The software sub-sector was amongst the biggest beneficiaries during COVID in 2020 as enterprises and small businesses accelerated digital transformation projects by adopting software to transform their businesses. This resulted in the software sub-sector seeing highest outperformance in two decades versus the SPX in 2020. However, since early 2021, the sub-sector has seen significant underperformance as macro concerns around inflation and higher interest rates have negatively impacted asset valuations.
Exhibit 1: Software Performance (Represented by IGV, Software ETF) Relative to SPX
Software valuation has been on a roller coaster ride with 2020 seeing multiple expansion off robust spending conditions and a complete reversal of multiples over the last 12 months driven by macro concerns around inflation and higher interest rates, with recent multiples reverting back to levels seen at COVID lows in March 2020 (Exhibit 2)
Exhibit 2: Enterprise Value/Next Twelve Months (EV/NTM) Sales (Total Software Group ex. New Additions)
Source: Morgan Stanley
Valuations compressing to COVID lows at a time when inflation is seen peaking by leading macro economists provides valuation support for the group. However, CIO surveys are showing mixed datapoints with sharp deceleration expected in IT budget growth over the next 12 months (Exhibit 3).
Exhibit 3: Global IT Budget Growth
As we look at our positioning in the software sub-sector, we see two equally dueling forces to take in to account. Multiples reversing to COVID lows have removed froth in valuation. However, further weakening of IT budgets can result in risks to revenue estimates for 2H22 and 2023. Thus, we have a neutral stance on the sub-sector versus the Benchmark as we await better clarity on both interest rates/inflation and 2023 IT budget plans.
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