The Case For Investing In The Software/Cloud Computing Space Now

Bert Hochfeld profile picture
Bert Hochfeld
20.97K Followers

Summary

  • The investment technology and cloud computing spaces have entered a noticeable bear market.
  • Valuations, as expressed in terms of enterprise value to sales have fallen by 1/3rd or more in just 2.5 months.
  • All the while, the fundamental outlook for companies in the space has continued to improve.
  • Sentiment, particularly amongst active long/short equity hedge funds seems as negative as at any time in the recent past.
  • The dramatic decline in software names has created a set-up which has created greater appreciation potential than has been the case for at least the last 5 years or more!

A businessman panics because of the crisis, business problems.

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The New Decline: What's been going on?

More than a few subscribers and some readers on SA have asked some questions that I have thought appropriate to answer in this article : How low is the market going? What should I be doing? How much longer will this bloodletting last? One subscriber wrote to me that he has been nauseous. He asked how I stay calm.

The reality is that I am not calm, but having gone through more than my share of market cycles I know that this one too, will ultimately fade away. There is a lot of pain now, which I share, and some blood as well, but the world is not ending and tech stocks aren’t about to dry up and blow away. For whatever it is worth, this cycle is very far removed from that of 2000/2001 when most of the companies involved in the internet bubble were really a collection of chimeras. I think I have heard and read most of the bear arguments animating markets. Some of them make sense; most do not. I would like to think I do not have a pollyannish outlook or disposition. And while I have a very positive attitude with regards to the business outlook for the Information Technology (IT) space, I am not a perma-bull and have recommended and implemented trims in my IT holdings on various occasions when I feel that valuations have gotten ahead of themselves.

I have broken this article into 2 parts. This first part deals with strategies to think about in dealing with what is self-evidently a bear market in the IT space. The second part will deal with the tactics, i.e. the specific recommendations that I think are the best candidates to take advantage of what I believe to be one of the more significant investment opportunities of the past decade or so in the IT space. The individual names mentioned here are for illustrative purposes.

One way to invest in the space, while mitigating some risk, is to consider making some commitments in the shares of representative ETFs in the space. I am not going to try to suggest which amongst many choices is a "better" or more representative ETF, but the ones I use as a bench mark are the IGV (IGV) which is the iShares Expanded Tech-Software Sector ETF and the CLOU (NASDAQ:CLOU) which is the Global X Cloud Computing ETF.

This is not, per se, one more article that tries to look at interest rates and valuations. I had thought that valuations had compressed enough last fall; that certainly was a mistaken belief. I am well aware of many of the bear arguments with regards to how higher interest rates should negatively impact the valuation of IT names, and find most of them to be unpersuasive. The fact that interest rates are rising is no new thing; it has been just about a year since speculation was first raised about the end of the Fed’s accommodative policies, Believe it or not, there was a sector rotation then, for the same reasons as now and it was fairly brutal with the Cloud ETF ('CLOU') falling about 18% in less than 1 month. This implosion has been deeper and of longer duration, with the same index down by 25% in the last 2.5 months. The IGV ETF, which basically is an extended software/tech ETF that includes some larger IT companies such as Adobe (ADBE) Salesforce (CRM) and Oracle (ORCL) that have lower growth rates, and lower valuations has seen a fall of 19% over the same period

Logically, the valuation compression already seen over the past 12 months (more than 50% on average for representative high-growth companies in the IT space based on free cashflow multiples) should have more than compensated for the valuation risks of rising rates. But sentiment, as it always does, speaks louder than logic in terms of the progression of the markets day to day and week to week. And sentiment seems at an almost otherworldly negative peak as I write this on Thursday, 1/13/22.

Sentiment is always illusive to handicap and impossible to quantify. Sometimes sentiment aligns with real world trends. Often it does not. In my view, it is sentiment, rather than substance, that has been ruling the market for the last two months +. It seems to me that almost all hedge fund managers and many other professional investors have deployed their portfolios in the belief that the reversal of Fed policy will make it difficult, if not impossible, to make money investing in tech names during 2022. Many individual investors have aligned their portfolios for value as opposed to growth.

It isn’t a popular stance but my thesis, and the purpose of this article, is to suggest that some of the conventional wisdom supporting this risk-off mentality lacks substance. But while I have no problem taking an unpopular stance, I haven’t the crystal ball to say when, at what level, and what event will bring this blood-letting to an end. Trading through the first 4 days of this week has been disheartening with a weak rally followed by renewed selling of high-growth shares. No visible selling climax, and no higher lows to encourage bulls.

