Software Investing: Riding the Rollercoaster

Key Takeaways

Within WisdomTree’s suite of thematic equity strategies, both the WisdomTree Cybersecurity Fund (WCBR) and WisdomTree Cloud Computing Fund (WCLD) are tracking indexes that focus largely on software-as-a-service (SaaS) companies. There is an overall feeling of concern as we reach the halfway mark in 2024, as we are receiving questions from investors and seeing a range of articles discussing the slowing growth rates in these types of stocks.

In what follows, we combine a sense of recent history with some data that we can pull in from our Fund Comparison software, available through the WisdomTree website.

Figure 1: Standardized Returns

For the most recent month-end and standardized performance and to download the respective Fund prospectuses, click the relevant ticker: WCBR and WCLD.

What’s Driving the Software Rollercoaster?

The Fund Comparison tool allows one to see, quite quickly, a range of summary information. What is immediately noticeable is a quantification of the so-called SaaS return rollercoaster:

• WCBR and WCLD, for their common return history,¹ which goes back to January 2021, have an annualized standard deviation of roughly 28%. Viewed in isolation, 28% doesn’t mean much, but over the same period, the S&P 500 Index had an annualized volatility of 17%. This means that the annualized volatility of WCBR and WCLD has been more than 50% higher than that of what many people view as “the market.”

• If any investment strategy has a volatility approaching 30% annualized, that is telling us that the returns experienced have been wildly different at different points in time. This coincides with the experience we hear when speaking to investors: some of them may have had a positive experience, while others—mostly the ones we speak with—have had a negative experience.

What Has Caused the Nearly 30% Annualized Volatility?

There is no way to isolate a singular cause for share prices moving in different ways at different times, but if we step back and think about what has characterized asset price behavior since January 2021, there is one macroeconomic variable that has dominated above all others.

• In 2021, for the most part, developed market central banks had interest rates at or near 0%, and many were engaged in policies that were also expanding monetary bases. Policies such as this have the potential to push valuations of riskier assets higher. Many times, SaaS companies are new to public markets and showing how they can use software to solve specific problems in more efficient ways. Lower interest rates lower the opportunity cost of capital that needs to be employed to run these businesses in order for them to achieve scale.
• In 2022, developed market central banks changed course to fight inflation, raising interest rates at a historic pace. SaaS returns were extremely challenged, as were the returns of most asset classes. Even though WCLD and WCBR were challenged, return-wise, because most asset prices were also delivering negative returns, there was less contrast, and it was less noticeable.
• In 2023, the market started to employ a more “forward-looking” character. We found it interesting that from the end of October 2023 to the end of the year, market participants were discounting in a strong view that the U.S. Federal Reserve was going to cut its policy rate early in 2024. There was a massive upward response in the share prices of riskier, more speculative tech companies. WCBR and WCLD certainly were positively impacted. However, this behavior injected risk into these strategies in that, while we cannot say that the share prices were rising solely due to interest rates (a factor that the companies do not directly influence), it was a main reason. If the market needed to adjust, possibly because the U.S. Federal Reserve was slower to cut rates, it’s possible that a chunk of the higher valuations at the end of 2023 was based on an assumption of a rate cut.
• 2024 has been a year defined largely by the need to continually push any expectation of a U.S. Federal Reserve policy rate cut further and further into the future. Unfortunately, the revenue growth of the companies within WCBR and WCLD is not enough to cancel out the adjustment to a “higher-for-longer” interest rate policy.

In what follows, we quantify this thinking using illustrations from the Fund Compare tool.

In figure 2, many may not directly remember that WCBR was up almost 70% during 2023 since the character of returns observed in 2024 has been very different. WCLD was only up about 40%. Both of these strategies dramatically outperformed the S&P 500 Index during 2023.

What’s clear is that most of this outperformance came during the last two months of 2023, so we have to zoom in there.

Figure 2: 2023 Returns of WCBR and WCLD Were Quite Strong

In figure 3, we zoom in on the period from October 31, 2023, to December 31, 2023. Both WCBR and WCLD were up roughly 30%. We cannot say that this move was solely due to expectations of lower interest rates—but we can say that it was a major factor that did create a risk of a mispricing if the path of interest rates was going to stay higher for longer.

