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Investors are weathering the biggest attrition in the value of technology stocks since the dot-com bust, but experts are citing cybersecurity as a business more resilient to recession than most.
Several developments have propelled cybersecurity stocks, says Ken Gonzalez, senior advisor at Momentum Cybersecurity Group LLC in San Francisco, which advises early and late-stage cybersecurity companies. He cites rising cybercrime and more sophisticated attacks among the drivers for this market.
“We’ve seen amateur criminal organizations become fully funded [research and development] organizations,” he says. “The threat landscape has increased dramatically.”
In the past year alone, a ransomware attack on the Colonial Pipeline Co. sent some U.S gas prices soaring at the pump and an attack on network management software company Kaseya Ltd. disrupted hundreds of customers. Ransomware attacks on food producers and distributors have also raised concerns about the effect on critical national infrastructure, sparking government pressure.
A White House executive order a year ago demanded stronger cybersecurity protections from suppliers selling to the U.S. federal government. This edict followed a 2020 attack on IT management software company Solarwinds Corp. that left back doors on U.S. government agency systems.
Geopolitical tensions have fanned the flames, he adds. Attacks by governments are on the rise, while Canada and the U.S have both warned companies about potential cyber actions from Russia following its invasion of Ukraine.
Analysts are heeding these signals and predicting strong growth in this market. GlobalData PLC predicts the global cybersecurity industry will grow to US$198-billion in 2025 from US$125.5-billion in 2020.
The market’s current bearish trend looks gentler for the cybersecurity sector. Momentum Cyber points to a 4-per-cent fall in cybersecurity stocks during the first quarter of the year compared to a 9-per-cent fall in the Nasdaq Composite.
Opportunities in cloud-based cybersecurity
Scott Collins, founding partner and deputy chief investment officer at Triasima Portfolio Management Inc. in Montreal, also sees opportunity in cybersecurity in spite of the technology sector’s problems. His company uses a three-pillar system when evaluating stocks: fundamentals, trends, and quantitative technical analysis.
“Many technology names have broken down from a three-pillar perspective as interest rates have moved up and company growth rates have moderated,” he says. “As such, we have significantly reduced exposure, but there are some areas holding up better than others.”
Triasima maintains strong positions on several cybersecurity companies. Mr. Collins differentiates between those offering cloud-based solutions and those selling what he calls “legacy” products running at their customer’s offices.
“The stronger names from a fundamental perspective are offering more comprehensive solutions including cloud elements,” he says.
Triasima classifies companies such as Palo Alto Networks Inc. PANW-Q and Fortinet Inc. FTNT-Q as hybrid stocks because they come from the on-premise security world but also have cloud offerings. They hit the sweet spot for delivering profitability at a more modest price.
Mr. Collins rates these stocks higher than legacy solution providers and pure cloud plays. The latter are more expensive, which he warns could affect performance if they fail to meet earnings or if interest rates continue to rise. They include CrowdStrike Holdings Inc. CRWD-Q and Zscaler Inc. ZS-Q
Meanwhile, cloud security spending was forecast to grow 41 per cent last year from 2020, according to Gartner Inc. – more than double the next fastest-growing category in cybersecurity.
A complex cybersecurity market
The cybersecurity sector divides further still into many subcategories. Some vendors offer solely hardware and others offer software. Some solutions specifically target e-mail security while others concentrate on detecting network intrusions. The pandemic-fuelled growth in remote work has left a subset of vendors focused on securing employees beyond the company network. Service-oriented companies take on the whole security process for customers short on resources.
It’s a complex landscape that makes it difficult to pick stocks. Exchange-traded funds (ETFs) offer a safer bet, some experts say.
One of these is iShares Cybersecurity and Tech Index ETF XHAK-T, a fund that RBC iShares, the alliance between RBC Global Asset Management Inc. and BlackRock Asset Management Canada Ltd., added to its collection in early May.
Cybersecurity may be a fragmented industry now, but signs of consolidation make its outlook even more positive, says Jay Jacobs, head of U.S. thematic and active equity ETFs at BlackRock Inc. in New York. He points to merger and acquisition activity at record highs in the cybersecurity market.
“As the space matures, large customers are seeking to work with fewer providers, hence some of the consolidation in the space,” he says. “This increased deal flow could provide tailwinds for cyber companies.”
Mr. Jacobs sees a longer-term opportunity in this area.
“Valuations are trading nearly a full standard deviation below their five-year average, while forward sales growth estimates for [iShares Cybersecurity and Tech Index ETF]are 500 [basis points] higher than the broader tech sector, representing a potentially attractive entry point,” he says.
Targeting growth investors
Who should invest in funds like these?
“Somebody who’s looking for growth within their portfolio and somebody who’s looking for differentiated technology exposure,” says Raj Lala, president and chief executive officer of Evolve Funds Group Inc.
The ETF provider launched Evolve Cyber Security Index Fund CYBR-T in 2017. It concentrates on companies with a minimum market capitalization of $100-million and a minimum active daily trading volume of $2-million. Rebalanced quarterly, the passive index-based fund exposes investors to a broad base of cybersecurity stocks.
Mr. Lala believes cybersecurity stocks will hold their value in the long term because, like insurance, companies don’t see this product category as a discretionary spend.
“This is not one of those technologies that will die by the wayside during a recession,” he says. “It’s a nice steady performer, recession or not.”
Those interested in investing in the sector should focus on risk management, Mr. Collins of Triasima warns.
“Layer in the risk,” he says, adding that people should move into this area over time. Even in a market that looks promising, it pays to be prudent.
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