The reasons why software has been a great investment for several years, until 2021, still exist. Supply/demand imbalances for stocks are not likely to be an existential problem of long duration. But there are some key themes that I suggest readers look at in creating a portfolio designed to take advantage of either the pain, or the opportunity depending on one’s perspective. The themes I highlight are not different from the themes on which I have focused for the last couple of years: digital transformation, artificial intelligence (AI) and cyber-security.

I am an analyst by trade, and not a market strategist. I have run a hedge fund but it was a tech hedge fund and I spent something more than 25 years + providing consulting advice to various hedge funds as well as other institutional investors, but again as a specialist consultant in the IT sector. I have seen my share of implosions over the years. Just to note a few here, the Russian Debt crisis, the Asian financial crisis, the Long Term Capital Management fund melt down all in 1998, the tech wreck of 2000-01, with a reprise of that in 2004, the financial crisis of 2008-9, the SaaS wreck of 2011-12 and then the “taper tantrum” of 2013. Of course there was the 1987 crash and the flash crash of 2010 as well. Interspersed between all of these market reversals have been periods of rapid appreciation in the software space as well as periods of sector rotation from high growth IT names to value names.

There have been plenty of brief periods of sector rotation, divergence and of course the Covid-19 panic in the late winter and early spring of 2020. Having lived through so many of them I know two things: these periods are never easy to deal with and they all come to an end, often when least expected-

This current implosion is particularly violent and gut-wrenching. I won’t pretend that I am unaffected by the malaise of despond that I see. I try to throttle down my emotions in writing or speaking, but they remain. One subscriber was kind enough to spend some time with me the other afternoon giving me some thoughts about his perspective. But the fact is I feel the collective pain of readers and subscribers and I share in it.

The current conventional wisdom is that portfolios should now be focused on company’s making tangible products rather than software. And indeed, that call has been working, and I suspect there is a bit of circular logic here-recommending what has been working to investors looking for an escape from drawdowns of the recent past is popular. It can even be right for a time. But because I am an analyst, and not making trading calls, I look out 12 months. When subscribers ask me for portfolio advice, I always respond with my expectations for the next 12 months and not the next 12 days or even 12 weeks.

How does this end? Most typically, this kind of severe valuation implosion ends with capitulation and a selling climax and some kind of violent reversal. But it often takes 2-3 such reversals before these panics really end.

Deere vs Okta: A Case Study

Just how far the pendulum has swung away from growth and towards perceived value: Jim Cramer tried to compare John Deere (DE) to Okta (OKTA) on one of his recent shows. He said that Deere makes tangible products such as tractors and earth moving equipment. He talked about demand tailwind coming from the new infrastructure law and its expenditures on road construction as well as a stronger agricultural economy. And he pointed out that Deere makes a profit and has a small share buyback plan in effect.

Okta sells software whose functionality may be hard for investors to understand, and it is not currently profitable. All of that is certainly true but, like most things the devil is in the details.

The methodology I use in determining the value of an investment isn’t unique or a special formula and it owes more to the traditions of Graham & Dodd then most anything else. Almost certainly, readers will are acquainted with the fact that interest rates are rising because the Fed is concerned about inflation. And the inflation numbers reported this week, both at the retail and wholesale levels might be seen as scary. Currently, the bond markets are pricing in 4 interest rate increases this year, compared to expecting 3 such increases a week ago. What some readers may not have read is that interest rates are only one component of the standard way to calculate valuations.

To do a proper discounted present value (DPV) calculation some kind of discount rate metric is required. The higher the discount rate, the lower the present value of a stream of future earnings or preferably free cash flow. No quarrels there. Usually discount rates these days are expressed as the weighted average cost of capital.

I might simply suggest that the weighted average cost of capital for Okta, as an example, will remain low. Why? Well part of the equation is the risk premium. Okta is a company with a totally SaaS business model. So what does that mean in terms of a DPV model. It means that because more than 90% of its revenues are recurring the stream of future cash flows has a relatively low risk and will not fluctuate a great deal.

The same cannot be said about Deere. The risk premium for Deere simply has to be substantially greater than that for Okta. That is because the free cash flow of Deere is so variable while the free cash flow for Okta is far more stable.

