Software and Services

Dear client, We will not be publishing the US Equity Strategy next week, as I will be participating in BCA Investment Conference. We will return to our regular publishing schedule on September 19, 2022. Kind Regards, Irene Tunkel   Executive Summary Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes In today’s sector Chart I-pack report we recap our structural investment themes. EV Revolution: The EV cohort benefits from a structural transformation of the automobile industry that is further supported by favorable legislative tailwinds, and shifting consumer preferences. Generation Z: Generation Zers are coming of age and wield an increasing influence over consumer trends. Cybersecurity: The pandemic-driven shift to remote work, broad-based migration to cloud computing and increasing geopolitical tensions, are all structural forces that will ensure a healthy demand pipeline for cybersecurity companies. Green And Clean: Green energy is becoming cheaper to produce, which supports a wider adaptation of green technologies. Green tech also enjoys favorable legislative tailwinds that are coming on the back of rising geopolitical tensions, the ongoing energy crisis, and climate change action. Renewables help to diversify energy sources and offer a path towards energy security. Bottom Line: Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities for investors who can stomach short-term volatility. Feature This week we are sending you a Sector Chart I-Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will overview recent equity performance and provide a recap of the US Equity Strategy structural investment themes. August – When The Rally Came To A Stall As we predicted in the “What Will Bring This Rally To A Halt?” report, the “inflation is turning, and the Fed will be dovish” rally has come to a screeching halt. The S&P 500 was down 8% in August as investors finally believe that Jay Powell’s Fed is hell-bound on extinguishing inflation even if it means squelching economic growth (Chart I-1). The message from Jackson Hole was very much Mario Draghi-like: “whatever it takes.” The market reaction was swift and brutal. The rally winners were in the epicenter of the sell-off that ensued on the back of Powell’s comments. Invesco QQQ Trust is already down nearly 9% off its August 16 peak, while Ark Innovation (ARKK) is down 13% (Chart I-2).  We expect that equities will continue to revert to their pre-summer lows. Chart I-1Summer Rally Winners Are At The Epicenter Of The Sell-off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-2Most Thematic ETFs Are Far Off Their Pandemic Peaks Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes With rates on the rise again, last week we shifted our overweight of Growth and underweight of Value to a neutral allocation. The last few months have been a rollercoaster. However, long-term investors may successfully survive the grind by resolutely sticking to some of the winning structural investment themes and ignoring short-term volatility. The fact that many themes are now more than 50% off their pandemic highs may indicate an opportune entry point. EV Revolution We initiated the EV Revolution theme in June 2021. Since then, the theme has outperformed the S&P 500 by 19%. The Auto and Components industry group is in the middle of a momentous transition to electric and autonomous vehicle manufacturing, thanks to technological advances in battery storage, AI, and radars. These technological breakthroughs help overcome most of the obstacles to the wide adoption of EVs. Multiple new entrants develop charging networks. Driving ranges are also rapidly increasing – Lucid promises a 500-mile range compared to Tesla’s 350. Couple that with the rising price of gas, the aging vehicle fleet, and the expectation that EVs will approach sticker parity with gas-powered cars as soon as 2023 (Chart I-3)  and there is no turning back to gas-guzzling vehicles. LMC Automotive forecasts that by 2031, EVs will reach 17 million units. Chart I-3EVs Will Reach Price Parity With ICEs In 2023 Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes The entire EV cohort also benefits from favorable legislative tailwinds, thanks to this administration’s support of decarbonization. The Inflation Reduction Act (IRA) includes approximately $370 billion in clean energy spending, as well as EV tax credits for both new and used cars. In addition, executive action by President Biden has tightened fuel economy standards. California has mandated a complete switch to EV vehicles by 2035. The surge in EV Capex and R&D spending will boost the entire supply chain, which consists of chip manufacturers, battery and lidar R&D, part manufacturers, and charging networks. Many of these companies are still small. An ETF may be the best way to capture the theme (Table I-1). Table I-1EV/AV ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Generation Z: The Digital Natives The GenZ theme, which we identified exactly a year ago, has collapsed since the beginning of the market downturn and is down 47%. Its success was at the root of its demise – it captured overcrowded names most popular among GenZers, who are avid investors (Chart I-4). However, the theme is not “dead,” as a new cohort of Americans is coming of age, and they are not shy about it. Generation Z in the US includes 62 million people born between 1997 and 2012 (Chart I-5). With $143B in buying power in the US alone making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. Chart I-4Gen Zers Are Avid Investors... Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-5Gen Zers Are Taking Over Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Gen Z is an umbrella theme that captures many other prominent themes, such as Fintech (Paypal & Social Finance), Crypto (COIN), Meme-investing (HOOD), Gaming and Alternative Reality (GAMR & ESPO), and Online Dating. But GenZers have a few behavioral quirks that make them different even from Millennials: Quality-Over-Price Shoppers: Gen Z was found to be less price sensitive when buying products, choosing quality over price. Lululemon (LULU) and Goose (GOOS) are among Gen Z’s favorites. Healthy Lifestyle: Gen Z is a “green” generation that deeply cares about the planet, loves the outdoors and traveling, and is crazy about pets. This is also a generation that prizes a healthy lifestyle and working out: Beyond Meat (BYND), Planet Fitness (PLNT), and Yeti (YETI). Generation Sober Chooses Cannabis: GenZers perceive hard liquor and tobacco as bad for their health. Curiously, marijuana is considered “healthy.” MSOS, CNBS, YOLO, and THCX are the biggest ETFs in this space. How To Invest In Gen Z? Gen Z is a nascent investment theme, so there are no ETFs available in the market yet. We propose that investors follow our Gen Z investment themes or replicate fully or partially our Gen Z basket. Cybersecurity: A Must-Have For Survival Despite its celebrity status, this is an industry that is still in the early innings of a growth cycle. The pandemic-driven shift to remote work, broad-based migration to cloud computing, development of the internet-of-things, and increasing geopolitical tensions create new targets for hackers who are after valuable data or just want to achieve maximum damage to the networks. Ubiquitous digitization requires increasingly more complex cyber defenses. With cybercrime costing the world nearly $600 billion each year and cyberattacks increasing in number and sophistication, the global cybersecurity market is expected to grow from $125 billion in 2020 to $175 billion by 2024. Both large and small businesses are yet to fully implement cybersecurity defenses. According to a survey by Forbes magazine, 55% of business executives plan to increase their budgets for cybersecurity in 2021 aiming to prevent malicious attacks. In response to the numerous breaches, the current US administration is placing a high priority on defensive cyber programs. Since 2017, US government departments have seen the cybersecurity share of their basic discretionary funding rise steadily from 1.38% to 1.73%. These developments are a boon for cybersecurity stocks (Chart I-6 & Chart I-7 ), the sales of which are soaring (Chart I-8). Chart I-6Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Cybercrime Losses Spur Demand for Cybersecurity Chart I-7Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Stepped Up Government Spending Will Lift Cybersecurity Stocks Chart I-8Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring Cybersecurity Sales Are Soaring We introduced cybersecurity as a structural investment theme back in October 2021. So far, the CIBR ETF, which we use as a proxy for the performance of the theme, has underperformed the S&P 500 by 11%. Monetary tightening has weighed on the performance of these companies as they tend to be younger, smaller, and less profitable than their S&P 500 counterparts, i.e., CIBR has a strong small-cap growth bias. However, with cybersecurity stocks down 26% off their November-2021 peak and valuation premium back to earth, now may be an opportune moment to add to the theme. After all, these stocks have tremendous growth potential, warranting a long-term position in most equity portfolios. There are several highly liquid ETFs powered by the cybersecurity theme, such as CIBR, BUG, and HACK, which can be excellent investment vehicles (Table I-2). Table I-2Cybersecurity ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Green And Clean We introduced the “Green and Clean” theme back in March. Since then, it has outperformed the S&P 500 by 22%, benefiting from this administration’s focus on the mitigation of climate change. Putin’s energy stand-off with Europe has also put the industry into the global spotlight. The development of renewables will help diversify energy sources and offer a path toward energy security. Thus, renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. The International Renewable Energy Agency (IRENA) expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract the lion’s share of investments. Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7% in 2000 to 10% in 2020 (Chart I-9). Chart I-9A Structural Trend A Structural Trend A Structural Trend The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year (Chart I-10). Renewables are similar to traditional utility companies: They require a massive upfront investment, but also enjoy substantial operating leverage. As production capacity increases, the cost of energy generation falls. Solar power generation is a case in point (Chart I-11). Hence, we have a positive reinforcement loop: more usage begets even more usage, bolstering the economic case for transitioning to cleaner energy resources. Chart I-10R&D Is Paying Off Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Chart I-11Capacity Is Inversely Correlated To Prices Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Increased renewables adaptation is possible thanks to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table I-3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table I-3Clean Tech ETFs Recap Of Long-term Investment Themes Recap Of Long-term Investment Themes Bottom Line Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities. However, these investments come with a warning: Technological innovation themes are intrinsically risky as they are rarely immediately profitable and require both continuous investment and technological breakthroughs to succeed. Also, most technological innovation themes carry high exposure to the small-cap growth style and are sensitive to rising rates and slowing growth. As such, they are fickle over the short term but pay off over a longer investment horizon.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-2Profitability Profitability Profitability Chart II-3Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-4Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-6Profitability Profitability Profitability Chart II-7Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-8Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart II-9C Macroeconomic Backdrop C Macroeconomic Backdrop C Macroeconomic Backdrop Chart II-10Profitability Profitability Profitability Chart II-11Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-12Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-14Profitability Profitability Profitability Chart II-15Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-16Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-18Profitability Profitability Profitability Chart II-19Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-20Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-22Profitability Profitability Profitability Chart II-23Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-24Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart II-26Profitability Profitability Profitability Chart II-27Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-28Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-30Profitability Profitability Profitability Chart II-31Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-32Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-34Profitability Profitability Profitability Chart II-35Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-36Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-38Profitability Profitability Profitability Chart II-39Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-40Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-42Profitability Profitability Profitability Chart II-43Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-44Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart II-46Profitability Profitability Profitability Chart II-47Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart II-48Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Recommended Allocation: Addendum What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up What Our Clients Are Asking: The Bear Market 2.0 Webcast Follow Up

