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  • Software stocks are down significantly this year.
  • High-interest rates, slowing growth, and year-end tax selling could be stiff headwinds to overcome.
  • Patiently waiting for the additional conviction that the worst is behind these stocks is smart. 

A widespread shift in the industry’s business model to software-as-a-service subscriptions helped software stocks perform remarkably well following the stock market’s COVID-era lows.

However, the industry is among the worst-performing groups this year.

Rising interest rates have forced valuation models to devalue forward earnings, a strong U.S. Dollar is limiting growth overseas, and a global recession is shrinking IT budgets. As a result, The iShares Expanded Tech-Software Sector ETF  (IGV)  and the Global X Cloud Computing ETF  (CLOU)  are down 34% and 41% in 2022.

Recently, inflation has moderated from its peak in June, sparking hope the Federal Reserve will stop aggressively increasing rates, allowing software stocks to rally. Unfortunately, the industry faces stiff headwinds, so optimism may be premature.

Why software stocks are struggling

In “4 Reasons to Tread Carefully With Software Stocks Even Now,” Real Money Pro’s Eric Jhonsa outlines the industry's challenges.

His first reason for caution is that while evidence could mean fewer smaller interest rates are on the horizon, we’ve yet to reach the terminal rate at which the Fed will stop increasing them. Jhonsa writes:

“Since they mean investors can get greater returns on bonds at little or no risk, higher Treasury yields (a byproduct of higher inflation and a tightening Fed) spell a higher rate at which a firm's expected future cash flows have to be discounted back to the present. And due to how the discount rate compounds with each passing year, this is a bigger issue for companies that (like many cloud software firms) aren't expected to produce significant cash flows for at least a few years than it is for, say, a company trading for just 10 times its trailing earnings and free cash flow…Unless we get a major deflationary recession featuring plunging consumer demand and a big spike in unemployment, it's not hard to see yields for long-dated Treasuries rising from current levels, given that the yield curve is already pricing in a substantial recession…I'm still not sold on seeing the kind of downturn/deflation/Fed pivot that the yield curve is pricing in, given how the labor market now appears structurally tighter than it was in the past, how healthy consumer and corporate balance sheets still are overall, and how the Fed will need to take its dual mandate (price stability and maximum sustainable employment) into account once job losses pick up.”

Inflation has slowed from above 9% in June. However, October's headline CPI of 7.7% is still near 40-year highs. As a result, the Federal Reserve is signaling rates will go higher than they are now. The Fed Funds rate is currently 3.75% to 4%. However, market participants think the terminal rate could be above 5%. For example, the CME FedWatch tool shows a nearly 75% probability that rates will be 5% to 5.25% next May. Moreover, on October 17, St. Louis Fed President James Bullard even floated the possibility – albeit small – that peak rates could need to go as high as 7% to be “potentially restrictive” enough to wrestle inflation back to the Fed’s 2% target. Given the Fed is telling us we haven’t yet reached peak rates, valuation models still pose a headwind for software stocks.

Jhonsa’s second reason is that stock-based compensation will dilute future earnings at traditional software and SAAS solutions companies, pressuring valuation. He writes:

“It's no secret that software firms often give out massive stock compensation packages to executives, developers, and salespeople. But it's perhaps not fully appreciated just how dilutive they are to earnings and free cash flow (FCF) per share over time and why it's now a bigger problem than it was 12 or 18 months ago…Even among the minority of software firms that can be valued using a non-GAAP P/E, GAAP earnings are often elusive due to heavy stock comp. For example, DocuSign  (DOCU)  trades for 30 times a fiscal 2023 (ends in Jan. '23) non-GAAP FactSet EPS consensus estimate of $1.65, but (thanks in large part to stock comp) it has a fiscal 2023 GAAP EPS consensus estimate of negative $0.78…Of course, one could argue that since stock comp is a non-cash corporate expense, the proper way to account for it isn't to expense it out of earnings but to calculate how much it will dilute the cash earnings and FCF per share that investors can expect over time…it's worth noting that with many software firms diluting shareholders by 4% to 6% annually via stock comp, dilution becomes enormous within a few years. For example, if a firm gave out stock grants equal to 5% of its outstanding shares each year, this would increase its share count by 27.6% within five years, assuming none of its cash was used on buybacks…If (as is often the case) a software firm's valuation depends heavily on the earnings and FCF it’s expected to produce several years from now and later, such dilution is especially harmful to a firm's valuation.”