Okta made a substantial acquisition 9 months ago, Auth0, and there are significant costs associated with that integration as well as a customary deferred revenue write down. But the company returned to positive cash flow last quarter and the track of free cash flow going forward is probably substantially upward from here. Further, the profitability component of the DPV equation is more interesting than that, actually. The acquisition that Okta made removed its principal competitor from the highest growth segment of its business. Almost inevitably, less competition means higher gross margins. It means shorter sales cycles that ultimately cost less to complete. And it probably will lead to higher DBE (Dollar based expansion) ratios as users double down on the acquiring software from the dominant supplier in the identity management space.

Many commentators continue to miss the point about SaaS models, or other consumption based models now the norm for software companies. They are simply far more profitable than the business model for most other businesses. If the mantra of investors is to find profits, or better yet, free cash flow, than companies with a SaaS model are where to go to find profitability. Unless a company is sustaining exponential growth, the math of a SaaS model is that over time, a higher proportion of revenues winds up coming from renewals. And renewals are far more profitable for a vendor than initial deployments. For one thing, there is rarely a substantial cost of sales component to a renewal sale. For another, the cost of sales and marketing expense ratio is far lower for renewals than it would be for a new deployment. Not only are commissions typically lower, but even general and administrative costs which often relate to contract negotiations are lower.

Now, Deere shares have appreciated about 9% over the past 6 months, and have had a sharp rise of 12% since the start of the year, while Okta shares are down by 19% over the same span and are down 10% since the start of 2022, now just a few days old. (Okta shares have actually been “buoyed” since the start of the year by speculation that the company will receive some kind of acquisition offer from Salesforce. That is not the kind of speculation on which I can usefully comment.) Which might be the better investment for the next year? My guess is it will be Okta-and not because I think it will be acquired by Salesforce or anyone else.

The fact is that Okta sells something without which modern life would cease. That isn’t hyperbole; identity management for almost all businesses of any scale is vital functionality. If you work for a corporation of some size, you almost surely use Okta or an equivalent to access the applications for which company policy allows access. If you want to log in to your on-line bank account, you probably use Okta or an equivalent solution. Okta now is the dominant factor in providing the software that consumers need to access their accounts at brokerages, on-line stores or anywhere that requires a password. Not really that hard to understand and pretty tangible.

Most hedge funds certainly, and many smaller investors, don’t go through the analysis that is required to see whether the conventional wisdom bears out. Sentiment is going to trump DPV analysis and has done so now for months. But not indefinitely. The conventional wisdom says that Deere must be a better investment in a rising interest rate environment than Okta because of its cyclical characteristics. My riposte is that a thorough analysis will show that while the discount rate used in a DPV analysis is rising, the capital requirements of Okta are so low that its weighted average cost of capital is barely budging. And because of factors specific to Okta, its gross margins are rising, its specific free cash flow estimates are rising, and the maturation of a SaaS model will result in a noticeable increase in free cash flow margins on a secular as opposed to a cyclical basis.

Deere’s free cash flow margin is now around 11%. I imagine that in a couple of years, Okta’s free cash flow margin will be 20%+. And unlike Deere, that margin is not cyclically variable but should consistently rise simply because of the subscription consumption model through which Okta’s solutions are consumed.

Deere may or may not be a good stock to own. But Okta is likely to achieve organic growth next year of just less than 40% and I imagine that growth at or near that level will be sustainable for several years. For what is worth, that is what the company is essentially forecasting. And Okta’s profitability will be rising as well. Inflation and interest rates are just part of the way to consider formulating a portfolio and not even the most important part.

Is this the “defining moment” to buy tech winners?

This is the time of the year in which analysts reevaluate their picks and make lists of stocks they recommend for the year ahead. One perma-bull, Dan Ives of Wedbush, calls this as a defining moment. Another analyst, Brent Thrill of Jefferies talks about digital digestion with falling growth rates amongst the companies that he follows. His ‘software playbook” calls out that 80% of his coverage will have lower growth rates in 2022 than in 2021.

Here is my take. Overall, the percentage growth in IT spending will continue to edge up. The basic reasons underlying the trends to higher percentage growth in IT spending are digital transformation and cyber security. Some analysts really don’t take a look at what specifically propels the growth in enterprise software spend.