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The Software and Services Industry is undergoing a fundamental transformation in its business model catalyzed by a momentous migration of software applications to the cloud and broad-based digitization of the economy. This shift is accompanied by displacement of the traditional on-prem license and support model with a more lucrative cloud-based subscription model.  While on-prem software sales are contracting, cloud revenue is growing in double digits. As a result, the industry enjoys spectacular margins and earnings growth. Its earnings have also proven to be resilient across the business cycle because software and IT services increase companies’ productivity in good times and bad. Rising rates are a headwind, but a temporary one. Margins Will Continue To Expand Margins Are To Continue Expanding Margins Are To Continue Expanding Bottom Line: The Software and Services industry group is an all-weather industry with resilient earnings and strong growth throughout the business cycle. It is also in the epicenter of technological innovation: Migration to the cloud and digital transformation enhance the industry’s growth and profitability.  We continue recommending both a tactical and a structural overweight. Feature Performance Technology stocks found themselves in the eye of this month’s market rout. After falling 19% from its peak, the NASDAQ is now firmly in correction territory. The Technology sector is down 11%, while the Software and Services industry group is down 10% (Chart 1). In the “Are We There Yet?” report published last week, we posited that it is not yet the right time to bottom fish: While the Technology sector appears oversold, macroeconomic headwinds from the imminent monetary tightening and a slowdown in demand for technology goods and services may prolong the pain. The interplay of valuations and fundamentals for the sector is not yet favorable. While we are underweight the Technology sector, thanks to our underweight positions in Semiconductors and Hardware and Equipment, we remain overweight Software and Services (S&S). In this report, we will conduct a “deep dive” into S&S and reevaluate our positioning (Table 1). Although S&S is down more than 10% from the peak,  it has outperformed the S&P 500 by 88% since 2011 (Chart 2). The million-dollar question we will try to answer is whether this outperformance continues over the tactical and structural time horizons. Chart 1Software And Services Outperformed Other Tech Industries Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 2S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years Table 1Performance Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Sneak Preview: We maintain our overweight of the Software and Services sector thanks to positive market trends, the all-weather nature of the industry, and resilient earnings. Industry Group Composition The Software And Services Industry Group Is Top Heavy The S&P 500 Software and Services industry group is the largest in the Technology sector and is 48% of the sector market cap. The industry group is split between Software, which is about two-thirds of its market cap, and IT Services, which is one-third (Chart 3). Just like other technology industries, it is dominated by one of the FAANGs+M, Microsoft in this case, which makes up 42% of the industry group index weight. The top 10 constituents out of 36 comprise 80% of the industry’s weight (Table 2). During the current pullback, the S&S industry group has fallen by more than 10%, cushioned by the performance of its larger players. But this masks the pain of the smaller and less profitable constituents, which have fallen by more than 30% (Chart 4). Chart 3Software Dwarfs IT Services Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 4Some Smaller Constituents Have Fallen More Than 15% YTD Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Table 2S&S Industry Is Dominated By A Handful Of Successful Companies Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud However, market dominance runs much deeper than just market capitalization: Microsoft, Adobe, Salesforce, and Oracle account for 87% of the Software Industry revenue, while Visa, Mastercard, Accenture, and PayPal generate 42% of the IT Services industry revenue. Larger industry players are also more profitable thanks to the high operating leverage the industry enjoys. Clearly, just a few companies drive sales and earnings growth, valuations, and performance. On the bright side, these are some of the most successful US technology companies, and their size is their competitive moat. We believe that the industry group is in “good hands.” Key Trends Cloud Migration Following the success of offshoring the US manufacturing base to China that allowed corporations to reduce labor costs, companies are now experimenting with outsourcing other key infrastructure elements. This time, however, the migration is happening to digital cloud platforms. Instead of investing in pricey servers and other hardware assets, corporations have the choice of going with Software-as-a-Service (SaaS), Platform-as-a-Service (PaaS), or Infrastructure-as-a-Service (IaaS) solutions offered by the tech titans. Not only are cloud solutions more cost-effective, but they also offer the convenience and flexibility to scale corporate hardware infrastructure by simply purchasing more or less computational power. COVID-19 lockdowns and the migration of the white-collar workforce towards remote work have motivated companies to transition their technology and operations to