The British software sector stars investors should buy now

You might not think of the UK as a market full of promising tech stocks. But our small and medium-sized companies are punching above their weight, says Dr Mike Tubbs.

When it comes to technology, Britain's stockmarket doesn't spring to mind immediately. There is no British Google or Apple, while our blue-chip index, the FTSE 100, is resolutely old-economy, dominated by miners, oil giants and banks. But it's time investors took a closer look. While we may not have any national giants, we have plenty of excellent smaller companies with leading positions in global market niches. Many are profitable, expanding rapidly, and offer ample scope for impressive share price gains.

Indeed, there is a palpable sense of excitement surrounding the UK tech sector. The digital technology sector is expanding at an annual pace of 4.5%, around two-and-a-half times faster than the overall economy, and is now worth £184bn. We rank third in the world for total capital invested in digital tech companies, behind America and China, according to research published by Tech Nation, a network of tech entrepreneurs. London is widely deemed the third-most important centre for tech startups after Silicon Valley and New York. Rapid growers such as Deliveroo and TransferWise tend to hog the headlines, but a more obscure and fruitful area for investors is software. This sub-sector has expanded at an annual rate of 10.1% over the past five years and boasts sales of roughly £29bn.

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UK software's strength in depth

A good example of how Britain has established a strong foothold in this sector is Craneware. A healthcare software firm, it has become the leading supplier of financial and performance-management software to US hospitals. Almost a third of registered US hospitals are now Craneware customers. Its shareholders have been rewarded by a 23-fold rise in the stock between January 2008 and October 2018.

Craneware offers US hospitals 16 different software packages including revenue recovery and retention, claims analysis, patient engagement (whereby patients can access their records and make appointments, for instance) and cost analytics. Craneware is growing both by introducing new software applications to existing customers and by recruiting new hospitals. Its revenue for 2017-18 grew by 16% to £67.1m.

Research and development (R&D) has been key to achieving leading market positions such as Craneware's, underpinning growth that has often been supplemented by bolt-on acquisitions. The EU industrial R&D Investment Scoreboard 2017 highlights the strength in depth of UK software. It lists all the EU software and computer services companies investing at least €7m annually in R&D. The UK boasts almost half the EU total, with 56 firms out of 114, followed by Germany with just 19, France with 16, Sweden seven and Finland five. There are also many smaller software companies investing less than €7m a year in R&D. We will concentrate on those focused mainly on software rather than IT services, and with market caps of at least £50m.

Overseas buyers snap up our winners

Given our wealth of software companies it may seem puzzling that there are only two UK software companies in the FTSE 100, Sage Group and Micro Focus. A major reason is that overseas companies regularly snap up quality UK software firms before they get very big. Recent examples include Arm Holdings, a FTSE 100 chip-design software group acquired by Softbank of Japan. Fidessa was a medium-sized, FTSE 250 member and software firm acquired by private equity group ION Capital. A majority stake in Aveva was acquired by Schneider Electric of France. In 2014, Alphabet, Google's parent company, pounced on DeepMind, an artificial intelligence (AI) company established in 2010. Nevertheless, there are still plenty of small and medium-sized software companies with strong positions in niche growth markets.

Wide range of sub-sectors and companies

UK software companies operate in six main sub-sectors: cybersecurity, engineering design, finance and trading, gaming and entertainment, mobile applications and process automation (administrative, production and testing processes). Given the wide range of business processes (BP), this category contains the largest number of companies. When it comes to software processes, many companies are taking advantage of a structural shift whereby clients essentially rent their services on the internet rather than buy them on a disc and install them as they used to. The SaaS (software as a service) model means clients can have their software automatically updated, while it is also easier to sell them related services; recurring revenues tend to be higher under the SaaS system.

Examples of large cybersecurity companies are Avast, a producer of antivirus software that also designs systems to keep mobiles, PCs and office networks safe. It has 400 million users and is a member of the FTSE 250. Sophos, also a mid-cap, specialises in network security. GB Group focuses on identity and location verification. The largest operator in engineering design is Aveva. A big name in the finance segment, with an emphasis on trading systems, is First Derivatives, while Craneware is active in this sub-sector, too. In gaming and entertainment key names are Playtech, Keywords Studios and Accesso Technology. Mobile applications are represented by SafeCharge International. For process automation we cite five companies in different areas FTSE 100 members Sage and Micro Focus, along with Blue Prism, SDL and EMIS Health. Sage specialises in accountancy and business management software for SMEs, Micro Focus in updating mature software infrastructure, Blue Prism in software robots for automating back-office processes, SDL in automated translation and global multi-language publishing, and EMIS in healthcare.

Further details for 12 of these software companies are given in the table above. Note that software is among the economy's more profitable industries, as the double-digit operating margins attest. The more mature companies offer consistent dividends SafeCharge, Sage and Micro Focus yield 3% to 5%, for instance. The faster-growing or unprofitable firms don't pay dividends.

