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'Tisn't the Season for Software

A seasonality study shows that the sector's bull run might be over.

Is the bull run in software grinding to a halt?

With exception of a handful of stocks, it is, says a team of Cowen analysts who studied the performance of 41 software issues over five years.

"The number of software companies that will sound as positive about their businesses in three to six months time as they do at present will be counted on the fingers of two hands," the analysts wrote in a note published Tuesday.

Here's why:

Investors who follow the software sector know that fourth-quarter sales are nearly always the year's best. Subsequent quarters, of course, are usually slower. Less obvious, though, is a similar seasonal pattern followed by the multiples of software stocks.

Cowen analysts Peter Goldmacher and Walter Pritchard studied 41 small-, medium- and large-cap stocks and found that forward P/Es have increased by 10% so far this quarter, double the seasonal average since 2001, and 4 points higher than the average expansion since 2003.

However, software multiples as measured by the Cowen team contract the rest of the year; on average, 3% in the first and second quarters, and 1% in the third. Although the stocks are "not expensive" by historical standards, the analysts believe that earnings in the coming quarters won't support the current multiples.

In other words, it may be time to back off from software investments, at least in the short run.

Software investors who correctly timed the trough caused by the options scandal have been well rewarded. Since mid-July, the Goldman Sachs Software Index (a reasonable proxy for the Cowen list) has appreciated by 22%, while the broader

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is up 16% and the

S&P 500

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But the next few quarters don't look as good, say the analysts. Besides seasonality, "We believe the organic growth rate of the sector continues to decelerate, due to maturing markets and the entry of larger systems vendors," they wrote.

And while the frenzied pace of M&A activity in the sector has convinced investors to buy companies that could become takeover targets, the Cowen team says there is currently a glut of potential acquisitions.

Lightening the generally bearish tone of the note is a list of software companies the Cowen team expects to buck the trend. They include:

Cowen has managed public offerings of Adobe, Symantec and Witness Systems within the last three years.