Canaccord Genuity’s Enterprise Software Team: “What worked – and didn’t – and what this means for 2017”

Mark McQueen

Back in the day, I’d share plenty of sell-side research with you from time-to-time.  I’m not sure why that stopped, but with the NASDAQ at all-time highs, there’s no time like the present to get back on that particular horse.  The Boston-based Enterprise Software Equity Research duo of Richard Davis and David Hynes Jr. at Canaccord Genuity recently published a couple of pieces that will be of interest to our ecosystem; a few reflections on 2016, plus some high level thoughts on what may be to come in 2017 :

“You are not entitled to your opinion. You are entitled to your informed opinion. No one is entitled to be ignorant.”

– Harlan Ellison, provocateur and sci-fi writer whom I read as a young man

Around year end, we like to run a few screens to see what happened in our sector. From these lists, we attempt to pull some threads as to why things happened. At a minimum we learn from this analysis, and at best it informs our view of the upcoming year.

2016: the year that was …

Small cap was the place to be. This largely was true for all sectors. For the software stocks in our comp table, we saw three drivers of this dynamic: 1) a steady stream of take-privates and a few strategic buys; 2) generally choppy execution caused small-cap software to underperform compared to quality GARP and large cap growth in 2015, so this meant small-cap software began 2016 at a valuation discount; and 3) the Trump victory meant rising rates and a rising dollar, and small-cap software firms tend to have less international exposure.

More specifically, you should have bought the slowest-growth small caps – ugh. Well, this goes against our notion of what makes for a good stock picking. These stocks were quite beat up, so 2016 was more of a catch-up rally. Indeed, you need to look no further than the long-maligned and now rock star status of semiconductor stocks to see this dynamic in action (see our sector charts in WM v65). Software certainly didn’t have any NVIDIAs in 2016. Stock picking-wise, you had a 30% chance to be up if you bought one of the Top 10 fastest-growing software stocks, but your odds jumped to a 70% chance to outperform the S&P 500 if you bought the 10 slowest growers on January 1, 2016.

Plain old FCF margins or our “Growth + Margins” did not work either. If you just bought the best-in-class free cash flow margin firms or G+M names … you got a heaping helping of underperformance on your plate. Again, most of the outperformers this year were pre-smashed in 2015. Indeed, if you bought a non-market cap weighted basket of the 10 worst performers in 2015, you would be up 12% this year, while sticking with the Top 10 software stocks of 2015 gave you a negative 2% return.

And “value traps” were less “value-trappy” in 2016 than normal. The high valuation crew entered 2016 with a 8.4x NTM EV/revenue multiple while our “Dogs of the Comp Table” began at 1.1x – the latter portfolio earned you 16% this year, and the cool kids got you a negative 13% return. Of course, if you bought that high-flyer, GAAP (growth at any price) portfolio, you had to have some pretty epic stock picks to beat your benchmark because the S&P 500 and Russell 2000 were up 10% and 20% in 2016.

Well, one thing did work –upward revisions. Not surprisingly, the companies that delivered the largest increase in our Growth + Margin metric versus expectations did outperform.

Here’s part I of their “Thoughts on 2017”:

Everything was going so well … until November 8. No, this isn’t a comment on politics. Instead, we thought software would have a nice Q4 rally because fundamentals of the sector are quite good. Unfortunately for our stock picking, investors decided that the incoming administration will be very good for industrials, financials and many low-valuation hardware firms.

The setup – seems like you should underweight the sector through spring or summer 2017. Again, software fundamentals remain quite strong and valuations are broadly attractive. However, stocks exist in a relative world, and it could take until the June quarter to prove or disprove the notion that industrial, financials or whatever is not a new secular growth sector.

Our preliminary 2017 top picks by market cap. We always struggle with “single best idea” requests because no single idea fits every money manager. We highlight a baker’s dozen of names that we believe could provide superior returns in 2017. We are still finalizing the list, but so far our core ideas for next year include: Salesforce, Adobe, Autodesk, Shopify, Splunk, Box, HubSpot, Q2 Holdings, and Five9. We believe Ultimate, Zendesk, Everbridge and Upland could be sleeper picks in 2017 that surprise on the upside for differing reasons.

The evolution of the IPO market. We discuss the puts and takes of how the market has evolved – and conclude that differentiated research will matter again in 2017 and beyond.

Four trends that could create some big software companies. Firms like Zuora help major companies become limber. The Uberization of software is upon us – this means software must ingest, understand and respond to IoT and subjective data inputs – which could help Afiniti. Developers as kingmakers – the rise of the B2D model should help Twilio, Atlassian and ServiceNow. Industrial upgrade cycle can help logistics firms like Kinaxis and Descartes, but also industrial- and construction-oriented Autodesk.

To do list in 2017. 12 years after trimming my coverage of the space, I will consider adding new names in security.

Below the line. Rocks on cars, no spell check at United, and a more tasteful Davis house lighting scheme.

MRM


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