2023 Stock Market “Re-Session”
Will the New FAANG please stand up? Small-cap growth in B2B software
If you work in enterprise software, high-tech, “Start-up Nation”, or all of the above, chances are you’ve been watching the current market environment like a hawk — I certainly have.
There is growing consensus that a recession in 2023 is highly unlikely — even if much of the tech sector has experienced recessionary characteristics — however, a “re-session”, that is, a new bull market session, is now underway.
(Past recessions have occurred with earnings falling an average of -18%, which are on track to finish +6% in 2022, with Q4 reporting still in progress. Further, never has a recession occurred with an unemployment rate below 5.5%, which recently declined to 3.4% this past week, the lowest reading since 1969.)
I hope the following perspective is useful for company execs, strategy teams, and investors alike as we navigate the year ahead.
1. “Listen to what the market is saying about others, not what others are saying about the market.” — Richard Wyckoff
In July 2022, I wrote, “recent indicators suggest there may be reason to be more optimistic about the future,” … and it just so happens that stocks bottomed one month earlier — not in reference to the heavily-weighted large-cap indices like the S&P 500 or NASDAQ 100, but the broader market of stocks. The number of companies in the Russell 3000 with new 52-week lows peaked on June 16, and despite a close retest of this in late September (which is when the US Dollar peaked, but more on this later), stock prices haven’t looked back.
Why did I have the nerve to suggest this back in July? I blame the data… But we never know if a new bull market has begun until certain thresholds are met after the fact, and this latest bull run from June was only confirmed a month ago. And given this new information: In 2023, companies across the globe must take a hard look in the mirror and choose whether to “be bold… or grow old.”
2. “Limits, like fears, are often just illusions.” — Michael Jordan
The largest economies are coming out of this latest economic downturn in phases, with India and Europe leading much of the charge, and China with perhaps the most recent momentum. Sector rotation is the lifeblood of a bull market, and the performances of sectors such as Energy, Industrials, and Healthcare, as examples, have been historic. Which types of companies are the crown jewels of the European economy? Not FAANG or other large-cap growth, but instead Energy (Shell, TotalEnergies), Industrials (ASML, Schneider Electric), and Healthcare (Novo Nordisk, AstraZeneca), to name a few. It’s not because of earnings multiples. Not quarterly performance. Not “rules” of 40 or 60. It’s been sector rotation all along. But enough about the large-caps…
The Russell 3000 is an index that delineates US-listed stocks by size, and I have continued to follow the Russell 2000 (the largest 2000 companies after accounting for the first 1000, so #1001–3000) at this point in the cycle. Small-caps range in size from $240 million to $4.6 billion, as of its latest reconstitution, and they have been trending. And while “value” companies may be leading this latest bull-market across large-caps, “growth” companies have been leading the small-caps. How can this be, when they are subject to the same US dollar implications, interest rate increases, and other market forces?… Exactly.
3. “There are only two losses to report, loss of capital or a loss of opportunity. If we preserve capital there will always be another opportunity.” — Louis Yamada
But… will there be another opportunity like this one in the foreseeable future?
The US dollar most recently peaked on September 26, but has declined sharply since, and this is largely due to interest rate differentials — the US Fed raised interest rates not only first but also faster than other central banks, and speaking of…
Core inflation (Core CPI, Consumer Price Index) is currently 5.7%, was 5.5% a year ago, and appears almost unchanged. But let’s say we decide to treat Core CPI like we treat publicly traded companies; or in other words, what if we take a quarterly view, i.e., annualize data from the most recent 3 months? In this case Core inflation would currently read 3.2%, compared to 7.6% in June, suggesting that inflation has been more than cut in half since stocks bottomed last summer!
As inflation continues to decline, lower rate increases become anticipated, and the present value of future free-cash-flows rises, and the current value of companies with higher future growth potential rises, and voila! We have a catalyst.
