Insights From ETFs: Software stocks � Catching a falling knife or a generational buying opportunity?

From software is eating the world…

In 2011, Mark Andreessen, the famous venture capitalist, made a profound statement that “software is eating the world”¹ to capture a fundamental shift in digital technology that was going to transform every industry.

In fact, that statement has turned out to be true over the last decade, as practically every industry—including media, retail, and banking—has integrated digitalization into its business to enhance customer experience and improve efficiency. Investors were very excited about the prospects of the Software-as-a-Service (SaaS) business model due to many favourable economic characteristics, including a subscription-based, capital-light model and “sticky”, hard-to-replace solutions with high gross margins that gave strong pricing power.

These SaaS companies tend to have high levels of stock-based compensation (SBC) in their cost structures to compete for and retain talented software engineers. In addition, they often spend aggressively on sales and marketing to attract new customers. Consequently, these SaaS companies seem to have limited current profitability. That said, investors were willing to value them based on price-to-sales multiples with the assumption that premium growth would be sustained for a long time to justify the lack of current profitability.

The theory states that since SaaS companies provide critical solutions that are highly sticky, customers would stay with these platforms for years, more than making up for the initial marketing spend. Just a few years ago, investors treated every SaaS company as if all of them would eventually become software giants like Microsoft (MSFT) or Intuit (INTU). It seemed like nothing could go wrong.

...to “Artificial Intelligence (AI) is eating software!”

A few years have gone by, and sentiment has shifted completely. SaaS businesses went from being an ideal business model to being seen as extremely vulnerable with the emergence of Artificial Intelligence (AI). The current narrative is that AI will replace most software offerings over the next few years, as AI has made coding drastically cheaper and practically turned it into a commodity.

Fundamentally, many SaaS businesses turned out not to be as promising as they initially seemed, with some experiencing a meaningful slowdown in topline growth. This has led to a significant mismatch between revenue growth and cost control. Share prices have dropped sharply from the highs in 2021. Consequently, there has been meaningful restructuring at many SaaS companies. Some have chosen to cut costs by reducing marketing spend and tightening share dilution, while others were acquired by larger companies or private equity firms. Investors now value these businesses based on near-term earnings rather than sales. As a result, the software industry has experienced significant multiple compressions.

It is true that some software businesses, such as Adobe (ADBE), once a behemoth, could potentially be at risk of replacement as editing and generating video or images has never been easier. However, most SaaS businesses will not be replaced anytime soon, if ever.

Investors today are overstating the disruptive effects of many software solutions. There are several factors that AI-alternative software may not be able to replicate anytime soon, such as customer intimacy, product consistency, ecosystem dominance, proprietary data, regulatory hurdles, and compliance. Price alone has never been the only determining factor when choosing software; reliability and compatibility matter just as much.

Due to this drastic reversal in investor sentiment—from software optimism to chasing AI names—the field is once again becoming attractive. We think software solutions where the cost of being wrong is higher than the cost of the software itself will likely remain strong in the long term. For instance, Google Sheets has been available for free for some time, but Excel remains the dominant choice for most enterprises.

Though uncertainty is high, investors who buy a basket of “beaten-down”, highly diversified SaaS companies could do well from current levels, given the negative sentiment and discounted valuations.

Here are a few of the ETFs we like.

iShares Expanded Tech-Software Sector ETF (IGV)

The iShares Expanded Tech-Software Sector ETF (IGV) provides investors with exposure to North American software companies. The fund targets software companies in the technology and communication services sectors that are expected to transform various industries.

IGV was founded in 2001, with Assets Under Management (AUM) of $7 billion and a net Management Expense Ratio (MER) of 0.39%. IGV’s portfolio is broadly diversified, with 115 holdings. On average, IGV’s portfolio is trading at 41x P/E with a decent track record of healthy organic growth.

The sector exposure breakdown is: Application Software (61.5%), Systems Software (34.9%), Interactive Home (3.1%), and others (0.5%).

Some of the largest positions include:

Microsoft (MSFT) at 9.7%
Palantir Technologies (PLTR) at 8.1%
Salesforce (CRM) at 7.6%
Oracle (ORCL) at 7.5%
Intuit (INTU) at 5.2%

The common theme across these holdings is that they deliver products through the cloud, all possess highly attractive gross margins, and provide subscription products that generate recurring revenue.

Most SaaS companies have been under pressure, and out of favour, due to fears about AI. As a result, IGV’s performance since its inception has been affected. With that said, in the last ten years, IGV has provided a solid annualized return of around 17.9%.

State Street Software & Services ETF (XSW)

The State Street Software & Services ETF (XSW) provides investors with exposure to emerging names in the U.S. software industry. The fund seeks to implement an equal-weighted approach to provide the potential for unconcentrated industry exposure across large-, mid-, and small-cap stocks.

XSW was founded in 2011, with an AUM of $334 million and a gross MER of 0.35%. XSW’s portfolio is broadly diversified, with 141 holdings. On average, XSW’s portfolio is trading at 20.7x P/E with an estimated 3–5-year EPS growth of around 15%.

Some of the largest positions include:

Adeia (ADEA) at 1.1%
Hut 8 Corp (HUT) at 1.1%
Onestream Inc. (OS) at 1.06%
Daily Journal Corporation (DJCO) at 1%
Clearwater Analytics Holdings (CWAN) at 0.9%

These are mainly emerging software names with great potential to become future incumbents. In the last ten years, XSW has provided a solid annualized return of around 14.6%.

Summary

Overall, we think technological disruptors like AI could replace some businesses. That said, it is unlikely to happen overnight. More likely, AI will eventually become an additional feature for SaaS businesses, enhancing their value to customers and making them even stickier. We believe the premise that SaaS businesses, as a group, represent some of the best business models ever created remains true. At current levels, we think the risk/reward is attractive for investors with a three- to five-year time horizon.

1 https://www.wsj.com/articles/SB10001424053111903480904576512250915629460