2023-12-13 11:42:02 ET
Summary
- XSW offers exposure to software stocks covering themes like cloud computing, AI, and blockchain.
- The fund's equal-weighting methodology delivers a unique profile with a tilt toward high-growth, mid and small-cap companies.
- We are bullish and expect XSW to continue delivering positive returns in the next stage of the bull market.
The SPDR S&P Software & Services ETF ( XSW ) offers targeted exposure to this high-growth industry within the technology sector. Companies here are capturing high growth opportunities in areas like cloud computing, digital transformation, artificial intelligence, and even the blockchain.
Indeed, the attraction of XSW is its extensive portfolio covering more than 144 stocks through an equal weighting which offers a unique diversification across both large-cap leaders to emerging disruptive players.
The fund has rallied impressively in 2023, up more than 30%, but remains well below its pandemic-era all-time high. We are bullish on XSW and view this segment as well-positioned to outperform going forward.
The following reasons highlight why we rate the fund as a buy:
- XSW has a portfolio tilt towards mid- and small-caps that should benefit from expanding breadth in the next stage of the bull market.
- High-growth names within the XSW portfolio can gain momentum as interest rates stabilize.
- Valuations in the industry appear more attractive compared to peak levels with more companies scaling into more consistent profitability.
What's In the XSW ETF?
XSW technically tracks the "S&P Software & Services Select Industry Index" which includes companies classified within the Application Software, Systems Software, Interactive Home Entertainment, IT Consulting, and other Technology Services sub-industries.
There's not much of a mystery here. If the U.S.-listed companies are within the eligible industries with a float-adjusted market cap of at least $300 million, they are considered for inclusion. The fund is rebalanced quarterly.
We mentioned the equal-weighting methodology . A result is that smaller companies gain importance within the index and in the fund's portfolio compared to market-cap-weighted alternatives dominated by mega-caps.
Notably, the median average market cap across all holdings is around $4.3 billion which means the majority of stocks fall in the "mid-cap" toward the small-cap range. Through each quarter, the top-performing stocks gain an incremental share against the lagging stocks with a reduced value.
The current ESW portfolio consists of 144 stocks with a clear "growth" profile consistent with the sector. This is evident by the estimated 3-5 year consensus EPS growth estimates of around 23%, while the forward P/E multiple is listed at 28x. Similarly, there is a modest quarterly dividend that yields 0.2%.
Going through the current holdings, what stands out is the diverse group of companies, many utilizing the Software-as-a-Service (SaaS) commercialization model.
The idea here is that the product can scale significantly with a worldwide addressable market while generating increasing levels of recurring revenue and often exceptional gross margins. Oftentimes, SaaS names are commercializing an alternative that either competes with a more established legacy solution or has created an entirely new market opportunity.
Cybersecurity has embraced this concept with XSW featuring several market leaders among the top holdings including CrowdStrike Holdings, Inc. ( CRWD ), SentinelOne, Inc. ( S ), and Zscaler, Inc. ( ZS ). In terms of more business productivity development applications, Palantir Technologies Inc. ( PLTR ) UiPath Inc. ( PATH ), Elastic N.V. ( ESTC ), HubSpot, Inc. ( HUBS ), and Splunk Inc. ( SPLK ) stand out.
Roblox Corporation ( RBLX ) within the portfolio is one representative of the "Interactive Home Entertainment" sub-industry related to video games.
Keep in mind that XSW also features mega-cap names and more high-profile software leaders such as Microsoft Corporation ( MSFT ), Salesforce, Inc. ( CRM ), Oracle Corporation ( ORCL ), and Adobe Inc. ( ADBE ). The point here is to say that software is a big basket and XSW has rounded them all up.
One quirk among the current composition of XSW is the prominent role "crypto" stocks between CleanSpark, Inc. ( CLSK ), MicroStrategy Incorporated ( MSTR ), and Marathon Digital Holdings, Inc. ( MARA ) are being held, currently the top-3 names.
The classification of the industry is based on their relationship to blockchain technology which is technically "software". In this case, the strong market returns for this segment with a large rally in the price of Bitcoin USD ( BTC-USD ) have driven related names higher with market-leading performance.
On this point, 2023 has been good for software, with a big rebound for the group compared to the extreme volatility in 2022. The trends at play include not only the stronger-than-expected economic backdrop, easing inflationary cost pressures, and the outlook for stabilizing interest rates.
A general theme for the group on the application software side has been an effort to rationalize expenses and generate cost savings, including through widely reported headcount reductions, to support margins. We sense that more companies are finding the right balance between top-line growth while also moving to generate stronger underlying earnings and cash flows.
At the same time, we highlight that many stocks within the XSW portfolio remain significantly below their highs in 2021. The silver lining is that this dynamic has translated into a widespread valuation reset, particularly among the growth premium and earnings multiples that reached extreme levels during the last cycle.
The argument we make is that while those all-time highs are likely out of reach for the foreseeable future for many of those names, these companies are entering 2024 in a stronger financial position and improved outlook.
What's Next For XSW?
What we like about XSW is that its equal-weighting methodology results in a distinct profile compared to the market-cap-based broad-market equity funds like the SPDR S&P 500 ETF Trust ( SPY ) or the tech-focused Invesco QQQ Trust ETF ( QQQ ).
Mega-cap tech stocks dominated returns in 2023, being led higher by names like Microsoft Corporation, Alphabet Inc. (GOOG), ( GOOGL ), and NVIDIA Corporation ( NVDA ). However, the way we see it playing out, the next stage of the bull market should be defined by greater participation among a wider group of stocks, including many of the names within the XSW portfolio.
A macro setup of resilient economic conditions that avoids a deep recession while interest rates stabilize should be supportive of risk sentiment as a tailwind for valuations into software stocks. With XSW trending higher over the past year since the fund's 2022 low, we expect that bullish momentum to continue.
Final Thoughts
XSW is a high-quality ETF supported by a positive long-term outlook in what is arguably one of the most important industries for the global economy. The fund is a good option for investors to add incremental tech and high-growth exposure that can complement a more diversified portfolio and existing large-cap equity allocation.
In terms of risks to consider, the big concern would be the possibility of a deteriorating macro backdrop. A weaker-than-expected economy would likely result in disappointing sales growth and earnings momentum, opening the door for renewed volatility in the tech sector.
For further details see:
XSW: 3 Reasons The Software And Tech Services ETF Can Outperform In 2024