the cloud, and have acted as a catalyst for “digital offshoring.” Digital Transformation Digital transformation is in many ways similar to cloud migration. Essentially, it represents broader software penetration into the US economy. Whether it is a manufacturing production or customer relationship management process, wider adoption of software allows for a more efficient business solution via automation and process optimization. Airbnb and Uber are the poster children of digital transformation. While some industries have already undergone digital transformation, there are notable areas which lag behind. For instance, banks’ failure to modernize their digital infrastructure to speed up transactions and to increase overall user convenience has arguably led to the development of the crypto space as an alternative to the slow-evolving traditional financial institutions. The broader implication is that there are still major sectors in the economy that are yet to ramp up automation and increase efficiencies via digital transformation, meaning that there is a healthy demand pipeline for the tech companies. Types Of Software And Services Companies Software: Migration To The Cloud Is A Key Driver Of Growth In the past, classifying software companies was a relatively straightforward exercise: They were divided into system software vs. application software. System software included such categories as operating systems for PCs, and other hardware and database software. Application software covered Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), Communications and Collaborations, etc. However, over time, the industry landscape has changed, first by the mergers that blurred the distinction across these lines, and lately, thanks to ubiquitous migration to the cloud model and digitization of the economy. Therefore, it is most practical to classify software companies by their type of business model, i.e., legacy license and support model, or cloud-based, or hybrid.  Pure cloud-first: These companies derive 100% of their sales from the cloud model – Salesforce.com (CRM), ServiceNow (Now), and Twilio (TWLO) are among the biggest winners. Cloud/license hybrid: These are companies that derive 50%+ of their sales from the cloud, such as Microsoft (MSFT), Atlassian (TEAM), Autodesk (ADSK), and Adobe (ADBE). Legacy license and support model (aka On-Premises): Constellation Software (CSU), Citrix Systems (CTSX) – these companies are likely to struggle to grow organically. Types Of Cloud Application Services The cloud-based business model in turn can be classified under three different types of service: Software-as-a-Service (SaaS), Infrastructure-as-a-Service (IaaS), or Platform-as-a-Service (PaaS). Software-as-a-Service: Customers configure and access a web-based application operated by a SaaS provider over the internet. Salesforce.com, Workday (DAY), ServiceNow, and Oracle are some of the most established players. Infrastructure-as-a-Service: This service gives customers access to virtual storage and servers over the internet, enabling them to develop and run any application just as if it were running in their own data center. Amazon’s AWS, Microsoft’s Azure, and IBM are the key competitors in this space. Platform-as-a-Service: This service occupies a middle ground between SaaS and IaaS, i.e. between a full-fledged app that can be used “out-of-the-box” and a “raw server and storage” instance, making the customer responsible for installing and configuring its own “full stack.” PaaS offerings tend to be less standardized. Salesforce.com, Microsoft, and Oracle are the leaders. IDC projects the continued strength of this segment and expects it to grow at an annualized rate of 29.7% over the next five years. The following table from Microsoft presents a perfect explanation of the different software service models (Table 3). Table 3Differences In Cloud Computing Service Models Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud License And Support Vs. Cloud Subscription Model Growth Rates Broad-based migration to the cloud is shifting the industry’s revenue composition, with accelerating bifurcation between cloud and on-prem models: Cloud subscription revenue is replacing the traditional license and support model. As a result, legacy on-prem revenue has recently been contracting, and once the last of the legacy enterprise applications are retired, it will be fully replaced by cloud revenue. According to estimates by CFRA,1  the software industry grew by 4% in 2021, with a 22% year-on-year increase in cloud subscription revenue, which now constitutes 37% of total industry revenue, and a 3% decline in traditional software revenue. The surge in cloud growth is likely to continue, thanks to the accelerating pace of digital transformation. This trend is also promulgated by some of the largest players, such as Microsoft, whose cloud subscription revenue now constitutes more than half of the overall revenue and is an engine of growth in the software space. Strong cloud revenue growth is not just a function of recruiting new users but is also supported by the proliferation of new cloud apps and upgrades to the existing ones.  Importantly, the cloud subscription model is also more profitable than the license model, whose EBITDA margins rarely exceed 40%. Cloud-based services take longer to become profitable but have much higher operating leverage: Once profitable, cloud and hybrid companies often have operating margins around 50-60%.  Software is one of the most resilient technology industries, performing equally well in a growing economy and during downturns: Subscription pricing is sticky, and switching costs are high. As a result, companies, which derive a large share of their revenue from the cloud, have stable and predictable sales. Once clients are onboarded, cloud providers may also be able to exercise their pricing power. IT Services IT services is a smaller segment of the Software and Services industry group and is a hodge-podge of different companies that provide a wide range of services from IT consulting to FinTech. The following is a brief description of the key categories: IT Consulting: The S&P 500 IT Consulting companies are Accenture, Gartner, and Cognizant.  