A Look Under the Hood at Software Indices
Finding some signal in the noise
During times of market turmoil, I like to look at major indices to get a sense for what the market is telling us about the nature of the downturn. This post will take a look through at the components of two software indices that I track closely and what learnings I glean from their behavior.
IGV - iShares Expanded Tech Software Sector ETF
The largest companies typically have the lowest movement as they have the most diversified revenue streams and generate meaningful free cash flow. They’re also the most widely held stocks and are the last to be sold. The companies that are positive YTD all have M&A events occurring.
If we look amongst the smaller companies we can see some interesting insights start to emerge. Particularly companies with significant cyber security exposure seem to be outperforming the market. (PANW, SNPS, CRWD, FTNT, SPLK)
The large market caps and therefore holdings in the IGV index make it hard to view what’s happening amongst the smaller companies so we need to dig a little deeper.
Next let’s explore the WCLD ETF which is mainly comprised of these smaller companies.
WCLD - WisdomTree Cloud Computing ETF
Here the security sector outperformance is even more pronounced (CRWD, TENB, QLYS). The other batch of best performers are those that are profitable on the P&L and generating significant free cash flow currently.
From there on out, the dispersion is fairly random with companies across sectors experiencing different performance.
What are the Takeaways
1) The market is taking into account that not only is security spend increasing because of factors like sovereign nation attacks and breaches/attacks leading to even more money but also that security is no longer just a cost center.
Now customers are demanding security from their providers. Customer trust means having quick breach remediation, transparent reporting and fast actions. A strong security posture makes it more likely that customers will trust a vendor to do business with them. Additionally, security is even pervading things like consumer logins. Increasingly authentication from the largest banks, retailers, and healthcare providers use credential management, previous login data (location & IP addresses), biometrics, and much more to truly assure the consumer is who they say they are. A customer logged in more frequently and securely, equals a customer spending more as well.
Glen Solomon of GGV had a great tweet from Morgan Stanley’s CIO survey showing increasing spend YoY. I honestly think this survey may actually undershoot spending now and in the future given the discussions I had at RSA recently.
2) The saying “don’t throw the baby out with the bathwater” applies here. Besides the companies that are already profitable and generating meaningful free cash flow, the correlation of most tech companies is heading to 1. This means everything is getting sold off regardless of business model, customer demand, and market share growth. For investors who can determine the long term durability of companies to continue taking share, there are large returns to be had in the future when business quality is indiscriminately not being taken into account.
3) Understand the environment the market is telling you that the world is in. When entering a recession, software infrastructure usually performs better. Investors tend to favor these models due to the customer stickiness. As such, many infrastructure companies may maintain higher multiples. The flipside is application software usually gets sold more aggressively as some of that spend can be classified as discretionary. If you aren’t creating as many ads, then you may not need as many creative tools. Take this into account when you are considering future returns in comparison to your risk profile. A portfolio balancing these two areas can significantly outperform in various environments compared to concentrating in only one sector of enterprise software.