Private company executives have asked the same question for the last decade: Do public market investors prefer profitability or growth? The recent trends in the data are clear, and the answer to that question is not simple.
The correlation between profitability and positive stock returns in the software sector was higher in 2021. Four years ago, revenue growth was the more important driver of software company stock performance.
This correction is large. The reversal in investor sentiment is clear.
Profitability correlation hit a seven-year high at the end of last year, while revenue growth correlation was close to a seven-year low. With the continued selloff, revenue growth correlation broke below the seven-year historic low, and profitability correlation stayed at record highs.
What is happening?
The S&P 500 and Dow Jones have performed better than the tech-laden Nasdaq. A number of recent high-profile/high-growth/unprofitable IPOs have broken their IPO price.
As the market turns, investors retreat to names they are comfortable with.
The emerging cloud index, which is made up of prominent software companies, is down over 30% from its peak, while some high-multiple names are down over 50%. The valuation multiples for the BroadSaaS have adjusted from a peak of about 17.5x Ntm EV/Rev in November 2021.
The finance and insurance sectors benefit from rising interest rates as investors are rotating out of high-growth/high-multiple software names. It is important to note that big, slower-growing, more profitable tech stocks like Microsoft, Google and Facebook have corrected, but to a much smaller degree.
The shift has been fast and strong.
Why are investors selling high-growth stocks?
Interest rates are going up.
The 10-year treasury yield has gone up by 40 basis points since the beginning of the year due to inflation and the Fed's signal of three or four interest rate hikes in 2022. As interest rates go up, investors focus more on profitability.
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