While small-cap growth continues to exhibit strength, many investors have been honing in on innovative tech companies that fit the bill, and even more specifically, those that are enterprise/B2B (higher predictability than consumer) that serve customers across industries (less affected by industry-specific trends such as fin-tech or health-tech). Let’s take 20 such companies with a Cloud/SaaS value prop and Q3 2022 revenue growth above 15% (in order of market cap, as of Jan. 13): GitLab, Smartsheet, Workiva, Elastic, Monday, HashiCorp, Qualys, DigitalOcean, Freshworks, Asana, Rapid7, Appian, PagerDuty, JFrog, Fastly, Amplitude, Semrush, Sumo Logic, Domo, Riskified, and Couchbase. And as was the case last summer, small-cap growth companies in B2B software are still being valued on revenue growth.
The above chart resembled more of a scatterplot 18–24 months ago, and that’s because this cohort was being valued not only on revenue growth, but other less rigid variables such as total addressable market (TAM). Now each of these companies falls almost squarely on the same trendline: the higher the estimated revenue growth, the higher the revenue multiple.
And those with increasing stock prices are exhibiting the highest revenue growth characteristics as well.
The chart above shows the decrease in stock prices from mid-January 2022 through mid-January 2023 on the X-axis, as well as increases in stock prices from their recent bottoms in Q2 2022 (except GitLab which bottomed in late Q1). While free cash flow (FCF) may be a trending theme in the overall market, there is no evidence that FCF is being rewarded within the small-cap growth cohort (no trend of stock prices increasing on account of positive FCF, nor FCF margin improvements of >10%). While the “Rule of 40” may be a trending theme in the overall market, there is no evidence that the Rule of 40 is being rewarded within the small-cap growth cohort (as only Digital Ocean and Qualys satisfy the rule on a forward-looking basis, and both are underperforming relative to the others). What are small-cap growth companies being rewarded for?… Growth!
4. “Never let a good crisis go to waste.” — Winston Churchill
So how should investors go about making their small-cap growth picks? (Why even invest in small-cap growth in the first place? For starters, some could be future members of the “New FAANG”, but are currently small/mid-caps and still early in their growth journeys.)
Should investors be making picks based on fundamentals? Which companies are:
… signaling the highest growth? GitLab, Monday, DigitalOcean, Smartsheet, JFrog
… maintaining the best FCF levels? Qualys, Digital Ocean, Rapid7, JFrog, Workiva
… investing most aggressively in Sales & Marketing? Asana, GitLab, Monday, Hashicorp, Freshworks
… investing most aggressively in R&D? Asana, JFrog, Hashicorp, PagerDuty, GitLab
Should investors be making picks based on recent purchases by company insiders? Point72 Asset Management recently revealed an initial 5% stake in Fastly. Abdiel Capital recently revealed purchases of over $10 million in Appian; further, Appian Director David Goeddel bought $400,000 worth of shares just weeks ago. What do these insiders know that the rest of us don’t?
5. “Learning and Innovation go hand in hand. The arrogance of success is to think that what you did yesterday will be sufficient for tomorrow.” — William G. Pollard
Many of these companies may have been in the right place at the right time during the previous bull run. From 2009–2021, software companies were both the most technologically mature and had the highest willingness to pay, i.e., increasing budgets to spend, on software innovation. But new sheriffs have come to town, other industries which are more technologically mature than they had been in previous years and who now have the high budgets for software innovation.
What will Novo Nordisk (Healthcare company based in Denmark) do with all this extra financial leverage and budget capacity? Maybe part of it will go toward its software innovation needs?
Which of the small-cap growth companies in B2B software are realizing that the “Novo Nordisks of the world” are where they’ll find success considering this market environment? Which will “be bold” and agile enough to alter their go-to-market strategies to win in current conditions, and which will stick to their old ways, and by default, begin to “grow old”?
Earnings season for this cohort kicks off after market close today with Freshworks. I for one am eager to see how each performed this past quarter, and even more curious about what they have to say about their respective futures.
Will the Next FAANG please stand up?
