As Fed Policy Tightens, Consider Valuation Opportunities in Software Megatrends

Markets this year have experienced a significant pivot away from growth stocks, bringing soaring valuations down. WisdomTree’s Christopher Gannatti, CFA and global head of research, dove into the valuations trends within thematic strategies centered around software and discussed the opportunities in cloud computing as well as cyber security in a recent blog post.

Software-centric strategies performed strongly at the onset of the pandemic and through 2021, offering strong revenue growth, drawing interest, and strong investment.

“As performance accelerated, so did valuations, at least as measured by enterprise value to trailing 12-month sales (EV-Sales). This tells us that even though sales were growing, investors were pushing up valuations because of their excitement about future potential,” Gannatti wrote. “Obviously, the environment in 2022 has changed.”

Image source: WisdomTree Blog

Gannatti demonstrated the valuation trends for two indexes, the WisdomTree Team8 Cybersecurity Index and the BVP Nasdaq Emerging Cloud Index, both indexes that offer exposure to megatrends within software.

The BVP Nasdaq Emerging Cloud Index hovered below 10x valuations between October 2018 and April 2020, grew to be 12x-14x from April 2020 until November 2021, and then fell dramatically to 4x to 5x where it sits currently. The index valuations reflect both the different stages of the pandemic as well as the onset of the Federal Reserve’s monetary tightening policy.

“We are tending to see cloud computing companies guiding in the range of either stable or slightly lower growth for 2022. As yet, we have not seen revenue growth ‘disasters,’ but that doesn’t mean it couldn’t happen as companies continue to report (earnings),” explained Gannatti.

The WisdomTree Team8 Cybersecurity Index has remained highly correlated to the cloud computing index since its launch, largely due to the overlap between cloud computing and cybersecurity.

Fed Impact on Software Megatrends

“We think that growth equals opportunity but recognize that it will be critical to see central banks transitioning from aggressive tightening to slowing or pausing their tightening,” wrote Gannatti. “One way to manage this risk could be a longer investment horizon, where the risks associated with any singular macroeconomic environment may be lessened. “

While growth and technology stocks have suffered in the first half of 2022, it means that funds such as the WisdomTree Cloud Computing Fund (WCLD) and the WisdomTree Cybersecurity Fund (WCBR) are currently undervalued, providing a good entry point to the space for investors.

WCLD provides investors pure-play exposure to companies that provide cloud-based software and tracks the BVP Nasdaq Emerging Cloud Index, an equally weighted index comprised of companies that derive the majority of their revenue from software provided via the cloud. That could mean remote delivery or a cloud-based business model that is subscription-, transaction-, or volume-based.

WCLD offers multi-cap exposure to emerging companies within cloud software and services and has an expense ratio of 0.45%.

WCBR seeks to track the WisdomTree Team8 Cybersecurity Index, which invests globally in companies whose main revenue is derived from cybersecurity and security-oriented technology that prevents attacks and intrusion into systems, networks, computers, applications, and mobile devices.

The index also utilizes exclusionary filters to screen out companies based on ESG criteria that violate UN and Global Standards Screening guidelines, are involved in controversial weapons (biological, chemical, cluster, nuclear, or white phosphorous weapons, and anti-personnel mines), have significant involvement in tobacco or thermal coal activity, or violate other ESG standards of the index.

WCBR has an expense ratio of 0.45%.

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