The State of Software — Is Profitability the New Growth?

Theme and Background

This chapter focuses on the phenomenon of software industry valuation multiples plunging from historical highs over the past 5-6 months, examining whether this sell-off is driven solely by interest rate expectations or if fundamental changes have occurred. By analyzing cases such as RingCentral (RNG), the report questions the market's prevailing belief that "high-valuation stocks are the main driver of the decline" and examines whether investor preferences have shifted from growth to profitability.

Core Thesis

The author's core judgment is that the collapse in software industry valuations is not driven by fundamental deterioration but by a shift in investor preferences from "growth first" to "profitability first." The counterintuitive findings include:

• Despite valuation multiples halving, software companies' expected revenue growth rates have reached a 20-year high of 21%, and the Rule of 40 metric remains stable.
• High-valuation stocks (such as RNG) have indeed led the decline, but all software companies have been severely impacted, with stocks in the cheapest quintile also falling by 37%.
• Current valuations remain above historical averages, with remaining downside of 24-40%, suggesting the sell-off may not yet be over.

Key Arguments and Data

1. Valuation-Growth Decoupling: The median EV/Revenue multiple for the software industry has fallen from 8.8x to 4.7x, yet expected revenue growth rates have risen to 21% (a 20-year high), and gross margins remain stable in the 69%-75% range. While EBITDA margins have continued to decline, the Rule of 40 metric is within normal range.

2. RingCentral Case: RNG's expected revenue growth is approximately 26% (near historical highs), but its valuation multiple has dropped 80% from its peak, indicating that the sell-off is not entirely driven by fundamentals.

3. High-Valuation Stocks Lead Declines but Are Not the Sole Cause: Historical data shows that "high-flying" stocks (30x+ revenue) saw valuation multiples surge from 4.5-7.0x before 2017 to over 30x by mid-2021, then fell 58%; the cheapest stocks (<2.0x) also declined 37%. All quintiles still have 24-40% downside from historical averages.

Quintile	Peak Multiple	Current Multiple	Decline from Peak	Downside to Historical Average
Most Expensive (High-Flyers)	30x+	~12.6x	58%	24%
Cheapest	2.0x+	~1.26x	37%	40%

4. Profitability Dominates Performance: From 2020-2021, high-growth/low-profitability stocks outperformed low-growth/high-profitability stocks by 91%. However, the trend reversed over the past 12 months; from November 2021 to January 2022, high-profitability/low-growth stocks cumulatively outperformed by 33%.

Companies/Assets Involved

• RingCentral (RNG): As a representative of high-valuation stocks, expected revenue growth is approximately 26%, but the valuation multiple has dropped 80% from its peak. The author notes that it may be affected by concentrated holdings of large growth funds and concerns about competition from Microsoft/Zoom, but the overall trend is representative of the industry.

• Oracle/Microsoft: As mature software giants, their high profitability margins are used as benchmarks for comparison. The market may believe that current software companies' terminal margins will be lower than those of these giants.

Investment Implications

• Beware of Valuation Reversion Risk: Software valuations remain above historical averages, with significant remaining downside (24-40%), so investors should not easily conclude that the sell-off is over.
• Focus on Profitability Signals: The market has clearly shifted to favor profitability over growth. Investors should prioritize companies where profitability contributes more to the Rule of 40, rather than purely pursuing revenue growth.
• Assess Management Responses: If companies continue to pursue "growth at all costs" strategies (e.g., heavy cash burn), their valuations may face further pressure. The author prefers companies that balance growth and profitability, as high valuations combined with high cash burn make downside risk difficult to assess.

• Structural Industry Changes: The software industry's transition to a subscription model has improved revenue visibility, but intensifying competition and capital inflows may limit long-term margins. Investors need to independently judge which companies can achieve sustainable profitable growth.

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Theme & Background

This section focuses on structural divergences within the software sector, examining whether the massive excess returns of high-margin/low-growth software stocks relative to other types of software stocks are nearing an end. The author believes that the current market's excessive preference for profitability may be creating a new imbalance, and future returns are likely to become more balanced.

Core Thesis

The author's key judgment is that the relative strength of high-margin/low-growth software stocks may soon end, and future returns in the software sector will be more evenly distributed, favoring companies that strike a balance between profitability and growth. This is a contrarian view—the market currently shows a clear preference for high-margin, low-growth firms, but the author argues this extreme divergence is unsustainable.

Contrarian judgments include:

• Despite software valuations having crashed to 20-year lows, the author believes there is still more than 20% downside risk, and this possibility cannot be ruled out.
• Large hedge funds are heavily concentrated in a handful of software stocks, which could trigger further "de-grossing" sell-offs.
• The author has already significantly reduced software exposure (from 40% to single digits), but if high-quality software stocks fall another 20%, the author would view that as an overcorrection and substantially increase the position.

Key Arguments & Data

The author supports the thesis through their own historical positioning adjustments and current market structure:

Metric	Data
Peak software position (early 2021)	~40%
Current software position	High single digit %

Author's estimated further downside	20%+ (cannot be ruled out)
Condition for substantially adding positions	High-quality software stocks decline another 20%

The author's core logic chain:

1. Position concentration risk: Large hedge funds are concentrated in a few software stocks; de-leveraging could trigger a cascade of selling.

2. Valuations have already corrected significantly: The author has avoided most of the losses through position reduction, and current valuations are "more fairly valued."

3. Overcorrection opportunity: If high-quality software stocks fall another 20%, the author would view it as an "overcorrection" because the industry's fundamentals remain sound.

Companies/Assets Involved

This section does not mention specific company names but analyzes the industry as a whole and "high-margin/low-growth software stocks." The author implicitly bears a bearish view on the currently market-favored high-margin/low-growth software stocks and a bullish view on software companies that balance profitability and growth.

Investment Implications

• Beware of a reversal in the relative strength of high-margin/low-growth software stocks: The current market's excessive chase of such companies may be nearing its end; investors should avoid chasing highs.
• Focus on balanced software companies: Future returns will be more even; companies with both reasonable growth and profitability may outperform.
• Keep cash on hand for opportunities: If high-quality software stocks fall another 20%, it could constitute a buying opportunity, but for now, investors should remain vigilant about further downside risk of more than 20%.
• Watch out for sell-off risks from concentrated hedge fund holdings: De-leveraging by large funds may amplify short-term volatility, and investors should avoid betting against these crowded trades.