The business software & services industry appears overvalued in aggregate based on a prior analysis which compared the average return on equity to average price-to-book ratios of different industries. As a whole, business software & services stocks appear promising for constructing net-short positions because they produce below-trend average ROE for their average price-to-book ratio. Using this top-down approach to choose industries for a net-short position, attractively-priced stocks and overpriced stocks were identified among these stocks.
Why create a fully or partially hedged position?
Alpha hunters might consider net short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net long positions in industries with attractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best industries or stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reducing exposure to industry and market volatility.
Business software & services Stocks
Plots of these companies reveal how some stocks are much more attractively priced than others:
In each of these graphs a measure of growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as indicators of growth. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
In the context of history many of these valuations are simply indefensible. Historically, a price-to-earnings multiple near 15 is considered reasonable, yet there are several business software & services stocks which exceed this rule of thumb.
Two above-trend stocks are presented in bold and three below-trend short picks are listed in italics:
Automatic Data Processing
Jack Henry & Associates
Data from finviz.com
Automatic Data Processing and Cognizant Technology were found to lie among stocks in the upper left of these plots (higher growth, undervalued stocks) while Aspen Technology, NetSuite, and TIBCO Software were found to lie at the lower right of these plots (lower growth, overvalued stocks). In fact, Netsuite and Aspen Technology did not even plot on the earnings growth vs. P/E chart because they suffered net losses over the past year. Essentially, they were off the charts in a bad way! Based on this work, a net short position for business software & services stocks can be constructed by buying ADP and CTSH shares while hedging with a larger total short position in AZPN, N, and TIBX shares.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.