Lastly Within a decade, executives at private companies have asked us the same question: “Do public market investors prefer profitability or growth?” While the answer to this question is not straightforward, recent trends in the data are clear.
In 2021, profitability — measured by free cash flow (FCF) margins, not revenue growth — had the strongest correlation with positive equity returns in the software sector. This broke a four-year trend of revenue growth being the single most important driver of the software company’s stock performance.
This fix is great. And the reversal in investor sentiment is clear.
In addition to deviating from the four-year trend, the data shows that the profitability correlation hit a seven-year high late last year, while the revenue growth correlation was close to a seven-year low. With continued selling, the revenue growth correlation was well below the all-time low of seven years, and the profitability correlation remained at record highs, as shown below.
What’s happening?
So far in 2022, the S&P 500 and Dow Jones have significantly outperformed the tech-heavy Nasdaq. Additionally, several recent high-profile/high-growth/not-profit IPOs have broken the IPO price (Hashicorp, Sweetgreen, Rivian Automotive, Rent the Runway, etc.).
As the market turns and volatility increases, investors will retreat to names they are comfortable with.
The Bessemer Emerging Cloud Index (comprised of prominent SaaS companies) is down more than 30% from its November 2021 peak, while some multiple names like Cloudflare and HubSpot are down around 50% from their peaks. Broad SaaS valuation multiples over the same period have been adjusted from a peak of around 17.5x NTM EV/Rev in November 2021 to around 10.5x.
Investors are “running” from high-growth/multiple software names to sectors like finance (banking) and insurance, which benefit from rising interest rates. Also, it’s important to note that large, slower-growing, and more profitable tech stocks such as Microsoft, Google, and Facebook have corrected, but to a much lesser degree.
This change was swift, resolute, and extreme.
Why are investors selling high-growth stocks?
Interest rates are rising
Inflation is rising, prompting the US Federal Reserve to signal three or four interest rate hikes in 2022, which has seen the 10-year Treasury yield rise from around 1.5% earlier in the year. to about 1.9% today, up about 40bps. As interest rates rise, investors focus more on profitability (or a derivative of profitability; Rule of 40 or Magic Number).