Enterprise software, by definition, is not a consumer product. Users buy it to achieve return on investment (ROI). Many readers at this point are going to say digital transformation is over-hyped. Perhaps. But what is underappreciated, I believe, is that users are buying what are considered digital transformation solutions because they must do so in order to stay competitive. Companies of all kinds have to change the paradigms for acquiring their products and services in order to remain relevant to the consumers of today. The ROI for digital transformation solutions is higher than almost anything else I have seen in the software space over the past 30 years or so. It isn’t just airline tickets or Shopify (SHOP) merchants or banks or insurance company but every component of the economy that has to digitize. It’s been decades since there has been that kind of imperative to acquire software.

The same is true, but more so, when it comes to cyber-security. Users acquire cyber security solutions because they are terrified with regards to the potential consequences of hacks. Losing data, getting shut down through ransomware attacks, or having millions of identities compromised when preventative solutions are available is a one way ticket to corporate and individual oblivion. Those threats will only increase this year, and for the foreseeable future not just because of brazen local criminals, but because of the cottage industries of hacking that have spread offshore. None of this is dependent on the Fed and its influence on the economy; all of it is basically part of user strategies to remain competitive and to mitigate risk.

Do higher interest rates impact the operational outlook for high growth IT companies?

Higher rates are designed to basically damp down excess consumer/business demands for some product and perhaps services. In some areas of the economy such as housing and perhaps autos they will do so. And to a degree, they will result in higher hurdle rates for capex. And that, too, is expected to slow the economy. Higher rates will probably have some impact on the construction of commercial structures although many other factors go into the equation of demand for non-residential facilities. Higher rates can also threaten some kinds of acquisitions, particularly those by private equity firms.

But do actions to limit housing and auto demand, or even perhaps to inhibit some financial transactions that mean much if anything to the demand for the solutions offered by software firms. Starting with cyber-security, not very likely. Users buy cyber-security to staunch cyber-attacks. It is almost impossible to quantify the cost of such attacks. At this point, buying cyber security solutions is a compliance/staying in business issue, and not something that can be quantified.

But despite the fact that higher rates are not correlated for the demand for cyber-security solutions, that has meant nothing to the valuation implosion of such businesses.

But even for those solutions whose ROI is amenable to quantification the impact of rising rates is not significant. Take Doximity (DOCS) for example. Doximity says that the ROI of its solutions is no less than 13X their cost. In other words, users who have been extensively surveyed by 3rd parties have reported that for every dollar they have spent on the usage of the Doximity platform, they have been able to generate $13 of additional margin through increased sales of their own products. But that calculation is set against the costs of funding the expense of detail people. Spending on the Doximity platform is actually replacing the cost of paying the salaries of detail people who call on doctors and hospitals, and the other expenses associated with their employment. The actual return of using the Doximity platform will increase in an inflationary environment because the salaries, and associated expenses of employing people will rise, while the cost of using the Doximity platform is not subject to inflationary cost pressure. The inflation leading to higher rates is enhancing its value proposition. The salaries of detail people and the cost associated with their employment is rising, while the cost of Doximity's software is not.

Almost inevitably, whether it is software used to create bots such as that sold by UiPath (PATH), or software used by GitLab (GTLB) to help develop software, or software from JFrog (FROG) that eliminates the need for manually controlled version processes, or the software available from Asana (ASAN) that enhances the productivity and reliability of the work teams who use the software. Overall, software is replacing higher cost humans with productivity tools. The demand for software, all things considered, will increase more rapidly in an inflationary environment.

One canard which I have seen lately is that the Fed might overshoot and will engineer a recession. I doubt that, but it is certainly a risk which is now being discussed. The concept is that slower growth in various segments of the economy and that higher unemployment and higher rates will lead to more defaults on the part of borrowers enabled by the new fintech/AI paradigms. That is a pretty long and tendentious chain of potential risks. My question is, if such a risk is really believed to be substantive, then why is it good strategy to invest in cyclical businesses?

The fact that investors are pivoting to those businesses as a focus of investment must mean that those investors do not believe the Fed will cause a recession. If there were to be a recession, the last place for investors to focus would be in cyclical areas of the economy that are based on the sales of tangible products.

Some investors and commentators seem to believe that higher rates will potentially lead to more defaults on the part of the borrowers who are the customers of Upstart (UPST) and Affirm (AFRM), amongst others. But that really doesn’t happen unless the Fed does engineer a recession, and that in turn leads to massive unemployment of the kind that took place at the end of the 1970s. That seems pretty farfetched at this point.

