By Jacob Sonenshine

President Donald Trump's tariffs are threatening the market again -- and software stocks are a great place to hide.

The S&P 500 index has dropped 0.9% during the first two days of the week as investors fret about the impact of renewed tariffs -- if certain concessions aren't met by Aug. 1. The iShares Expanded Tech-Software Sector exchange-traded fund has declined only 0.2%, despite having a "beta" of 1.16, suggesting it should be more volatile than the stock market, not less.

Helping the ETF: Software companies tend to buy fewer physical products, so they're not as vulnerable to the rising prices that tariffs could cause. Also, demand isn't as economically sensitive as it is for other industries, so if the economy takes a light hit from increased levies, software isn't among the market's top concerns.

For software companies, "tariffs don't matter," says Rhys Williams, chief strategist at Wayve Capital. "If tariffs get slightly worse, software will trade well."

Though tariffs are getting all the attention, investors shouldn't ignore the impact of the tax bill that just passed Congress and the impact it could have on software companies' cash flow. The bill allows them to expense research and development spending immediately, instead of spreading the cost over a number of years. Of course, higher near-term expenses push down pretax earnings, but they also result in a lower tax bill -- and higher free cash flow. And those cash flows are ultimately what will make a company more valuable.

Okta, Autodesk, and CrowdStrike Holdings are the three software stocks that benefit the most from the changes in the law, according to Morgan Stanley analyst Keith Weiss. He estimates, based on their R&D expenses in the past three years as a portion of their free cash flow, that their free-cash-flow margins increase between 9.9 and 10.2 percentage points in 2026, when the full effect would appear in financial statements.

Software stocks are also getting a boost from a weak U.S. dollar, which has dropped 6.7% since the end of April. This makes overseas sales worth more when converted back into dollars. The companies, however, usually give earnings guidance based on where currencies are trading at that moment, so the weaker dollar should help second-quarter earnings beat expectations, all else being equal. That's particularly true since analyst estimates for the group's second-quarter earnings have barely budged since the end of March.

"FX tailwinds increased in June, implying companies across our coverage should see FX benefits in Q2 should trends sustain," Weiss writes.

The stocks have longer-term tailwinds, too. Sales for the companies in the ETF are expected to grow 11.5% annually for the two years from the end of 2025 through 2027, according to FactSet, as companies continue to invest in new software, particularly artificial-intelligence tools. That provides a big boost for companies like Microsoft and Oracle, purveyors of AI-enabled software.

Yes, the iShares Expanded Tech-Software Sector ETF trades at 38.8 times earnings estimates for the coming 12 months, well above the S&P 500's 22.2 times. But the outsize growth of the industry makes the valuation look tolerable. The fund's PEG ratio -- its price/earnings ratio divided by its earnings growth rate -- is just 1.9 times, only 0.3 points above the S&P 500's PEG ratio of 1.6. Historically, it has traded at just over a 0.4-point premium. If their earnings growth meets or exceeds expectations, software stocks can keep gaining.

Owning them reflects real intelligence.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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July 09, 2025 03:00 ET (07:00 GMT)

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