Market Extra: For hedge funds, software-as-a-service stocks are the new FAANG

Once upon a time, a primary concern for stock market investors was the unprecedented dominance of a handful of consumer-facing technology companies over broad market performance.

Just one year ago, equity strategists and investors were nervously pointing out that the so-called FAANG group of stocks, an acronym that stands for Facebook Inc.

FB, 0.10%

 Apple Inc.

AAPL, 1.35%

 Amazon.com Inc.

AMZN, -0.10%

 Netflix Inc.

NFLX, 4.84%

 and Google parent Alphabet Inc.,

GOOG, 0.53%

GOOGL, 0.59%

 were responsible for most of the S&P 500 index’s returns during the first three quarters of 2018, shielding from investor view the less impressive performance of the typical U.S. stock.

Then came the nearly 20% decline for the S&P 500 index 

SPX, 0.64%

 during last year’s fourth quarter, which wiped out these gains, followed by a series of negative headlines for the tech group of stocks, as some of these firms faced political backlash for their market power, use of personal data, and influence over the flow of news and information.

These headwinds have weighed on FAANG stocks, whose performance during the past year has been much less impressive, even as the information technology sector and communications services sectors have outperformed the S&P 500 more broadly. The tech sector has held up because of a quiet rotation away from FAANG stocks and toward business-facing tech companies featuring the “software as a service” business (SaaS) mode, according to hedge fund data firm PivotalPath.

“When you look at the performance, it’s astounding how strong SaaS has been,” Jon Caplis, chief executive officer at PivotalPath told MarketWatch. Caplis discovered the trend through conversations with hedge fund managers, which led him to create a basket of SaaS stocks to measure their relative performance against the market and previously market-leading FAANG stocks.

He found that SaaS stocks, including Microsoft Corp.  

MSFT, 0.62%

 , Salesforce.com Inc.

CRM, -0.44%

 , ServiceNow Inc.

NOW, 0.44%

 , Workday Inc.

WDAY, 0.59%

 and Atlassian Corp. Plc,

TEAM, -0.69%

 ended up outperforming FAANG stocks in 2018, rising 76.8% versus FAANG’s 7% rise. That performance outperformance has continued this year, with the aforementioned SaaS stocks rising more than 35% on a market-cap weighted basis, versus about 26% for the FAANGs and an 18% rise for the S&P 500.

Meanwhile, the S&P 500 is no longer dependent on FAANG names for its gains, as Microsoft has become the biggest gainer for the broad index. The Software giant’s market capitalization has risen roughly $194 billion during the past year, 353% of the overall market cap advance for the S&P 500 of $54.9 billion, according to FactSet data.

Hedge funds have taken notice and helped drive the rotation from SaaS to FAANG, as their ownership of FAANG names have fallen by $23.4 billion since the beginning of 2018 through the end of the second quarter of this year, while they have added $13.6 billion to SaaS names, according to 13-F filings.

Caplis said that hedge funds are attracted to these names because we’re in the “beginning innings of a multi-decade shift to cloud computing”, in which businesses move their core functions to the cloud, aided by software. Meanwhile, investors are attracted to the evolving business models of software companies.

In the past, deploying new software required large, up-front costs that many businesses would simply forgo in tough times. Today, SaaS companies engage their customers with subscription-based models that provide a steady revenue stream, while a growing dependence on enterprise software for core business functions has created a sticky customer base.

Third, companies in this space are ripe for merger and acquisition activity. According to Software Equity Group, M&A transactions for the SaaS industry are at record highs, with 250 transactions during each of the four quarters through the second quarter of 2019.

SaaS stocks have “certainly been on quite a run for about a year,” Dan Romanoff equity research analyst at Morningstar told MarketWatch. He says that some younger companies claiming the business model, including Slack Technologies Inc.

WORK, -3.05%

 and Zoom Technologies Inc.

ZOOM, -1.92%

 have faced pressure in recent weeks due to “stretched valuations,” and their struggles to convert users of their free products into paid customers. However, the more established companies offer investors both high revenue growth and quality earnings that are sustainable over the long haul.

For investors who are worried about a coming recession, “You’re going to focus on the larger companies with lower valuations,” Romanoff said. “Microsoft and Adobe Inc.

ADBE, 0.26%

 , these cases have been adjudicated. In a downturn, their revenues will dip and then rebound, but it won’t change their competitive position going forward.”

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