Trying to find a logical explanation for a panic of this kind is a search for a negative. There is a kind of angst that is hard to quantify and which is not rooted in anything specific. Higher rates are unlikely to result in some dramatic reduction in growth or decreasing profitability at tech firms, at least so far as I can determine.

Try not to overthink stories

There is a tendency these days for investors and commentators to try to rethink their recommendations based on woeful share price performance since early November, 2021. I can be guilty of the overthink sin, myself, although I try to guard against it. Perhaps the worst or greatest example of overthink has been in the fintech space. As of the close today, Thursday, Jan. 13th, Upstart shares are down more than 70% from their recent high. Does that mean that there is a flaw in the Upstart story? Or does it mean that investors are really no longer paying much attention to valuation and discounted present value analysis. A few days ago, the analyst at Piper, Sandler who covers Upstart, Arvind Ramnani, reiterated his buy rating on the shares but lowered his price target. His thesis is the same, his expectations are the same but since the market for all tech stocks is lower, his price target had to be reduced. There is a huge disconnect at the moment between professional analysis and actual valuations.

I generally write about individual companies and not ETFs. That is my training and discipline. But some readers are horrified by seeing something like Upstart shares decline by 70%+ in less than 3 months. So far as it goes, as a holder of the name, so am I. But historically, that has been one of the perils of investing in this sector. An alternative approach, particularly at this point with risk-off sentiment seemingly in ascendancy, is to use ETFs as a vehicle to enter the space without being subjected to the horrible percentage drawdowns that can lurk in individual stocks.

I suppose there are those who believe that there can be yet another year of divergence between growth and valuation based on higher rates and an inflationary environment. Yes, all things being equal, the value of future free cash flows from whatever asset are lower. But by how much lower? The value of those future cash flows isn’t zero. And if expectations of future free cash flows are rising, then how much do free cash flows have to rise to offset higher rates? At least in my opinion, stories aren’t changing, except for the better. Thursday afternoon, another large software company, SAP (SAP), preannounced a growth upside and said it expects accelerating growth throughout 2022.

Just because the value of IT shares have imploded really doesn’t indicate that either the revenue growth or profit outlook for IT companies has deteriorated, and the empirical data from IT firms suggests that quite the opposite is going on. That is true for companies as diverse as Alteryx (AYX), Infosys (INFY), SAP and Elastic (ESTC) all of whom have now announced upside results for their most recently finished quarters.

Patience/Conclusion

As I wrote this on Thursday evening, the CLOU ETF wound up the day losing 4%, and after a weak attempt at rallying, the index is once again down by almost 2% for the week. The IGV ETF fell by more than 4% Thursday, and it also is back to negative for the week. Individual stocks, particularly those with higher EV/S ratios than average have done worse.

Is this week, the week to start building or adding to a high-growth portfolio or buying a position in the representative ETF's in the space? That is not the kind of advice that I like to proffer. I think that investors can, and should start to increase their weightings in the space, and one way to do so is to buy ETF's. The potential returns are greater than any I have seen in some years. For those not enamored with ETF's, I will be back with specific recommendations that match up with some of themes discussed in this article in Part II.

ETF's for the most part don't have the violent moves on a given day as do individual stocks. They do serve to mitigate risks but also rewards. But for readers horrified by the percentage fluctuations in individual stocks in the IT space, one reasonable way to take advantage of the opportunity I see is to invest in ETF's. Stage purchases to take advantage of possibly lower prices if sentiment causes a retest of current lows.

But my conviction is that this is the right time to enter the space, and the ETF's I have mentioned are a reasonable way of starting that will mitigate some risk.

It takes some level of conviction to maintain holdings when all seems steeped in gloom and doom. I confess that from time to time, the black bear of gloom and doom strikes me as well and leads me to question my own thesis on more than a few names. But that is really what does make bottoms…when the last bull is driven from the field. As some readers and subscribers may know, my cultural ambit, at any rate, is stuck in an era that ended decades ago. From my era is a song, with which I leave you, “Tomorrow.” It was the theme of a Broadway musical, "Annie". Tomorrow was one of the show stopping numbers and the specific lyric of relevance here is the lyric "the sun will come out tomorrow...tomorrow is just a day away!" And so it is!

This article was written by

Bert Hochfeld profile picture
20.97K Followers
Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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