Last week was volatile to say the least. But the major silver lining is that we’ve dealt with many of the risks that were outstanding: a hawkish pivot from the U.S. Federal Reserve (Fed), spreading COVID and Omicron fears, and finally, a major sell-off in oil.
Notably, the early data from South Africa suggest that while the variant might be a whole lot more transmissible than Delta, so far it appears it may be less likely to cause severe disease. Also, the decision by OPEC+ not to pause production output due to Omicron, believing it will not cause a big hit to oil demand, was another positive affirmation. Meanwhile, the steep selloffs in travel stocks and oil suggest that Omicron fear is already largely priced into the market. Further, a leg down in the shares of tech, crypto, clean energy, and high growth/high multiple sectors suggests investors have cleared out of many speculative positions.
What has emerged is a buying opportunity in several sectors, including biotech, energy, and travel re-opening – and most recently in a growth sector that is not often on sale: Software. In this week’s commentary, we discuss why we like buying the dip in software, following a 12% pullback from its highs.
Pullback in valuations in line with historical averages
The software sector has been a darling of investors all year. It was one of the most overweight sectors by hedge funds and it rose 28.9% year to date prior to its November 16 peak,1 outperforming most other S&P 500 sectors. As a result, software’s EV/sales multiple reached 16.9x.2 However, as Info Tech was sold amid last week’s pullback, the average EV/sales multiple for the software group declined 23%, more than the 21% pullback the group experienced during the past six pullbacks.3
It is true that some of the higher multiple software names or smaller companies have yet to fully correct in line with their prior averages but, in aggregate, this is consistent with pricing in a 100-basis-point rate increase.4 This seems more than fair – the markets are pricing in 2.5 rate increases in 2022 and most assume that the Fed will end its bond purchase program by March. The 10-year U.S. Treasury yield is also set to rise to 1.90% by the first quarter of 2022.5
Attractive technical set-up and cleaner positioning
Another constructive development arising out of last week’s trading is that we’ve also seen significant clearing out of excess risk positioning. For example, U.S. equities saw the largest 10 days of net selling since April 2020, and U.S. Info Tech stocks saw the largest 10 days of net selling in more than five years.6 The tech selling was led by software and payments names. This selling pressure brought the software group down to its 200-day moving average and a technical oversold level.7
Positive fundamental catalysts still ahead
After this welcome capitulation in the software sector, the fundamentals of software stocks still screen among the best in Technology. For example, global information technology spending grew almost 10% in 2021 but is expected to drop to a 5% growth rate in 2022.8 Software, however, is still projected to grow 11.5% in 2022, down from 13.6% in 2021, which would make it the top area of spending growth.9 Cloud, cybersecurity, digital marketing, digital twin software, virtualization technologies, blockchain, and now metaverse are among the major trends driving software adoption. For example, within cybersecurity spending, cloud security in particular is growing at 41.2% this year and, as companies increasingly turn to the cloud, cloud security spending should continue into 2022.10 And the spending on digital twin software, primarily used in the industrial sector today, is forecast to grow 18% annually through 2026.11 Metaverse is estimated to be an $8 trillion addressable market and its very existence relies heavily on software development, another positive sign for the sector.12
Investment Implications
Software adoption continues to be one of the most robust secular growth trends today. Not surprisingly, valuations for these stocks have been rising to reflect this reality. Rarely is the sector on sale. While valuations are still not at a discount, they are cheaper than they were three weeks ago and, against a backdrop of marginally slower GDP growth (slowing from 5.6% in 2021 to 4.0% in 202213), the software sector should continue to be a favorite among investors. We share the sentiment and recommend adding to public and private software stocks on this pullback.
(1) Source: Bloomberg, as of December 6, 2021
(2) Source: Morgan Stanley, December 6, 2021
(3) Source: Morgan Stanley, December 6, 2021
(4) Source: Morgan Stanley, December 6, 2021
(5) Source: JPMorgan, Treasuries 2022 Outlook, November 23, 2021.
(6) Source: Goldman Sachs Prime Services, December 6, 2021
(7) Measured by Relative Strength Indicator (RSI), which hit 42.15 as of December 3, 2021.
(8) Source: Gartner, July 14, 2021.
(9) Source: Gartner, July 14, 2021.
(10) Source: Gartner, May 2021.
(11) Source: Verdantix, Market Size And Forecast: Digital Twins For Industrial Facilities 2021-2026, November 2021.
(12) Source: Morgan Stanley, November 16, 2021.
(13) Source: Goldman Sachs Research, December 6, 2021.
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