For the first time in 4 years, profitability beats growth

For the last decade, private company executives have all asked us the same question: “Do public market investors prefer profitability or growth?” While the answer to that question is not simple, the recent trends in the data are clear.

In 2021, profitability — measured by free cash flow (FCF) margins, not revenue growth — had the higher correlation to positive stock returns in the software sector. This broke a four-year trend of revenue growth being the more important driver of software company stock performance.

This correction is big. And the reversal in investor sentiment is clear.

In addition to deviating from the four-year trend, the data shows profitability correlation hit a seven-year high at the end of last year, while revenue growth correlation was close to a seven-year low. With the continued selloff, revenue growth correlation broke well below the seven-year historic low, and profitability correlation stayed at record highs, as shown below.

What’s happening?

So far in 2022, the S&P 500 and Dow Jones have significantly outperformed the tech-heavy Nasdaq. Additionally, a number of recent high-profile/high-growth/unprofitable IPOs have broken IPO price (Hashicorp, Sweetgreen, Rivian Automotive, Rent the Runway, etc.).

The Bessemer Emerging Cloud Index (made up of prominent SaaS companies) is down over 30% from its November 2021 peak, while some high-multiple names like Cloudflare and HubSpot are down about 50% from their peaks. Broad SaaS valuation multiples over the same period have adjusted from a peak of about 17.5x NTM EV/Rev in November 2021 to about 10.5x.

Investors are “rotating” out of high-growth/high-multiple software names into sectors like finance (banks) and insurance, which benefit from rising interest rates. Also, it is important to note that big, slower-growing, more profitable tech stocks like Microsoft, Google and Facebook have corrected, but to a much smaller degree.

This shift has been fast, resolute and extreme.

Why are investors selling high-growth stocks?

Interest rates are increasing

Inflation is rising, which led the U.S. Federal Reserve to signal three or four interest rate hikes in 2022, which has caused the 10-year treasury yield to rise from about 1.5% in the beginning of the year to about 1.9% today, an around 40bps increase. As interest rates go up, investors focus more on profitability (or a derivative of profitability; Rule of 40 or Magic Number).