The Hidden Way to Play the $18.3 Billion Tech Sector Trend

Today I want to tell you all about a highly lucrative tech sector trend that's flying under Wall Street's radar.

I'm talking about private equity's plunge into Silicon Valley in order to take advantage of software's high profit margins. Publicly held software companies are now regularly agreeing to be acquired and taken private.

In the last 18 months, four software firms have been delisted in leveraged-buyout deals worth a combined $18.3 billion. On April 7, software publisher Informatica Corp. (Nasdaq: INFA) agreed to be taken private in a deal valued at $5.3 billion - the biggest leveraged buyout in 2015 so far.

With money like that flying around, you'd think this would get more attention. But Wall Street's ignorance is fine with us.

tech sectorWe often find that the best way to make money is to jump on a trend before other investors wake up.

Now, I understand the temptation to start trying to guess the next software buyout candidate. When a company becomes a buyout target, its share price soars.

Before you start such guesswork, though, you should know that's a dangerous game. Unless you have "inside information," you might as well be flipping a coin in most cases.

However, I've found one simple way to hitch a ride on this trend with very little risk - and a very big upside.

Let's take a look...

The Most Profitable

Software companies are so profitable because they don't have to spend heavily on "plant and equipment" the way hardware companies like chip makers do.

And with the movement to cloud computing, in which software developers deliver applications via the Web, they don't spend much time burning CDs and shipping them out anymore either.

According to data from IBISWorld, five of the most profitable "micro-sectors" are in software: urban planning software (with profit margins of 37%), business analytics and enterprise software (37%), human resources and payroll software (40%), and online survey software (55%).

Big and growing revenue numbers are important, but profits are where companies - and their investors - live or die. So, software is a good place to be.

To get an even better sense of the software industry's high profit margins, let's take a look at the operating margins of two big players in the space.

Microsoft Corp. (Nasdaq: MSFT) has operating margins of 30%, and those of Oracle Corp. (Nasdaq: ORCL) come in at 38%. By comparison, the highly respected chip firm NVIDIA Corp. (Nasdaq: NVDA) has operating margins of 16%.

Private equity's recent foray into software began in December 2013, with the $6.9 billion buyout of BMC Software Inc.

Besides Informatica and BMC, Compuware Corp. agreed to go private last December 2014 in a deal valued at $2.5 billon. And in September 2014, Riverbed Technology Inc. struck a deal valued at $3.6 billion.

Like I said, we're not going to be guessing which software firm is next in line to get snapped up.

But with fewer software stocks available, investors will be bidding up the value of shares as a group.

And there is a way we can take advantage of that...

The Single Best Way

With the SPDR S&P Software & Services (NYSE: XSW) exchange-traded fund (ETF), we can take a ride as those other investors bid up the value of software stocks.

And XSW will also rise in value as private equity firms put their targets on various holdings within the ETF.

XSW holds roughly 175 stocks, and software firms are involved in wide range of technologies, including e-commerce, social networking, data processing, cloud computing, and Big Data. So, with this one equally weighted investment, we touch a wide swath of the entire global tech sector.

XSW holds several big-cap firms, including Microsoft, Oracle, and Google Inc. (Nasdaq: GOOG, GOOGL).

In addition to the stability of those mega-cap leaders, you also get an intriguing mix of smaller, growth-oriented firms with the potential to become takeover candidates. Let's take a look:

  • Cadence Design Systems Inc. (Nasdaq: CDNS) should be thought of as a "twofer." Not only is it a great software firm, but it's also focused on the booming semiconductor sector. Since launching back in 1988, the Silicon Valley firm has grown to where it now licenses its products to roughly 200 firms. It counts seven of the top 10 chip firms as clients and has added cloud computing to its lineup. With a market cap of nearly $5.5 billion, Cadence has grown its earnings by an average 17% over the past three years.
  • FireEye Inc. (Nasdaq: FEYE) is a rising star in cybersecurity. It provides threat protection for corporate networks, mobile devices, and email systems as well as forensic analysis of attempted intrusions. It counts some 2,500 customers in 65 countries. With a market cap of $6.7 billion, this is the kind of stock you want to own in an ETF. FireEye is growing quickly - but the stock is highly volatile.
  • Splunk Inc. (Nasdaq: SPLK) is focused on the key tech trend of Big Data. Specifically, it analyzes "machine-generated data." That's a loose term for information generated by the Web, computer servers, networks, mobile devices, and the billions of sensors in use around the world. With a nearly $7.5 billion market cap, Splunk has weak profit margins but averaged a 57% annual sales growth rate over the last three years.
  • Group Inc. (Nasdaq: WWWW) is a leader in small-business Web design and e-commerce services. Counting some 3 million customers, sells Web hosting, search engine optimization, and social media and mobile platform subscriptions. It even has a Web-based phone management system. With a market cap of $974 million, has grown earnings per share over the past three years at an average 34%.

XSW may strike some beginning investors as pricey because it's trading around $101. But as I like to remind investors, the share price isn't important - it's the amount of money you can make that's crucial.

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Here's why XSW is such cost-effective investment vehicle. It does three things at once.

First, it gives us a targeted investment that covers 175 firms in a highly profitable industry. Second, it sets us up to profit from more software M&As.

And third, it offers us market-beating returns. XSW has beaten the Standard & Poor's 500 Index by significant margins over the past two years.

During the period, the overall market rallied for gains of 32%, but XSW yielded profits of 46% - nearly 44% better.

And since I last recommended you take a look at XSW on June 13, 2014, the ETF is up nearly 18%, more than double S&P 500′s 8% return over the period.

I can't emphasize enough how important it is to have this kind of stable source of gains in your tech portfolio. To take advantage of discounts the market throws your way as you build long-term wealth, I suggest you average in to this kind of ETF.

It's the kind of foundational play you'll want to hold for the long haul in order to build your wealth through tech.

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About the Author

Michael A. Robinson is a 36-year Silicon Valley veteran and one of the top tech and biotech financial analysts working today. That's because, as a consultant, senior adviser, and board member for Silicon Valley venture capital firms, Michael enjoys privileged access to pioneering CEOs, scientists, and high-profile players. And he brings this entire world of Silicon Valley "insiders" right to you...

  • He was one of five people involved in early meetings for the $160 billion "cloud" computing phenomenon.
  • He was there as Lee Iacocca and Roger Smith, the CEOs of Chrysler and GM, led the robotics revolution that saved the U.S. automotive industry.
  • As cyber-security was becoming a focus of national security, Michael was with Dave DeWalt, the CEO of McAfee, right before Intel acquired his company for $7.8 billion.

This all means the entire world is constantly seeking Michael's insight.

In addition to being a regular guest and panelist on CNBC and Fox Business, he is also a Pulitzer Prize-nominated writer and reporter. His first book Overdrawn: The Bailout of American Savings warned people about the coming financial collapse - years before the word "bailout" became a household word.

Silicon Valley defense publications vie for his analysis. He's worked for Defense Media Network and Signal Magazine, as well as The New York Times, American Enterprise, and The Wall Street Journal.

And even with decades of experience, Michael believes there has never been a moment in time quite like this.

Right now, medical breakthroughs that once took years to develop are moving at a record speed. And that means we are going to see highly lucrative biotech investment opportunities come in fast and furious.

To help you navigate the historic opportunity in biotech, Michael launched the Bio-Tech Profit Alliance.

His other publications include: Strategic Tech Investor, The Nova-X Report, Bio-Technology Profit Alliance and Nexus-9 Network.

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