A Less Volatile Way to Benefit From the Cybersecurity Boom

The global cybersecurity market has grown incredibly over the past dozen or so years, hitting an estimated $120 billion last year, according to Cybersecurity Ventures. The pace of spending isn't going to slow down anytime soon as corporate organizations and governments have been bolstering their defenses to tackle the constantly evolving threats from hackers.

The firm estimates that the market will keep growing at an annual rate of 12%-15% over the next four years as threats become more advanced. An obvious way to take advantage of this trend is by investing in top cybersecurity companies such as Palo Alto Networks (PANW 1.43%) or Fortinet.

But there could be a better way to benefit from the cybersecurity opportunity in the form of the ETFMG Prime Cyber Security ETF (HACK 1.18%), which claims to be the world's first cybersecurity exchange-traded fund (ETF).

Image Source: Getty Images.

A lowdown

ETFs are made up of shares of multiple companies, allowing investors to get into several stocks from a particular industry at the same time. Buying shares of the Prime Cyber Security ETF gives investors a piece of 50 cybersecurity stocks, and that diversity has the benefit of spreading risk and potential volatility across more than one cybersecurity stock.

This is a big advantage as cybersecurity stocks, especially the pure-play ones, have been prone to wild swings in stock price. Additionally, the Prime Cybersecurity ETF has an expense ratio of just 0.60%, so an investor who owns $1,000 worth of this ETF will have to pay just $6 toward the ETF's operating costs.

This is a small price to pay to mitigate the risk of volatility, and also get access to diverse cybersecurity plays. Here's the top five holdings of the ETF:

Source: ETFMG.

Strength in diversity

The top five holdings of the Prime Cybersecurity ETF, which account for nearly 22% of the fund, make it clear that it tracks a mix of both fast-growing and relatively mature cybersecurity stocks. Palo Alto, for instance, spends nearly half of its revenue on sales and marketing to acquire new customers, and recently hired former Google exec Nikesh Arora to scale up its business.

The company has been aggressively reducing its GAAP net loss by increasing subscription-driven sales that carry a lower cost of revenue than the legacy product business. The subscription business is currently 62% of the company's total sales, so the growing contribution from this bucket will improve its earnings power in the future.

Check Point Software, on the other hand, is a play for conservative investors. The Israel-based cybersecurity specialist prioritizes bottom-line growth over the top line. Its operating margin of nearly 50% is way above Palo Alto's negative operating margin of around 5%. But this doesn't mean that the company isn't looking to take a bigger bite out of the cybersecurity opportunity.

Check Point has been gradually boosting its subscription business and striking bigger transactions. Its subscription-based business increased 18% year over year during the last reported quarter, and now accounts for two-thirds of the total revenue. What's more, the number of $1 million-plus deals struck by the company had increased 11% annually, to 110 last quarter, indicating that customers are spending more money on its offerings.

With a price-to-earnings (P/E) ratio of 21, Check Point should fit the bill of those looking for a reasonably priced cybersecurity play (outside of an ETF), as the industry average is more than 100. Risk-averse investors would also be inclined toward Cisco. The networking giant has done well to expand its cybersecurity business by leveraging the strength of its legacy hardware business.

Its cybersecurity revenue is on track to exceed $2 billion this fiscal year. The company generated nearly $1.6 billion in cybersecurity revenue in the first nine months of the fiscal year, an increase of 12% over the prior-year period. Cisco is well-placed to sustain, or even ramp up, the growth of its cybersecurity business thanks to its integration strategy.

It is building cybersecurity capabilities right into its hardware products with the Talos platform that underpins Cisco's entire ecosystem. The company claims that "if you own a Cisco security product, you're harnessing the power of Talos' threat intelligence, which flows to each and every one of our products."

Such a strategy allows Cisco to replace pure-play specialists as it can provide an end-to-end solution by embedding cybersecurity features right into the network. Moreover, Cisco is able to continually upgrade Talos thanks to the huge amount of data it receives and analyzes on a daily basis.

Finally, the fact that cybersecurity is just one of Cisco's many businesses means that investors will be able to benefit from more than one catalyst, such as the Internet of Things. But if you don't want to pick individual stocks in the sector, you can consider the HACK ETF.

Buying the ETFMG Prime Cyber Security ETF might not yield as handsome returns as investing in a specific cybersecurity play, as evident from the chart below. But it provides a hands-off approach toward investing in cybersecurity stocks and insulates investors somewhat from volatility.

HACK data by YCharts