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By Christopher Gannatti, CFA
In 2020 and 2021, investors are placing record amounts of investments in thematic funds – another way to describe strategies that are a bit further from the growth end of the spectrum. While there is no way in which every thematic fund are the same, two common aspects are noted:
- Software-focused strategies have shown very strong revenue growth metrics, often by providing solutions that are more widely used during the COVID-19 lockdown. Investors are drawn to these growth metrics – and in many cases, assets pile up.
- As performance accelerated, so did valuations, even as measured by enterprise value up to trailing 12-month sales (EV Sales). This tells us that even as sales grow, investors are driving up valuations because of their excitement about future potential. Obviously, the environment in 2022 has changed.
The result – well, we see it in figure 1:
- The WisdomTree Team8 Cybersecurity Index (WisdomTree Cybersecurity) and BVP Nasdaq Emerging Cloud Index are unique indexes that aim to capture companies in two megatrends, both focused on software.
- Looking at the EV Sales metric, we can see that the BVP Nasdaq Emerging Cloud Index has gone through three phases. From October 2018 to April 2020, the valuation moved but remained below 10 times. Then, from April 2020, the valuation ratio expanded towards a level of 12 to 14 times, more or less, until November 2021. Then, the ratio decreased and seems to have stabilized at around 4 to 5 times, in July 2022. It is clear to see how these dates correspond to the different stages of the COVID-19 pandemic and then the announcements of changes in central bank policies.
- WisdomTree Cybersecurity, during its shorter life history, has performed highly correlated with the BVP Nasdaq Emerging Cloud Index. It is worth noting that ‘cloud security’ is an important part of cybersecurity today, and there is overlap between these indexes. Now, one can consider whether the fact that cybersecurity is important to any company’s strategy translates into a much higher valuation than what we see for the general cloud computing company.
Figure 1: Historical Evolution of Enterprise Value in Trailing 12-Month Sales Ratio for Specified Indices
Conclusion – A Signal to Invest?
We want the thing to be as simple as, the valuation has dropped to a certain percentage, therefore, it is bottoming out and it is a good time to enter. Unfortunately, the indices shown in figure 1 may drop further from this. We can observe the revenue growth of a select few cloud computing companies, recognizing that the BVP Nasdaq Emerging Cloud Index saw a larger overall decline in the EV Sales ratio.
- Squarespace (SQSP), Tenable (TENB), ServiceNow (NOW), AppFolio (APPF), 2U (TWOU), Shopify (SHOP), and Zendesk (ZEN) reported quarterly results the week of July 25 , 2022, at the early end of the quarterly earnings reporting cycle.1
- If we think in terms of ranges, Squarespace and 2U saw revenue growth in the 0%-10% range, Shopify between 10% and 20%, Zendesk, ServiceNow and Tenable at 20% -30% range and then AppFolio was the leader with 32% year-over-year revenue growth.2
We tend to see cloud computing companies guiding the range of either stable or slightly lower growth for 2022.3 So far, we haven’t seen earnings growth ‘catastrophes,’ but that doesn’t mean they can’t happen as companies continue to report.
Tobias Lutke, CEO of Shopify, wrote a letter posted on Shopify’s public site about their strategic decision to lay off about 10% of the company’s workforce. Along with the chart we show as figure 2, which we think illustrates what we see in many software spaces.
- Shopify focuses on e-commerce, so the adoption rate of e-commerce is critical to their business.
- E-commerce is on a significant growth trend, but it is clear that the slope is moderating back to the long-term trend after the massive spike. Many software companies may have been priced as if the ‘COVID spike’ in growth will continue, and what we see in 2022 is the need to moderate to a still growing but more sustainable growth. In the case of Shopify, the big news of the week of July 25, 2022, is the need to lay off 10% of staff to deal with this e-commerce moderation.
Figure 2: Growth rate of US e-commerce adoption
We think growth equals opportunity but recognize that it will be critical to see central banks move from aggressive tightening to slowing or stopping their tightening. A massive rally in the software company’s share prices will be hard to see in the face of a sustained 75-basis point rise. One way to manage this risk can be a longer investment horizon, where the risks associated with any unique macroeconomic environment can be reduced.
Those interested in cloud computing or cybersecurity can click to learn more about WisdomTree’s unique options within the thematic equity space.
1 Source: Bloomberg for compilation of quarterly earnings reporting dates. 2 Sources: The respective company’s investor relations website for each specified company where they have posted a press release and presentation reporting the latest results. 3 Sources: Company investor relations websites, recognizing that not all companies provide guidance or provide it based on the same exact metrics or time period.
Important Risks Associated with this Article
Christopher Gannatti is an employee of WisdomTree UK Limited, a European subsidiary of WisdomTree Asset Management Inc.’s parent company, WisdomTree Investments, Inc.
As of August 9, 2022, WCLD held 1.33%, 1.50%, 1.47%, 1.49%, 1.48%, 0.97% and 1.05% of its weight in Squarespace, Tenable, ServiceNow, AppFolio, 2U, Shopify and Zendesk, respectively respectively.
As of August 9, 2022, WCBR held 0%, 3.20%, 0%, 0%, 0%, 0% and 0% of its weight in Squarespace, Tenable, ServiceNow, AppFolio, 2U, Shopify and Zendesk, respectively respectively.
Christopher Gannatti, CFA, Global Head of Research
Christopher Gannatti started at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. In January of 2014, he was promoted to Associate Director of Research where he was responsible for leading a diverse group of analysts and strategists within the broader Research team at WisdomTree. In February of 2018, Christopher was promoted to Head of Research, Europe, where he will be based in WisdomTree’s London office and will be responsible for WisdomTree’s entire research efforts within the European market, as well as supporting on the platform of UCITs worldwide. Christopher comes to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant. He received his MBA in Quantitative Finance, Accounting, and Economics from NYU’s Stern School of Business in 2010, and he received his bachelor’s degree from Colgate University in Economics in 2006. Christopher holds the Chartered Financial designation Analyst.
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