Companies offer Professional advice in IT, management, HR, logistics, and many others. Since the pandemic, these companies’ key focus is on assisting their clients with digital transformation and improving companies’ operations. This industry is one of the key beneficiaries of accelerated migration to the cloud and has enjoyed exponential growth over the past decade. Its revenue stream is highly resilient, as even during economic downturns, clients are seeking advice on the best ways to navigate an uncertain market environment. Outsourcing: Companies such as ADP and Paychex provide HR and business services solutions for mid-sized and small companies. Their services cover payroll, benefits, retirement, and insurance services.   This industry has been growing its sales and profits at a healthy clip over the past few years. Now it is focused on modernizing itself by moving its own operations to the cloud and deploying Artificial Intelligence to improve operations. These companies are also undergoing digital transformation and are moving towards the SaaS model. Financial Transaction Services: This is a FinTech industry that includes card and payment processors, such as Visa, Mastercard, and PayPal, and each of these players operates their own proprietary payment networks.  Digital payments and the wide acceptance of e-commerce drive this space. Lately, these companies have been at the forefront of the adoption of digital currencies as viable payment options. Payment companies are among the earliest adopters of the cloud, and their business model is best described as Transaction-processing-as-a-service. These are highly profitable companies that consistently generate an operating margin above 60%. Key Industry Drivers Software Enhances Productivity And Improves Profitability Broadly speaking, the Software and Services industry group is considered a defensive holding owing to the resiliency of its earnings (Chart 5). Software enhances productivity: During economic downturns, it helps reduce costs, and during expansions, it helps overcome capacity constraints and labor shortages. While pandemic labor shortages and lockdowns produced a spike in productivity, more recently it has been falling, which has warranted a year-over-year increase in software investment (Chart 6). Chart 5S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle Chart 6Investing In Software Improves Productivity Investing In Software Improves Productivity Investing In Software Improves Productivity Further, both labor shortages and rising wages are prompting companies to redesign their operations to contain costs and preserve margins. To do so, many are accelerating investments in Capex and automation, much of which is achieved through investment in software and IT services, replacing both labor and capital.  According to CFRA, “software is no longer used to manage a means of production, but rather IS means of production .” Software-related Capex is not only garnering a larger slice of tech spending budgets but also of the overall Capex pie (Chart 7). Chart 7Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Macroeconomic Backdrop Imminent Rate Hikes Tighter monetary policy and runaway inflation are at the fore of investors’ minds and, arguably, a cause of the current market rout.  Software stocks have outperformed the other long-duration technology stocks. To gauge the reaction of S&S to the upcoming rate hike, we have repeated an exercise we conducted for the Technology sector last week – historical performance of the industry six months before and after the first rate hike (Chart 8).   Clearly, industry returns fall two to three months before the first rate hike, but eventually recover once a new monetary regime is priced in. The year-to-date correction of the software stocks is textbook behavior. Chart 8S&S Underperforms Before The First Rate Hike Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Software And Services Is A Global Industry – Beware Of A Strong Dollar The Technology sector is one of the most global sectors in the S&P 500 and derives 40% of sales from abroad; similarly, Software and Services has a broad international footprint. As US rates trend higher, and the interest rate differential favors the US vs. other countries, the USD is likely to appreciate further. With a stronger dollar, products of US software firms are more expensive to foreigners, which may have a dampening effect on demand. The US firms’ profitability has also been hit by an unfavorable translation from foreign currency back to the USD. Historically, the path of the dollar and the returns of S&S were inversely correlated (Chart 9). Chart 9Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry The redeeming grace is that, as we mentioned before, software subscription revenue is sticky, and switching costs for customers are high. As such, we expect the adverse effect on demand to be minor. Fundamentals Sales Growth According to Grandview Research , the business software and services market is expected to grow at a compound annualized rate of 11.3% from 2021 to 2028. This strong growth is underpinned by the robust pace of enterprise application cloud migration and digital transformation, which see no end in sight. The street expects the Software and Services industry to grow on par with the Technology sector at just under 20% over the next 12 months, and growth is slowing off high levels.  The pandemic has shifted forward some of the spending on software, as companies rushed to adjust to remote work.  However, the industry continues to grow at a healthy clip (Chart 10). Chart 10Sales Growth Is Slowing Sales Growth Is Slowing Sales Growth Is Slowing Labor Costs Are Contained For Now The S&S companies first and foremost rely on the talent and ingenuity of their workforce to deliver cutting-edge technological solutions. Wages are one of the largest expenses in the industry. Recent increases in salaries accompanied by labor shortages and “the great resignation” are bound to cut into the margins of these companies. So far, software and services companies have been able to counter the trend (Chart 11) by deploying creative solutions, offering their employees a wide range of perks, and throwing their net wide in search of talent by offering remote work.   