Which Software Is Eating The World Relatively Best

As the markets correct, I am hunting for relative strength. It helps me figure out who might lead when the markets inevitably turn and it also helps me think about startups and where the money and best entrepreneurs are flowing.

One unexpected outcome of this market correction (so far) was that many of the widely-followed (and expensive!) software IPOs had incredible relative strength versus the market. Specifically, I am thinking of Elastic ($ESTC), Smartsheets ($SMAR), Anaplan ($PLAN), Atlassian ($TEAM), Alteryx ($AYX), and MongoDB ($MDB), among several others.

There are three reasons why Software outperformance is significant.

First, it’s counterintuitive, and that always bears investigating. You’d think highflying expensive IPOs, at a market peak, in a momentum industry, would get crushed.

Second, the strongest performing stocks during a correction often emerge as new leaders when the correction ends. Software’s relative strength during this decline informs us we need to keep paying attention to this group.

Third, I love software. I’ve written extensively on how software is eating the world (thanks Marc Andreesen), and that a primary focus of our Social Leverage funds is finding new companies whose software solves a million different complicated problems in a simple and beautiful way (like Robinhood, Rally Road, or SecFi).

With this in mind, let’s examine some companies, and the Software industry as a whole.

Using Koyfin, my preferred market dashboard and quant tool, we can take a quick look at the companies to get a sense of where they’re trading valuation-wise, and also look at relative performance versus the Nasdaq 100 ($QQQ), an appropriate benchmark.

ESTC: Company Snapshot:

Performance vs. QQQ: Measured from IPO (after the Nasdaq peak on 8-29-18), ESTC fell 3.3%, outperforming the QQQs by +14%.

SMAR: Company Snapshot:

Performance vs. QQQ: Measured from the Nasdaq peak on 8-29-18, SMAR initially underperfomed, but stabilized early, and has since outperformed the QQQs by 4%.

PLAN: Company Snapshot:

Performance vs. QQQ: Measured from IPO (after the Nasdaq peak on 8-29-18), PLAN is positive on an absolute and relative basis; +5.7% since IPO and also vastly outperforming the QQQs by +20% over the same time.

This is only part of the story however…

The next thing to check is the Software industry as a whole. Specifically, if there was a relationship between how the more expensive Software stocks performed, and draw some comparison to the Nasdaq that way.

Using Koyfin’s Scatter Plot tool, I was able to load the holdings of the Software ETF $IGV and measure the relationship between EV/Sales and Percent Change in the last 3 months (since the sell-off started). I added a vertical red line to mark the performance of the Nasdaq in that period, and a black horizontal line which is the average Sales multiple of the group at the peak.

You can read this like a quadrant: upper right is more expensive than average and outperformed the Nasdaq, lower right is less expensive than average and outperformed the Nasdaq, and so on.

Here’s what stood out to me: One, how easy it is to perform this type of quantitative analysis in Koyfin. But two, when you look at where the concentration of companies were on a performance basis, there were more cheap stocks that underperformed the market (lower-left quadrant) than expensive ones (upper-left quadrant)!

In plain English, even though software as a whole outperformed the Nasdaq, among the individual stocks that were weaker, those stocks were more likely to be the cheap ones, not the pricey ones.

The exact opposite of what you’d expect!

While these results speak for the group, there is one tiny issue. This particular ETF doesn’t hold ESTC, SMAR, PLAN, TEAM or MDB. They are too new and are not yet in the ETF.

To fix this, I rebuilt the software index to include these names.

First, I ran a screen for software companies that met certain thresholds for size and similarity

Next, the companies were ranked by peak market EV/Sales multiples (to make sure we were looking at how expensive companies were before the decline, not after).

Then, I measured the relative share performance of these companies from the Nasdaq peak on 8/29/18 to 12/26/18, the day of a possible capitulation low.

Last, the companies were grouped from least expensive to most expensive at the peak, in order to see which groups had better or worse performance compared to the Nasdaq in that period.

The results point to the same conclusion. This Software industry group overall outperformed the QQQ (albeit more modestly than IGV). The cheaper valuation groups did worse than the QQQ (corroborating our findings above). The more expensive companies had the strongest relative performance.

I was surprised how quickly a simple observation (“Man, you’d think ESTC would be getting creamed here”) led to a quick research project, but was glad to see the conclusions hold. These stocks are staying on my watchlist, and from a technical point of view PLAN, TEAM, MDB, and AYX are worth paying attention to.

Also published on Medium.