Contributory
Jeremy Abelson is the founder and principal portfolio manager of Irving Investors. Combining his experience as an operator and institutional investor, Abelson drives Irving as a multi-strategy platform offering long-term sustainable investments in both the public and private markets.
Jacob Sonnenberg
contributory
Jacob Sonnenberg is a portfolio manager at Irving Investors and runs the Irving Technology & Consumer Crossover Fund. Jacob has been investing in technology for over a decade and applies a deeply analytical approach coupled with a true passion for entrepreneurship to his investment strategy.
For decades, private company executives have asked us all the same question: “Do public market investors prefer profitability or growth?” Although the answer to this question is not easy, the recent trends in the data are clear.
In 2021, profitability – measured by free cash flow (FCF) margin, not revenue growth – had a high correlation to positive stock returns in the software sector. It broke a four-year trend of revenue growth by being the more important driver of software company stock performance.
This improvement is huge. And the reversal in investor sentiment is evident.
In addition to deviating from the four-year trend, the data shows that the profitability correlation reached a seven-year high late last year, while the revenue growth correlation was near a seven-year low. With continued selling, the revenue growth correlation broke significantly below a seven-year all-time low, and the profitability correlation remained at record highs, as shown below.
What is happening?
So far in 2022, the S&P 500 and the Dow Jones have outperformed the tech-heavy Nasdaq. Additionally, several recent high-profile/high-growth/unprofitable IPOs have broken the IPO value (Hashicorp, SweetGreen, Rivian Automotive, Rent the Runway, etc.).
AS THE MARKET CHANGES AND VOLATILITY INCREASES, INVESTORS TEND
TO BACK AWAY FROM NAMES THEY ARE COMFORTABLE WITH.
The Bessemer Emerging Cloud Index (composed of major SaaS companies) is down more than 30% from its November 2021 peak, while some high-end multiple names like Cloudflare and HubSpot are down nearly 50% from their peak. Over the same period, the broad SaaS valuation multiples have been adjusted to approximately 10.5x from a peak of approximately 17.5x NTM EV/Rev in November 2021.
Investors are “rotating” by high-growth/high-multiple software names into sectors such as finance (banks) and insurance, which benefit from rising interest rates. At the same time, it’s important to note that the larger, slower-growing, more profitable tech stocks such as Microsoft, Google and Facebook have improved, but to a much lesser extent.
This change has been rapid, firm and extreme.
Why are investors selling high-growth stocks?
interest rates are rising
Inflation is on the rise, prompting the US Federal Reserve to hike three or four interest rate hikes in 2022, causing the 10-year Treasury yield to rise from about 1.5% at the start of the year to about 1.9% today. 40 bps increase. As interest rates rise, investors focus more on profitability (or the derivative of profitability; the rule of 40 or the magic number).
Source: TechCrunch