Chart 11Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Resilient Earnings Growth For the reasons discussed above, S&S earnings growth is remarkably resilient and stable throughout the business cycle (Chart 12). Currently, earnings expectations of S&S over the next 12 months exceed growth expectations for both the Technology sector and the S&P 500. Over the next 12 months, S&S earnings are expected to grow at 14% compared to 8.6% for the S&P 500 (Table 4). Chart 12S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 Table 4Earnings Growth Vs. Valuations Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Despite the slowdown in sales growth and the pick-up in labor costs, EBITDA margins have exceeded the previous peak, and are projected to trend higher towards 40% over the course of the year (Chart 13). Expecting a growth slowdown, analysts have been revising earnings expectations down for S&S companies, but by now the downgrading process has run its course, and the bar is set low (Chart 14). Chart 13Margins Will Continue To Expand Margins Will Continue To Expand Margins Will Continue To Expand Chart 14Downgrades Are Bottoming Downgrades Are Bottoming Downgrades Are Bottoming   Valuations Since the S&S industry group’s earnings are expected to grow faster than the earnings of the Tech sector and the S&P 500, it is not surprising that it trades with a 44% premium to the S&P 500 on a forward earnings basis – a steep mark-up. The current correction has taken some froth off the industry’s valuations , with multiples contracting by 3.9 points. Even after the correction, the sector appears overvalued (Chart 15). Adjusting for expected 12-month EPS growth, S&S appears more attractively valued and trades with a discount both to tech and the broad market (Table 4). It is also important to note that the industry group is home to a plethora of quite a few smaller companies, which tend to be more expensive and more volatile: Chart 16 plots companies’ forward earnings multiples against their weight in the industry group.   Chart 15Valuations Are Still Dear... Valuations Are Still Dear... Valuations Are Still Dear... Chart 16Significant Valuation Dispersion Among The Constituents Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Technicals Recently, the BCA Technical Indicator has moved into the oversold territory, indicating investor capitulation. This means that this bar is cleared, and from a technical standpoint alone, Software and Services is a buy (Chart 17). Chart 17... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold Investment Implications We are both tactically and structurally bullish on the Software and Services industry group. Tactically Bullish The Software and Services industry group is an all-weather industry with an unprecedented combination of both earnings resiliency and strong growth throughout the business cycle. It is also undergoing a fundamental transformation in its business model catalyzed by a ubiquitous shift in software applications to the cloud, accompanied by displacement of the traditional on-prem license and support model with a more lucrative subscription model. The industry is expected to grow earnings in double digits and expand margins, unhindered by rising labor costs. Rising rates are certainly a headwind, but hopefully a temporary one. Froth has come off valuations, and a new monetary regime is gradually getting priced in. According to the technical indicator, the sector is oversold. On balance, we have a positive outlook on the industry group (Table 5) and maintain our overweight position. Table 5Software And Services Scorecard Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Structurally Bullish Our long-held belief is that the broader push to the cloud, augmented reality, AI, cybersecurity, and autonomous driving, which are all software dependent, are not fads but are here to stay. Software and Services are at the epicenter of technological innovation and are home to some of the best American companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     CFRA, Industry Surveys, Software, July 2021 Recommended Allocation

Strong Connnection Strong Connnection Overweight The juggernaut trend in the US software & services industry is as strong as ever, and today we are reiterating our overweight call for this large sector. First, within the context of our recent recommendation to rotate into growth, software & services stocks are quintessential growth companies that outperform during periods of a growth slowdown and benefit from rate stabilization. Second, the US private fixed investment in software is going to the moon with the latest print making a 20-year high (top panel). There is no doubt that all this capex will boost both top-line and bottom-line growth. Finally, software & services earnings growth expectation data is also revealing. Sell-side analysts have completely thrown in the towel on software companies with relative forward earnings probing dotcom and GFC era Mariana Trenches (bottom panel). Bottom Line: Secular software & services growth story remains intact and we reiterate our overweight recommendation for this key sector.  

Cyclical Software Theme Is Intact Cyclical Software Theme Is Intact Overweight Our long-held view that digitalization of the economy is still in the early innings remains intact, and hence we reiterate our cyclical (and structural) preference for software companies. The recent pullback in the relative share price ratio also offers a compelling entry point for investors to further augment their overweight stance. Importantly, generationally low interest rates along with ample software companies’ free cash flow has emboldened the industry to embark on a new M&A frenzy that effectively reduces the supply of stocks available to investors and pushes prices higher (top panel). Already, the average M&A premium paid is probing new highs since the GFC at the same time as the actual count of deals is going through the roof. Both of these dynamics bode well for the future earnings power of software stocks. As a reminder, we are currently employing a barbell portfolio strategy within the GICS1 technology sector by preferring defensive software- and services-related stocks over more aggressive hardware and equipment equities. Bottom Line: Stay overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL.  

While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Shades Of 2003/4? Shades Of 2003/4? Chart 2 Shades Of 2003/4? Shades Of 2003/4? As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Appendix Appendix Chart A2 Appendix Appendix Chart A3 Appendix Appendix Chart A4 Appendix Appendix Chart A5 Appendix Appendix Chart A6 Appendix Appendix Chart A7 Appendix Appendix Chart A8 Appendix Appendix Chart A9 Appendix Appendix  

