The Chart Below Shows:

  • the market cap of just software stocks valued at over 10x price to sales is over $6 trillion
  • that means that software stocks priced at preposterous levels are now worth ~30% of US GDP
  • KCR thanks Scott McNealy for using Sun Microsystems history to make investment decisions on stocks valued like this simple

Summarily: when you have to move away from price to book or price to earnings ratios because they are negative or so high they don’t make sense, piling into a company at 10x price to sales based on grand promises in the future is probably a suboptimal decision. To see the mirror image of this, please see our research on what we believe are the outsized opportunities for GARP investors.

10x Price to Sales Ratio Market Cap of Software Stocks Priced for the Implausible

We would like to give our sincerest thanks to legendary investigative reporter Herb Greenberg for asking us to build this chart. Seeing that the market capitalization of software stocks floating on valuation metrics that have failed every historical sanity test is north of $6 trillion was eye-opening. Certainly, we would not have thought to do this.

We would also like to highlight the ever brilliant Lu Wang’s article on software stocks where she quotes Michael Purves of Tallbacken Capital as saying “To pretend that every stock is really exciting and is going to be the next Google is kind of absurd” – a sentiment we brought the empirical data to in our piece “Who is the Next Amazon?

Please see the chart below to pound the point home just a tad further. The percentage of the market cap of software stocks trading over 10x price to sales has just hit 80%. A number last seen at the peak of the dot.com mania.

Market Cap of Software Greater Than 10x Price to Sales Represents 80 of the Total Software Industry

High Ratio vs. Low Ratio: Is it “different this time”?

As so many famous investors like Seth Klarman, Andrei Shleifer, Galbraith, and historical fiascos like Enron have documented and proven, every mania goes through a period where people start to say high valuation ratios don’t matter. There is always an excuse.

A stock’s share price is not, in our view, an accurate reflection of a company’s value. We believe market prices are wildly inefficient. There are over 100 software stocks that meet the manic criteria described above.

Let’s thin the list out and compare the most fragile companies. The first row in the table below is software stocks over 10x P/S that also burn cash. This cash burn is often after massive add-backs for stock compensation. The second row is the broad market.

The first row in the table below shows that these cash-burners are trading at 25x sales. Even more remarkable is their -4% Total Yield. Investors are subsidizing these stocks’ to the tune of -4% a year, which dwarfs the dilution we explained in our piece comparing ARKF’s negative yield to the XLF dividend.

KCR Believes Overpriced Software Burning Cash Charging Owners Appear Very Risky

A good price-to-sales ratio depends on the company’s underlying fundamentals. A low price-to-sale ratio does not mean a company is a bargain. For those looking for cheap stocks with dividends or high-quality stocks with long histories of safely compounding wealth, or growth stocks trading at reasonable prices, the bubble today provides some terrific opportunities in our view.

In contrast, we believe the stocks below offer investors very weak risk/reward features going forward. A good price to sales ratio attached to a good company is, in our minds, a much better alternative!

Please view below our list of Software Stocks >10x Price to Sales that Burn Cash.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

January 28, 2022 |

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