.

The charts for the Distillers & Vintners, Electronic Equipment Manufacturers, Electronic Manufacturing Services, Semiconductors, Systems Software, and Water Utilities groups each had upward-sloping trends that were above their nine-month moving averages and were within their one-standard-deviation bands (i.e., one standard deviation above or below the 17-year mean relative strength measure).

A Standout Among Subindustries

However, the one that really caught my eye was the Systems Software subindustry. This group had the highest aggregate S&P STARS ranking—at 4.8 out of 5.0—and had a positive fundamental outlook by S&P's equity analysts. Year to date through Dec. 7, the S&P 1500 Systems Software subindustry index rose 15.3%, vs. a 6.2% advance for the S&P 1500 index. In 2006, the subindustry index was up 16.8%, vs. a 13.3% advance for the broader market.

Is there still upside potential for this subindustry? Jim Yin, who covers this group for S&P Equity Research, has a positive fundamental outlook on the Systems Software subindustry. He is optimistic about prospects for certain segments of the subindustry in 2008, including Internet security, data security on mobile devices, desktop and server virtualization software, data storage, and backup recovery. For the longer term, S&P expects certain positive trends to remain intact, such as the leveraging of the existing hardware infrastructure.

S&P forecasts that spending on systems software will increase at a percentage rate in the low teens in 2008. Yin's positive outlook reflects a pickup in the growth of PC sales, driven by stronger growth in laptop, consumer, and international markets. Although enterprise adoption of Microsoft's (MSFT) Vista operating system has been slow, Yin expects the adoption rate to accelerate after Microsoft releases the SP1 service pack for the OS, which he thinks will occur in the first quarter of 2008, and companies complete their software compatibility testing.

Web Services Will Drive Growth

In S&P's view, the Systems Software subsector will benefit from the rapidly evolving Internet, intranets, and extranets, creating strong demand for software applications and systems that take advantage of these platforms. Many software vendors and customers are focusing on Web services, with particular emphasis on the integration of disparate systems and applications. In addition, Yin sees incremental growth opportunity from the convergence of personal computers, cell phones, and home entertainment, as the way we communicate and share information becomes more diverse.

The Systems Software subindustry will benefit from industry consolidation, Yin believes, as software companies such as Oracle (ORCL) acquire smaller vendors to broaden product suites. S&P expects the industry's operating margin to expand as a result of consolidation. Additionally, most software companies have strong balance sheets with significant amounts of cash, in S&P's view, and they have been buying back shares.

However, Yin is cautious on security software. He views this market segment as mature, despite a modest growth opportunity for software to secure cell phones and handhelds, driven by the increased prevalence of mobile devices. In addition, Yin thinks Vista will adversely affect some of the security software vendors due to its improved security protection, although some consumers will purchase competing software that offers higher levels of protection from growing online threats.

So there you have it. The group's longer-term momentum is firm by S&P's analysis, and its overall fundamental outlook is positive, indicating that this subindustry index should continue to see strong price performances in the period ahead. Of the companies mentioned in this story, both Microsoft and Oracle are ranked 5 STARS (strong buy) by S&P.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of subindustries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).

Subindustry Company (Ticker) S&P STARS Rank Price (12/7/07)
Coal & Consumable Fuels Peabody Energy (BTU) 4 $59
Commodity Chemicals Lyondell Chemical (LYO) 3 $48
Computer Hardware Appple Inc. (AAPL) 4 $194
Construction & Engineering Jacobs Engineering (JEC) 5 $94
Construction & Farm Machinery Manitowoc (MTW) 5 $45
Diversified Metals & Mining Freeport-McMoRan Copper (FCX) 2 $108
Education Services Career Education (CECO) 5 $28
Fertilizers & Agr. Chem. Monsanto (MON) 3 $106
Health-Care Services LabCorp (LH) 5 $73
Industrial Gases Air Products (APD) 3 $102
Internet Retail (AMZN) 2 $94
Life Sciences Thermo Fisher (TMO) 5 $58
Oil & Gas Equip. & Svcs. Baker Hughes (BHI) 5 $83
Tires & Rubber Goodyear Tire (GT) 3 $28

Source: Standard & Poor's Equity Research

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