SWS Quarterly Research – January 2023 Update

Last week we published our quarterly update to SWS Growth Equity, our in-house actively managed equity strategy designed to exploit market inefficiencies over multi-year periods. For investors with higher risk tolerances and longer time horizons, Growth Equity takes a more concentrated approach with its 36 portfolio positions, in contrast to our asset allocation strategies that utilize diversified passively managed ETFs. We provide highlights of our analysis below, while the full piece can be accessed via pdf or audio stream.

Since our days of managing capital during the global financial crisis inside a $100 billion pension, a lot has changed regarding the composition of incremental buyers to US public equity. It’s an easy dynamic to discard as significant, but it’s a critical one to consider at our current market juncture.

Record Passive Flows = Record Number of Rocks Unturned

The market capitulation in the first half of 2022 occurred in hands of a record number of algorithmic participants, leaving the opportunity to bargain hunt in the second half of 2022 to an ever-shrinking number of fundamental investors. We have some tools to assist in quantifying this, and it also reveals a changing composition of the marginal buyers to public equity: 2022 capped another year where passive US equity flows dwarfed that of active: $278 billion flowed into passive whereas $232 billion departed active US equity funds last year. Over the past decade, $1.8 trillion in total has left actively managed US equity funds. The total AUM snapshot at year-end 2022 favored passively managed US equity at record disparity to active, with passive funds having amassed $6.3 trillion compared to active’s $4.6 trillion. We also know a record number of options contracts traded last year, making triple-witch days more eventful than any prior period. 

Target Rich Environment for Discounted Pricing

Coming off a year where 1,200+ issuers in the Russell 3000 Index experienced 50%+ drawdowns off their 52-week highs, 753 of whom went on to close the year at a >50% discount off that high, these conditions make it highly unlikely for 2023 pricing outcomes to pattern match any prior precedent. Yes, inverted yield curves are powerful prognosticators for recessions. However, we’d argue that this magnitude of indiscriminate selling—largely at the hands of an entirely different composition of algorithmic/passively focused players on the field—could make a solid portion of the likely economic recession reflected in the pricing levels of some (but certainly not all) issuers.

New Generation, New Lessons Learned

A whole new generation of investors has again been schooled on how 30-100x forward sales valuation entry points rarely, if ever, pencil out to being attractive returns over any reasonable holding period. However, now many of these 30-100x names now trade 3-16x, and some issuers in the cohort have gotten religion on the need to prove cash flow generation potential. Vista Equity Partners’ $2.6B bid this month for Duck Creek Technologies [DCT] at 6.5x EV/sales, and Thoma Bravo’s $8.0B bid for Coupa Software [COUP] at 7.6x last month act as tangible reminders of how valuation floors can occur, especially in software.

Boots-on-Ground Observations

Tying in observations from our recent due diligence meetings, we have increased confidence that the wholesale indiscriminate selling we experienced in 2022 has entirely dismissed many opportunities that will yield meaningful value creation. Coming away from our Consumer Electronics Show meetings, we see a clearer runway for uptake on the undeniable trend of higher semiconductor and software content into the automotive sector over the next decade and beyond. We go into greater detail in the discussion of one of our top contributors in our quarterly, but we are on the cusp of specific opportunities penciling out to meaningful revenue and profits starting next year.

Latest Reads on 2023 Business Outlooks

Countless opportunities exist where price levels suggest issuers have been left for dead despite improving operating environments. Netflix’s [NLFX] recent quarterly print is one such case, and it represents a reminder of how falling victim to indiscriminate selling doesn’t require a company to dispel every existing bear case thesis. We are still very early on NFLX’s model transition to an ad-supported pricing tier, and we don’t have perfect clarity of how its password-sharing clampdown will ultimately impact churn and ARPU. However, these questions didn’t require answers for the stock to recover over 100% off its May 2022 bottom, especially as a multi-year transition towards scale that begets meaningful cash flow generation begins to take hold.

Download our entire SWS Growth Equity quarterly update here:

PDF version | Audio version


Investment advisory services are offered through SWS Partners, LLC (“SWS”). SWS is an investment adviser registered with the Securities & Exchange Commission. Registration as an investment adviser does not imply any particular level of skill or training. All opinions and views mentioned in this report constitute our judgments of the date of writing and our opinions are subject to change at any time. We will not advise you as to any changes in figures or views found in this report in the future. Investing involves risk of loss and the investment return and principal value of portfolios under our management will fluctuate as the stock and bond markets fluctuate. Past performance is not indicative of future results.