While software stocks were all the rage in 2020 and 2021, they fell by the wayside in 2022. It's not uncommon to see some software stocks down 80% or more from their all-time highs, which may scare off some investors.
However, there were some well-founded reasons investors loved software stocks over the past two years. It's the same reason I think the top software companies are buys now. Three that I think are great purchases are Snowflake (SNOW -2.80%), CrowdStrike (CRWD -10.13%), and Datadog (DDOG -2.88%).
Let's look at what separates these three from the rest of the pack.
Each of these companies operates in a niche and is the top company in its industry.
Snowflake is focused on deploying its data cloud. With its software, clients can store massive amounts of data through the cloud and then use it to drive business decisions through machine learning and artificial intelligence. It's extremely popular among its customers, with a 100% Dresener customer satisfaction score and a net promoter score (NPS) of 72.
Protecting the thousands of devices connected to a network from cyberattacks isn't easy, but CrowdStrike's software gives companies the best chance possible. Its endpoint security software is easily deployed through the cloud and uses trillions of data points gathered weekly to better inform its software on the current threats facing its customers. In addition, the value CrowdStrike's software provides its customers is incredible -- third-party Forrester Research found a CrowdStrike subscription provided the equivalent of $1.5 million in IT staff per year, and had a three-year return on investment of 403%. That's some serious value.
Managing how these software programs interact can be a headache, but Datadog's solution fixes this issue. Datadog's software gives IT teams visibility into how software programs interact, and provides security for these data streams. It can also be harnessed to solve problems before they are even noticed. Datadog has been recognized as a leader in the application performance management and visibility space by Gartner, while claiming the highest position for "ability to execute."
These providers are also highly rated in Gartner's customer review section.
|Rating (Out of Five Stars)
If customers don't love the software, they will always look for an alternative. Of course, these ratings can be skewed by one or two bad reviews, but the several hundred reviews for each product establishes a positive trend that investors can utilize.
All three of these businesses have great products that customers love, but what about their stocks?
Highly valued, but for a reason
One of many people's first comments about tech companies is how overvalued they are. For this trio, they may be right.
Paying 20 times sales is a lot for any company, no matter how you look at it, and these stocks are trading for more than that. Valuation represents a near-term risk, but if these companies continue their growth rates, it could be a price worth paying.
In their most recent quarters, this trio's growth was impressive.
|Q2 Revenue Growth Year-Over-Year (YOY)
As a company increases its sales, it drops the denominator in the price-to-sales (P/S) ratio, thus decreasing its valuation. However, when companies deliver this level of growth, their valuations often stay at the same level because their stock prices increase.
This mechanism keeps fast-growing tech stocks highly valued for multiple years. As a result, investors sometimes need to purchase the stock knowing that the valuation is a risk, but the bet on long-term performance is safe.
Over that long holding period, the profitability of this trio should improve. As of now, none are producing positive earnings per share (EPS), although Datadog is close ($0.02 loss last quarter). However, each is free-cash-flow positive, which means their businesses are generating cash instead of burning it.
This positive cash flow state allows the businesses to self-fund and acquire other businesses as they see fit. It also makes businesses more robust during downturns, as they don't need to borrow at unfavorable rates.
The opportunity for this trio is huge, with each operating in a $50 billion minimum market opportunity. While no company can capture every dollar in its target market, I'm confident that these leaders will maintain the top position in their respective industries.
Over the long term, this will make each company an excellent investment. With these stocks well off their all-time highs, now is an good time to establish a position.