- We are seeing a market rotation from momentum to value on macro factors and internal market dynamics.
- Keys are to stay diversified, look for businesses with strong moats and that produce solid cash flow and compare to historical valuations.
- Favored themes are industry consolidation plays, mobile and Internet.
In recent weeks there has been a dramatic shift in alpha generation from hyper growth technology stocks to more value-oriented names. We can attribute this to a number of factors: 1) improving economic data means a lower multiple for hyper growth stocks and higher multiples for value/cyclical names; 2) Fed Chair Janet Yellen’s reaffirmation of the taper; 3) geopolitical upheavals; 4) prime brokerage data suggests that hedge funds were positioned with factor and style exposures to growth and momentum on the long side and value exposure on the short side; 5) benchmark-chasing rotation into mega-cap “old tech” stocks; and 6) a heavy increase in supply from IPOs and secondary offerings.
As investors try to sort through the recent volatility and accompanying headline noise, it might be a good time to review some core principles that are relevant during such periods.
1. Stay diversified. The technology universe is a very broad space. We have a mixture of growth and value-oriented names with a few momentum names sprinkled in.
2. Tech adheres to the same fundamental rules as other industries. We try to own great businesses. Our selection process starts with looking for several key attributes including: sustainable competitive advantages, high barriers to entry, high barriers to scale, strong ROA and ROE. We focus on the value chain, looking at relative strength compared to suppliers. We try to avoid business in secular decline, businesses with little/no cash flow and weak balance sheets. And finally, we try to look for innovative firms with excellent management teams and sustainable growth of 20%+ a year in revenues and earnings per share. Motherhood and apple pie, perhaps, but too often tech investors can be unduly influenced by hype and emotions.
3. Seek out catalytic tailwinds. Tech is a rapidly changing, Darwinian industry. Having some wind at one’s back is always desirable. Characteristics we look for include:
• Businesses exposed to new product cycles
• Low penetration rates in a fast growing market
• Highly predictable annuity business with a strong recurring revenue component
• Rising margins and asset turns are a powerful combination
• Improvements in balance sheet items: day sales outstanding, inventory turns, deferred revenue, capitalized software
• Structural changes within an industry such as consolidation
Some current themes we find attractive include:
• Businesses exposed to the continued move towards e-commerce
• Pivot of business models towards mobile
• Growth in the China Internet sector
• Industry consolidation
• Content providers with growing abilities to monetize across new mediums
So, within this approach, how do we respond to the recent painful move down in certain sectors of the technology space? In particular, cloud software stocks have borne the biggest brunt of the sell-off with many stocks down 40% over the past six weeks. Similarly, the Internet sector is down approximately 15% from the highs on March 7, 2014 with many stocks down more than 25%. The market seems to have less appetite for the longer duration TAM (total available market) and revenue multiple stories, with greater preference for current earnings power. We wanted to share some historical perspective on the hyper growth software (SaaS or Cloud) names as well as the Internet sector and how we are thinking about valuations and trying to find the floor for these stocks.
SaaS or Cloud
The potential of rising rates, steep valuations and a plethora of “cloud” based IPOs and follow-ons have sent the high-flyers in the space into a tail spin. Stepping back, there are secular shifts underway in software distribution. The percentage of software to be delivered as-a-service is expected to double from 24% today to 48% in five years. SaaS (Software as a Service) is generally easier to install and maintain versus the traditional legacy vendors and should not be considered just a fad.
At the peak of the last bull market SaaS stocks traded around 5.6x EV/NTM sales (enterprise value to next twelve month’s sales) on average. The market has been willing to pay a premium for the faster growing SaaS stocks. Six weeks ago, SaaS companies forecasting 30%+ revenue growth traded at approximately 12x EV/NTM sales, and trade at approximately 8x EV/NTM sales today. We have seen the largest downdraft in the fastest growers due the valuation premium paid. At the trough of the 2008/2009 bear market, SaaS stocks traded at 2.1X EV/NTM sales. Over the next few years we saw M&A activity pick up in the space and the median price paid was 6.2X EV/NTM sales.
Is history repeating itself? We have seen volatility in this space before. For example, Salesforce.com, a bellwether “Cloud or SaaS” company, experienced 50%+ intra-year stock declines in each of its first five years as a public company, though it is up 14-fold since its IPO.
Similarly, there has also been a significant sell-off in the Internet space over the last few weeks with many stocks down 20% or more. The business models today are very different from the “Internet Bubble Era” of 2000, especially with the leaders, where growth comes with enormous global scale, underpenetrated markets and real profits (not metrics such as “clicks” and “eyeballs”).
Given the significant sell-off in the sector of the last few weeks, we believe it is prudent to take a look at valuations from a historical context.
Forward EV/EBITDA multiples are now at 14x and peaked at 16.7x mid-quarter. The five year average forward EV/EBITDA multiple is 12.4x. This puts us around 13% above the five-year historical average forward EV/EBITDA multiple. Again, it is worth emphasizing that we see the strong franchises in this space as developing into powerful and durable brands, not the flash-in-the-pan business models that served as caricatures of the dot.com excesses.
On a P/E basis, the majority of large-cap Internet stocks are now trading at or below the midpoint of their recent historical ranges. Priceline and Google are trading closer to the midpoint. We favor the online travel sector; it is currently trading at the high-end of its five-year range at 27×2015 EPS and 15x EBITDA.
In summary, we would expect volatility to continue. We are monitoring valuations very closely, are looking for opportunities to optimize our investments and will continue to invest using our barbell approach.