Software stocks led the market higher in 2020 and 2021 as software-as-a-service companies could seemingly do no wrong in the eyes of investors. However, after two years of incredible performance, these stocks have taken a big hit in 2022 as investors worry about inflation and interest rate hikes.
While sentiment has shifted for now, many software companies are still great businesses to own for the long term because they feature strong margins and durable recurring revenue -- the types of companies you want to have in your portfolio a decade from now.
Let's look at three of the top software stocks to buy and hold for 2022 and beyond.
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1. Adobe
It often doesn't pay to overthink things when looking for good investments. Adobe (ADBE -1.73%) is one of the biggest and best-known software stocks, and for good reason. Over the last 10 years, this software juggernaut has given shareholders a return of over 1,100%. This return would be even more impressive if not for a 35% decline this year, which creates an opportunity to buy shares of this market leader at a discount.
Adobe is best known to most investors for its creative software like Photoshop and Illustrator. And its Acrobat software allows users to create, read, and edit PDFs. These products are part of the Creative Cloud subscription within Adobe's Digital Media segment.
This is a highly profitable business that just grew revenue 15% year over year in the most recent quarter despite being around for a long time. Adobe has a wide moat as the category's creator and it's the industry standard that professionals are already familiar with.
Adobe's growing Digital Experience business centered around digital marketing could be a significant growth driver for years to come. Revenue for this segment grew by 17% in the most recent quarter.
Adobe has gross margins of 87.9%, among the best in the entire software industry (which is saying something because the space is already known for strong margins). Net dollar retention is a key metric for evaluating software companies, and Adobe's net dollar retention rate is an incredible 125%. This means that it does not lose many customers (thus retaining the recurring revenue it brings in each year) and on top of that, it is gaining 25% more revenue from these customers.
While Adobe isn't cheap at 37 times earnings, the valuation does come down to 24 times forward earnings based on next year's estimates. Furthermore, a top software stock like Adobe almost always comes with a premium valuation, so the current sell-off probably offers as good a time as any to add this market leader to your portfolio for the long term.
2. Bill.com
Shares of former highflier Bill.com Holdings (BILL -2.26%) are down over 60% from their 52-week high of $348.49. The aptly named company streamlines and automates back-end financial operations for small and medium-sized businesses (SMBs), such as -- you guessed it -- billing.
Bill.com seeks to help owners and proprietors of SMBs simplify the billing process. As anyone who has tried to book a job with a landscaper or contractor this year knows, these types of SMB owners are busier than ever thanks to a shortage of labor, so thus have a real need for automation and simplification.
The numbers show that Bill.com's value proposition is working. While the company is not yet profitable, it is growing revenue rapidly. The company generated $157 million in revenue in 2020, increased it to $238 million in 2021, and is guiding for $625 million in revenue in 2022. If it can hit that target, that would mean revenue growth of just under 400% in a two-year time frame. It is rare to find a company growing at that rate, and if Bill.com continues to execute, it could be worth a lot more than it is today.
3. DigitalOcean
DigitalOcean Holdings (DOCN -1.52%) had an incredible 2021, but like the rest of the software sector, shares have fallen hard in 2022 and are now down 66% from their 52-week high.
Like Bill.com, DigitalOcean serves SMBs. For the most part, the major cloud providers like Amazon's AWS and Microsoft's Azure are focused on serving enterprise-level customers, leaving SMBs out in the cold. This is where DigitalOcean comes in.
It offers infrastructure and tools to independent developers and developers at companies that are too small for the big cloud providers to focus on. What I like is that DigitalOcean acquires the majority of these customers using a cheap and efficient "self serve" model: Customers come to the website to learn about a tool and then use it, negating the need for an expensive salesforce.
While they start out as lower-spending customers, DigitalOcean says that 94% of its high-value customers started out through self-service. This indicates that these users are willing to spend more on DigitalOcean over time as they grow with the company. As such, like Adobe, the company has an impressive net dollar retention rate of well over 100% at 116%.
While DigitalOcean is not yet profitable, it trades at a price-to-sales multiple of 9, which isn't bad for a fast-growing software stock.
The current market environment has created an opportunity to invest in some compelling software companies at prices that are much lower than they were just a few months ago. With impressive growth, recurring revenue, and strong margins, these stocks look like good bets to add value to your portfolio through 2022 and beyond.