Potential in software small caps

There are also many smaller firms operating in a wide range of niches and geographical regions. Eight of the most intriguing are introduced below and listed below with their key financial data. The largest three have market caps of £250m to £300m and the smallest five £60m to £110m. They are fast-growing and pay little or no income. Most are listed on Aim. Quixant provides gaming platforms for pay-gaming and slot-machines and makes nearly three-quarters of its sales outside Europe. In 2017, earnings jumped by 29% and the group has net cash on its balance-sheet. Microgen offers business-process systems and analysis suitable for chief financial officers (CFOs), and software for the global wealth-management sector. It is a profitable company, with the UK accounting for just over half of its revenue. WANdisco is dual-headquartered in Silicon Valley and Sheffield, with 82% of revenue from North America. It provides software to help ensure crucial parts of a business keep working if there is a cyber attack or some other catastrophe, and also helps firms move their businesses onto the cloud. Orders continue to rise quickly.

Gresham Technologies specialises in software to manage financial transactions and keep data consistent and accurate across databases (data integrity). Sopheon provides software to help companies improve their R&D to achieve shorter time to market. It gains 60% of its revenue from North America and paid its first ever dividend this year. Tax Systems provides corporation tax and associated software to large corporations and the accountancy profession in the UK and Ireland. It narrowed its annual loss from £3.7m in 2016 to £0.5m in 2017. Elecosoft offers software to the architectural, engineering and construction industries the UK accounts for 55% of revenue with the rest from Scandinavia and Germany.

Which ones should you pick?

We would advise against opting for the blue-chip software groups in the FTSE 100, both of which are struggling. Micro Focus saw its shares drop 20% in January when it revealed sales would fall this year following problems with its acquisition of HP Enterprise, while its CEO left in March. Sage has been a sound investment for many years. It produced an organic growth rate for 2018 of around 7% and yields 2.9%. But its market-leading position in small-business software is under threat from cloud-based competitors such as Intuit.

Instead, consider engineering design specialist Aveva (LSE: AVV), which boasts a fine record and a strong market position. In the past few years it has incorporated the industrial software division of its majority owner, Schneider Electric. It is now involved in activities ranging from optimising mining supply chains and utility management to designing smart cities. Aveva yields 1.5% and says it intends to continue a progressive dividend policy.

First Derivatives (Aim: FDP) has notched up 21 years of double-digit revenue growth and recently announced sales growth of 23% for the financial year 2017-18. The dividend was raised 20% but this still only gave a yield of 0.7% since the share price has increased by four times over the past five years.

Then there is Craneware (Aim: CRW), which again has a fine record, a strong market position and high profitability. Among the larger companies growing fast but still making losses is Blue Prism (Aim: PRSM).Nevertheless, the long-term outlook is compelling given that robots doing back-office admin is a strong growth area. So despite an impressive share-price performance in recent years, there is plenty of scope for more. Cybersecurity expert Avast (LSE: AVST) floated in London last May. It is known for its emphasis on security for small and medium-sized businesses, but it is also the world's largest antivirus supplier for consumers.

In the gaming segment, Keywords Studios (Aim: KWS) looks a better bet than the many video-game developers. Keywords provides developers with a full range of software support and services, and has also bulked up with acquisitions. Its clients include most of the top-25 developers, including Microsoft and Sony. It helped produce the famous game Rise of the Tomb Raider.

In entertainment, Accesso Technology (Aim: ACSO) is clearly risky but also offers potentially high rewards. It controls 40% of the North American online ticketing market for theme parks but 5% in Europe and nothing in Asia, so the latter two regions offer clear potential for expansion. Among the smaller companies, we like Elecosoft (Aim: Elco), Sopheon (Aim: SPE) and Tax Systems (Aim: TAX). Quixant (Aim: QXT) is another possibility provided its second half shows improvement as it predicts.

Diversify your software portfolio

In building a portfolio of software companies it makes sense to combine some larger, well-established and dividend-paying stocks with growth-orientated ones of medium size. Those with a wide global spread of sales reduce geographic risk. The 11 companies named above include ten with substantial non-European sales the only exception is Tax Systems, given its focus on domestic tax rules. A software portfolio should also contain some of the large US companies with strong global positions in their sub-sectors. Salesforce.com (NYSE: CRM), the world leader in customer relationship management, is just one of many examples.

Keep an eye on minnows coming to market

There are also many unlisted UK software and AI companies that may list in the future and provide big gains, just as Sophos and Blue Prism have done. Blue Prism's IPO on Aim in March 2016 was at 78p but the shares are now in the region of 2,025p. Fast-growing private software companies include Neuven (human resources software) and Thoughtonomy (automation software).

When it comes to AI, examples to look out for include Darktrace (cybersecurity) now valued at $1.65bn, BenevolentAI (drug discovery), FiveAI (autonomous vehicles), Babylon Health and Improbable (complex virtual worlds for game development). Although one or two of these could see a direct acquisition as DeepMind was for Google, others could easily decide to float in the next few years and could then be the next Blue Prism or be acquired at a big premium as Arm and Fidessa were.

Dr Mike Tubbs owns shares in Aveva, Craneware, Fidessa, Sage, and Salesforce.com