Software Inflected. So, What’s Next?
We called the SaaS Inflection. It’s time for an update.
Software is finally inflecting higher 🚀, outperforming the semiconductor complex in May. At The Pragmatic Optimist, we invested in IGV at the start of May and doubled down on our high conviction names during the software sell-off at the start of the year.
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Let’s Set The Stage
The month of May has finally ended with the S&P 500 up 5% this month. That MTD performance is impressive given that through May markets had to navigate through a deluge of distractions and distortions of epic proportions.💣
The Middle East conflict continues to remain deadlocked. Oil prices remain elevated (although retreating from $100 levels). Same for yields, which remain elevated (but have backed off their 52w highs). Inflation is at its highest since June 2023. And we now have a new Fed Chair that prefers cutting rates as well as the size of the US Fed’s balance sheet.
Yet, markets rose for the month because AI continues to attract more capex with analysts now expecting $800B in capex, up from ~$700B previously expected. Amidst this euphoria of capex increasing, portfolios continue to chase winning market segments like semiconductor stocks that were broadly up just under 20% for the year.
But if we told you that while markets were chasing semiconductors, software stocks just about outperformed semiconductor stocks through the month of May?🤯
📈That’s right, Software ETF IGV IGV 0.00%↑ returned 21.2% compared to 19.8% returns for the Semiconductor ETF SMH SMH 0.00%↑ on a MTD basis.
Below, we provide an updated outlook on our recent SaaS inflection call from early May, where we explained our reasoning behind initiating a position in IGV at the start of the month, alongside our existing high-conviction positions in Palantir PLTR 0.00%↑, ServiceNow NOW 0.00%↑, CrowdStrike CRWD 0.00%↑, Cloudflare NET 0.00%↑ and Rubrik NET 0.00%↑.
In this post, we will also highlight which software names are poised to extend their market leadership in the next phase, based on our updated Conviction Scores that can be found in the AI Stock Tracker 2.0.
📌The TPO Portfolio has staged an impressive rally since March 1, now up 32% 💪, significantly beating the S&P 500 and benchmark ETFs that include QQQ QQQ 0.00%↑ , GRNY GRNY 0.00%↑ and IVES IVES 0.00%↑, during this period of time.
You can track our entire portfolio and all our live trades in the AI Stock Tracker 2.0 tool using the link below. 👇
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Brief Update On Our Previous SaaS Call
While our research and portfolio holdings do have a majority of semiconductor stocks, we had been regularly updating our subscribers about how irrational the software carnage had become in Q1 this year.
Two months ago, we explained in a detailed post how rapidly tightening private credit spreads and intense competitive pressures from Anthropic/OpenAI were ganging up together as one single headwind to strike SaaS companies with unprecedented volatility. Earlier this year, the rapid advancement of frontier models, such as Anthropic, sparked concerns over their potential to disrupt the recurring revenue models of established SaaS companies. These SaaS-disruption narratives escalated into broader financial anxieties, as market observers questioned whether highly leveraged SaaS firms could successfully service their debt amidst mounting competitive pressure.
While we broadly agreed with some of those SaaS-disruption narratives, we maintained that “AI won’t eat all of software,” with cybersecurity, data, and core infrastructure companies as areas of opportunity that were already well positioned to deliver on “game-changing inflection[s].”
On a first-principles basis, we argued that SaaS companies that were able to get their product packaging and menu pricing right would be rewarded by the markets.
In our view, as we stated in this post from two months ago, SaaS companies that demonstrated dexterity in monetizing their position as a “system of record” or the “control plane” that feeds AI would eventually see through the first rounds of SaaS inflection.
Within the SaaS industry this is exactly how it has played out. So far through May, investors can see that while the broad-based software sector beat all other broad-based tech sectors in the last 30 days, it was the cybersecurity category of SaaS stocks that roared higher over the same time period.
For now, we are very pleased with our decision to invest in IGV at the start of the month, while initiating and/or doubling down on our individual high-conviction names (mentioned above) during the software sell-off at the start of the year.
Note: that roughly 15% of the capital in The Pragmatic Optimist Portfolio is allocated to software.
However, developments over the past 30 days have introduced new variables that offer fresh insights and will dictate our investment strategy for software stocks through the rest of the year.
Remember, if there is one thing that AI has taught investors like ourselves is that the rapid evolution of this groundbreaking technology is highly capable of shifting market leadership overnight. Recent earnings reports from Snowflake SNOW 0.00%↑ as well as earnings reports from companies like Atlassian TEAM 0.00%↑ and Twilio TWLO 0.00%↑ markedly indicate a shift in market expectations as the SaaS inflection switches gears at a key juncture of the market.
Therefore, in the next section, we will explain 2 key performance metrics that we will be looking for in earnings reports moving forward while also sharing a few of our software picks that could lead the SaaS complex this year. We will also end the post with updated data points regarding the private credit fears in SaaS.