Figure 3: Zooming in on the Final Two Months of 2023

In figure 4, we see the challenge faced by WCBR and WCLD in 2024. Now, most of the underlying constituent companies are growing revenues, year-over-year, above 10%. Some are growing revenues above 20% or even above 30%. But the growth is not accelerating and getting investors anywhere near as excited as they might have been in 2020 or 2021. In short, the growth we are experiencing is not enough to cancel out the negative impact on valuations of higher-for-longer interest rates.²

WCBR and WCLD are underperforming the S&P 500 Index, but we’d caution against benchmarking these rather narrow, high-volatility strategies against such a broad benchmark since we expect the return experience to always be dramatically different.

We believe that, with the higher risk of WCBR and WCLD, the time horizon needs to be extended, and anyone who needs to place a lot of focus on the 2024 performance results in a portfolio may face a significant risk of a negative return contribution from these strategies.

Figure 4: The Performance Challenges of 2024

Valuation vs. Growth: The Critical Question in Software

Yes, WCBR and WCLD are also “expensive” from a valuation perspective. But figure 5 shows valuations were significantly higher in 2021 when interest rates were at or near zero. The massive rallies in WCLD and WCBR at the end of 2023 were likely largely driven by interest rate expectations. But, interest rate expectations can change and are independent of company results. Maybe it is accurate to indicate that as we started 2024, these stocks, in many cases, were too expensive IF the U.S. Federal Reserve was not going to cut its policy rate quite quickly.

Figure 5: Price-to-Sales Ratios over Time for WCBR, WCLD and the S&P 500 Index

Now, anytime software companies are in focus, we caution investors to look at valuation without looking at growth. Figures 6a and 6b indicate measures of both sales growth and EBITDA³ growth, looked at from both a median and a weighted average basis.

• In our view, this speaks to why investors waiting for software-focused strategies to have the same or even lower valuations than the S&P 500 Index could be waiting a very long time. Structurally, these businesses tend to grow sales and EBITDA a lot faster than the broad-based benchmark. Obviously, that doesn’t mean they always outperform, but since investors tend to be willing to pay for growth, it makes it hard to see “valuation discounts” with WCBR and WCLD.
• The reason why we show both sales growth AND EBITDA growth is that we are seeking to show something that represents the top line of the income statement—before any expenses are considered—and then a measure that is closer to the concept of “operating earnings,” which does include various expenses related to running the day-to-day business. Still, we note that we do not show measures of bottom-line earnings since significant portions of companies within WCBR and WCLD are not profitable, meaning they do not have positive net income as of the most recent reporting period.

Figure 6a: Measures of Sales Growth

Figure 6b: Measures of EBITDA Growth

 

Conclusion: The World Needs Cybersecurity and Cloud Computing

There’s a large divergence between what the world thinks about the themes of cybersecurity and cloud computing through their actions and the share price performance of the companies within WCBR and WCLD.

As we adopt more AI, we will need more cybersecurity since AI is just a tool—it can be used in negative ways and positive ways. The more that different industries adopt, the more they have to secure. We don’t know which cybersecurity companies will be the long-term winners—that is why we like a basket and ETF approach—but the topic is only getting more important.

Nvidia is getting the lion’s share of attention in the technology space. If we think about who is buying the chips, it is the companies that offer the largest public cloud computing infrastructure. The world is spending hundreds of billions of dollars over a period of years to build more compute infrastructure in the cloud than we have ever had. However, we do not know yet which companies will be the long-term winners based on what they are using AI to do.

This divergence from the potential of the theme and the current share price performance signals a time to invest IF one has a time horizon of multiple years. This is because with big technology shifts, very little happens in the earlier years of the transition, but in the later years, the compounding effect of the growth can be quite large. Volatility will likely remain quite high—but if we follow the spending, the world loves and needs both cybersecurity and cloud computing.

Figure 7: Other Information about WCBR and WCLD, as of 4/30/24

 

 

¹ Specific period of calculation: January 27, 2021, to May 29, 2024.

² Growth rates are sourced from Bloomberg and represent the year-over-year sales growth of the most recent quarterly financial report of the respective constituents within WCBR or WCLD, available as of May 30, 2024.

³ EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization and allows investors to go down the income statement and get closer to a measure of “Operating Earnings.’”