Here are some tech buying opportunities for investors to consider
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Markets endured a rough January, with the S&P 500 Index suffering its worst monthly performance in nearly two years. Technology was responsible for much of the carnage, as investors became spooked by some notable earnings misses and the prospect of four interest rate hikes by the Federal Reserve in 2022.
The good news is that revenue-multiple compression within this sector tends to be short-lived. Tech last took a beating like this in September 2000, and despite an economic downturn creating headwinds it was over within eight months.
The landscape today is different. While inflation is running hot, the economy is otherwise strong and corporate earnings, broadly, remain solid — all of which provides a good foundation for a quicker technology recovery this time around.
That said, the bottom is still not here. That will likely occur after the first rate hike from the Fed, which could happen in March. That will rattle growth stocks again, setting the stage for bargain hunters, particularly if the Fed deviates from the norm and institutes a half-point increase.
Though the drawdown in tech and software was faster than most anticipated, the peak-to-trough decline is consistent with past slumps that coincided with rate increases. Nevertheless, software firms continue to trade at approximately double the 20-year average.
Still, no one should expect multiples to approach historical averages, especially among software-as-a-service, or SaaS, firms. That’s because such firms generate healthy recurring revenues through subscription-based models, which allows them to expand margins and produce more free cash flow.
In other words, some of the high valuations in this space are justifiable. Fourth-quarter earnings will likely bear this out even further, with many software companies set to report strong numbers.
So, where is a good place for investors to look?
Stalwarts such as Adobe, Autodesk and Intuit will have clear upside when the tide turns in the wake of the Fed’s first increase, thanks to having defensible businesses and strong free cash flows. Even so, these are mature companies, which means outsize gains are unlikely.
The more explosive growth opportunities will be with less established, more beaten-down companies that nonetheless have resilient businesses. Notably, Zoom Video Communications has shed more than 75% since reaching its all-time high. A massive decline like that suggests to some that it was merely a short-term pandemic beneficiary plagued by fundamental problems.
The truth is more complex. While the company did reach silly, indefensible heights as work-from-home models became entrenched during 2020, many businesses will continue to live on Zoom going forward, including those who prefer the simplicity of its platform compared to similar offerings like Microsoft Teams.
At the same time, millions of workers across the country will eventually go back to an office. When that happens, organizations large and small will have to replace decaying, legacy phone systems, creating a huge opening for the company. To be sure, Zoom won’t capture all that business, but it will get enough to keep growing.
Relative to the average SaaS company, Zoom now trades at a discount. More clarity will come after the company reports earnings on March 1, when it will provide 2023 guidance. Anyone who sold the stock believing it was a one-hit-wonder, not to mention hedge funds that shorted it on implied billings growth last quarter, may be surprised by the forecast.
The case for CrowdStrike is more straightforward.
Businesses of all sizes are shifting their data to the cloud, a trend that has accelerated during the pandemic with the increased adoption of digital communication tools. All of them need to protect themselves against cyber threats. This is a massive addressable market, and it’s getting bigger by the day.
CrowdStrike now trades at 14 times 2023 revenue guidance, a premium given that SaaS firms as a whole trade at about 10 times 2023 revenue guidance. But it’s important to keep in mind that the company’s implied revenue growth is much higher (about 70% vs. 20%).
Meanwhile, Cloudflare and Datadog are other fast-growing companies worth considering. Yet they remain among the most expensive within software, so it’s probably best to wait until well after the first Fed rate hike takes place before thinking about adding either.
For years, euphoria has reigned in the markets. Slumps and slips were few and far between. Even a once-in-a-lifetime pandemic couldn’t knock stocks off stride for long.
But the environment has changed. As the first weeks of the year have made clear, the everything rally is over. Still, opportunities will come — you just have to be patient and know when and where to pounce.
— By Andrew Graham, founder and managing partner of Jackson Square Capital