Overweight The Software Juggernaut Is Intact The Software Juggernaut Is Intact We remain on the sidelines with regard to the broad S&P technology sector, but we continue to recommend a barbell portfolio approach preferring defensive software and services stocks to aggressive hardware and equipment equities. In that light, we reiterate our overweight stance in the key S&P software sub-industry that still commands the highest market cap weight in the tech sector, just shy of 33%. While the overall capex data is sluggish, software capital outlays have recovered smartly and according to national accounts are growing at a 10%/annum pace. Stock market-reported capex confirms that software capital expenditures are on an absolute tear and remain a key pillar of our secular preference for this defensive tech group (see chart). True, there is an element of stealing revenues from the future, but as long-time readers of our publication know we do not believe that SaaS is a fad and the adoption of cloud services remains in the early innings, which will continue to underpin the S&P software index. Bottom Line: Continue to overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. For more details, please refer to this Monday’s Strategy Report. ​​​​​​​

Dear client, Next week instead of our regular Strategy Report we will be sending you a Special Report from BCA’s Equity Analyzer service on Inflation and Factor investing penned by my colleague Lucas Laskey, Senior Quantitative Analyst. Finally, on February 22 we will be hosting our quarterly webcast one at 10am EST for North American and EMEA clients and one at 8pm EST for Asia Pacific, Australian and New Zealand clients “From Alpha To Omega With Anastasios”. Mathieu Savary, who heads our Daily Insights service, will be our special guest in the morning webcast. On March 1 we will resume our regular publication schedule. Kind Regards, Anastasios Highlights Portfolio Strategy China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Continue to overweight the S&P software index.  Recent Changes Last Tuesday we closed out our VIX futures hedge for a gain of 19% since the December 7, 2020 inception. Last Wednesday we re-initiated our long “Back-To-Work”/short “COVID-19 Winners” pair trade. Feature Equity volatility settled down last week following a ferocious ten-day SPX oscillation that sent the VIX soaring to roughly 38 near the peak at the end of January, courtesy of the GME/Wallstreetbets (WSB) saga before collapsing back down near 21 last week. Chart 1 shows that this was likely an equity-only event: both risk off currencies – the yen and the franc – actually fell versus the USD, junk bond spreads barely budged and the vol curve violently inverted, a move that more often than not signals that complacency has morphed into panic. Importantly, when the Fed embarks on active QE the SPX drawdown maxes out at 10% based on empirical evidence, including the recent September/October 10% drawdown. Using the ES futures low hit two Sundays ago, the S&P 500 experienced a 5.3% peak-to-trough pullback well within the range of previous Fed active QE iterations. As a reminder, the 2010 and 2011, 17% and 20% respective drawdowns took root after the Fed had concluded QE1 and QE2 operations. The implication is that for a more significant drawdown to materialize, likely the Fed has to end the current QE operation and reinject some volatility in the bond markets (bottom panel, Chart 1).  Isolating the true signal from all this noise, convinced us to book handsome gains to the tune of 19% in our VIX June futures hedge (conservatively assuming that no leverage was used), reinitiate the long “Back-To-Work”/short “COVID-19 Winners” pair trade and put the small cap size bias on our upgrade watch list. As volatility has slowly died down, investors can start to refocus on profit fundamentals. Similar to the steep fall in EPS that the SPX 35% drawdown predicted in March of 2020, in recent research we showed that were we to hold the SPX at current levels, its 12-month rate-of-change would surpass the 61% mark next month and forecast that profit growth would rise by a similar amount. Indeed, sell side analysts’ bottom up earnings estimates corroborate this analysis as quarterly EPS will peter out roughly at a 48% year-over-year (YOY) growth rate next quarter and vault to all-time highs in quarterly level terms in Q3 following a three-year hiatus (Chart 2). Chart 1Equity-only Event Equity-only Event Equity-only Event Chart 2Joined At The Hip Joined At The Hip Joined At The Hip Importantly, the tech sector no longer commands an earnings weight similar to its market cap weight likely because it’s run ahead of itself and also because the rest of the sectors are playing catch up this year as the US economy is slated to reopen on the back of the herculean inoculation efforts (profit weight and mkt cap weight columns, Table 1). Table 1Sector EPS And Market Cap Weights Re-grossing? Re-grossing? This is most evident on the sector contribution to this year's SPX earnings growth. Historically, the tech sector commanded the lion’s share of profit explanation for the SPX, but not in 2021. In fact, the S&P IT sector is ranked 4th in terms of contribution to overall SPX profits, behind industrials, financials and consumer discretionary (Chart 3).   Delving deeper into 12-month forward earnings growth figures is instructive. Table 2 shows our universe of coverage ranked first by GICS1 sector growth rates and then re-ranked per sub-group. As an aside the energy sector’s EPS is slated to contract in calendar 2020 and thus any YOY growth rate figures are rendered useless for the broad sector and the energy sub-industries. Chart 3Sector Contribution To 2021 SPX EPS Growth Re-grossing? Re-grossing? Table 2Identifying S&P 500 Sector EPS Growth Leaders And Laggards Re-grossing? Re-grossing? Our portfolio positioning is well aligned with the sector ranking of EPS growth for the coming year. Put differently, given the havoc that COVID-19 wreaked to the US industrial and service bases it is normal that deep cyclical sectors along with financials and the decimated services-heavy parts of the consumer discretionary sector to occupy the top ranks. In contrast, defensives sectors that were largely COVID-19 beneficiaries (especially health care and consumer staples) are near the bottom of the pit. The sole misalignment is the bombed out real estate sector that we remain overweight (Table 2). Netting it all out, our sense is that the market has successfully navigated a tumultuous two-week period and we reiterate our long-held sanguine 9-12 month cyclical view on the prospects of the S&P 500. This week, we update a defensive tech sub-group and put a tight stop in the cyclicals/defensives portfolio bent in order to protect profits. Risks To The Cyclicals