There’s will be downward pressure on compensation as many technology companies are rethinking hiring strategies amid declining profit margins. A rise in sector unemployment could happen soon, given companies like Google  (GOOGL)  and Meta Platforms  (META)  have said they’ll reduce headcount. Perhaps, the most egregious example is Twitter. After failing to back out of acquiring it, Elon Musk reportedly let go over half its workforce. Nevertheless, we’re still talking about highly-skilled and compensated workers, and attracting the best talent will require dilutive stock options, particularly troublesome for unprofitable cloud services software stocks.

The third reason why Jhonsa is recommending caution is industry growth rates are slowing rather than rising. He writes:

“The last few weeks have seen quite a few well-known software firms issue disappointing guidance and/or signal that deal activity is slowing, particularly among larger enterprises. And among firms that bill customers based on their consumption levels rather than via per-user subscriptions, commentary about lower consumption levels (especially within pressured verticals, such as retail and financial services) hasn't been hard to find…Cloudflare  (NET) , Atlassian  (TEAM) , Twilio  (TWLO) , and Varonis Systems  (VRNS)  are among the software companies to have recently plunged post-earnings in recent weeks, thanks to their guidance and commentary. And on Wednesday, ZoomInfo  (ZI)  nosedived after CFO Cameron Hyzer suggested at an RBC conference that (after having guided for 4% sequential Q4 sales growth two weeks ago) his company is modeling 4% to 5% sequential growth for each quarter in 2023, a growth rate that implies high-teens full-year growth… For comparison, the FactSet consensus prior to the RBC conference had been for ZoomInfo to grow revenue by 27% in 2023, following 47% growth in 2022. With many other cloud software firms having thus far only guided as far as December or January, ZoomInfo's outlook (while potentially conservative due to an uncertain backdrop) might be a sign of things to come.”

During the post-COVID low go-go easy-money days, soaring sales caused many on and off Wall Street to project robust revenue growth into the future. That helped them justify multiples on assumptions that operating leverage would swell earnings. However, those assumptions fall flat now, given a weakening economy and downbeat management forecasts. Until software companies’ growth reignites, the likely path for future earnings growth will likely be lower, not higher, keeping a lid on their valuation.

Finally, Jhonsa worries that tax-loss selling and institutional repositioning away from technology could accelerate, particularly if portfolio managers use recent strength to unwind their bets. He writes:

“A lot of the hedge funds and other institutional growth investors that crowded into high-multiple software stocks in 2020 and 2021 now have big year-to-date losses. What's more, some of these investors have a lot of money tied up in illiquid venture-capital investments that have been or will be significantly marked down…As we get closer to year's end (and the aforementioned investors run out of time to make their 2022 numbers look better), I think such chasing action is likely to diminish…we could see a pickup in forced selling by institutional growth investors due to fund redemptions, as well as more tax-loss selling by both institutional and retail investors.”

Jhonsa points out that money managers, eager to improve performance for quarterly statements, have tried to prop up beaten-down software stocks. However, the pressure to do that wanes when we flip the calendar to 2023.

Moreover, if investors' patience is worn thin by any end-of-year weakness, we could see another batch of redemption letters, causing portfolio managers to raise cash. With few winners this year to tap for gains, funds may cut bait on poor performers for the tax benefit and ensure they have enough money to meet redemptions.

The Smart Play

I’ve previously written about how knowing where we are in the business cycle can help investors navigate historically weak to strong sectors. Technology performs best in the early-and-mid stage of the business cycle when the Fed is easing monetary policy. It typically does worst in the late and recessionary stage when profits are thinning because of inflation and economic activity is declining.

business cycle.jfif

The stock market is forward-looking, so the shift from stage to stage leads rather than lags.

Nevertheless, the shift can be choppy, characterized by a lot of back-and-forth as bargain-hunters battle with trapped sellers eager to sell.

Furthermore, bear markets are notorious for head-fake rallies. Therefore, while it’s smart to be looking ahead to contemplate the baskets that may perform best, discarding the bear market playbook based on assumptions rather than facts is unwise.

Yes, we’ve seen software stocks rally since September, but the rally has been tepid. The iShares Expanded Tech-Software Sector ETF is up 5.2% but significantly trails the S&P 500’s 10.8% return.

Furthermore, the ETF’s returns are negative since June, while the S&P 500 is up 5.4%. Defensive sectors, including healthcare and consumer goods – which perform best during the recessionary stage – have performed far better. The SPDR Healthcare ETF  (XLV)  and SPDR Consumer Goods ETF  (XLP)  are up 10.2% and 11.5% since September. Hardly reassuring for a risk-on move into high-growth stocks.

Until the Fed says it’s taking its monetary foot off the economic brake pedal or software stocks start outperforming the stock market or defensive sectors, it’s best to consider them a high-risk bet to approach cautiously.

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