Over Defensives Portfolio Bent Last December we highlighted that China’s four year cycle will peter out in the back half of 2021 and could cause some equity market consternation, with stocks likely sniffing out any trouble likely by the end of Q1/2021. It appears that investors have been sleeping at the wheel and largely distracted by the GME/WSB saga. Not only did they neglect the robust SPX profit season, but they also ignored that something is amiss in China as we first showed last week (please refer to Chart 12 here). Importantly, what worries us most is the transition from China being the primary locomotive of global growth to the US taking the reins in coming quarters. Clearly such a handoff is tumultuous, especially given the recent added risk of a reflex rebound in the greenback that we first warned about on January 12 when we set the cyclicals/defensives ratio on downgrade alert. Subsequently, we upgraded the S&P utilities sector to neutral locking in gains of 15% for the portfolio, and today we decide to institute a 2.5% rolling stop in the cyclicals/defensives portfolio bent, in order to participate on further upside but also protect 16% gains for the portfolio since the July 27, 2020 inception in case of a market relapse. Practically, when the rolling stop gets triggered we will move the cyclicals/defensives bent down to neutral via executing the downgrade alert we have in the S&P materials sector. In more detail, China’s slamming on the brakes is the key risk to cyclicals/defensives. Not only are the Chinese authorities trying to engineer a slowdown with the recent reverse repo operations, but also BCA’s China Monetary Indicator, the selloff in the Chinese sovereign bond market and the cresting in the PBOC’s balance sheet are all corroborating the economic deceleration signal (Chart 4). Chinese total social financing has peaked, the 6-month credit impulse is plunging, and the nosedive in Goldman Sachs’ Chinese current activity indicator (CAI) are all firing warning shots that the economy is slated to slowdown (Chart 5).  Chart 4Everywhere… Everywhere… Everywhere… Chart 5…One Looks… …One Looks… …One Looks… Already both the Chinese manufacturing and services PMIs have hooked down with the manufacturing new orders-to-inventories (NOI) in free fall and export orders in outright contraction. Tack on the reversal in the Citi economic surprise index (ESI) for China and the outlook dims further for US cyclicals/defensives (Chart 6). No wonder Chinese demand for loans has turned the corner, infrastructure spending has topped out and railway freight volumes have ticked down as a direct response to the tightening in Chinese monetary conditions (Chart 7). Chart 6…China… …China… …China… Chart 7…Is Slowing… …Is Slowing… …Is Slowing… Chinese imports flirting with the zero line best capture all this softening in Chinese data and also warns that the US cyclicals/defensives ratio is nearing a zenith (Chart 8). Beyond the dual risk of a counter trend rally in the USD and China’s undeniable deceleration, returning to US shores reveals another source of potential trouble for cyclicals/defensives. Chart 8…Down …Down …Down The US Citi ESI has come back down to earth, and the ISM manufacturing PMI cooled off last month with the NOI ratio flashing red (Chart 9). Importantly, Goldman Sachs’ US CAI is sinking like a stone corroborating that, at the margin, US economic data is softening (Chart 10). Moreover, US capex is in the doldrums courtesy of the collapse in EPS last year that dealt a blow to CEO confidence. Worrisomely, the rollover in the latest capex intentions from regional Fed surveys along with the downbeat NFIB survey’s capital outlays in 6-months component underscore that CEOs remain reluctant to invest (Chart 9). Chart 9Even US Trouble… Even US Trouble… Even US Trouble… Finally, relative valuations have surged to all-time highs leaving no cushion in case of a mishap, while relative technicals are in extreme overbought territory near a level that has marked the commencement of prior relative share price drawdowns (Chart 11). Chart 10…Is Brewing …Is Brewing …Is Brewing Netting it all out, China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Bottom Line: Prepare to move the cyclicals/defensives portfolio bent back down to neutral from currently overweight. Today we recommend investors establish a 2.5% rolling stop to the cyclicals/defensives relative share price ratio as a risk management tool in order to protect profits. Chart 11Overstretched And Pricey Overstretched And Pricey Overstretched And Pricey Software On The Ascend While we remain on the sidelines with regard to the broad S&P technology sector we continue to recommend a barbell portfolio approach preferring defensive software and services stocks to aggressive hardware and equipment equities. In that light, we reiterate our overweight stance in the key S&P software sub-industry that still commands the highest market cap weight in the tech sector just shy of 33%. While overall capex is sluggish as we highlighted above, software capital outlays have recovered smartly and according to national accounts are growing at a 10%/annum pace. Stock market-reported capex confirms that software capital expenditures are on an absolute tear and remain a key pillar of our secular preference for this defensive tech group (Chart 12). On the sales front, COVID-19 accelerated the push to the cloud and 2020 has been a bumper year for industry sales. True there is an element of stealing revenues from the future, but as long-time readers of our publication know we do not believe that SaaS is a fad and the adoption of cloud services remains in the early innings. Impressively, while relative forward top line growth expectations have rolled over, the attempt of the software price deflator to exit deflation suggests that software stocks will easily surpass this lowered revenue bar in coming quarters (Chart 13). Chart 12Primary Capex Beneficiary Primary Capex Beneficiary Primary Capex Beneficiary Amidst the IPO frenzy that has captured investors’ imagination especially given the spectacular increases in both SNOW and PLTR (neither of which is in the SPX yet), software M&A fever remains as high as ever. This constant reduction of software stock supply, coupled with the insatiable appetite of software executives to aggressively retire equity, signals that software equity prices will remain well bid (Chart 14). Chart 13Software Tries To Exit Deflation Software Tries To Exit Deflation Software Tries To Exit Deflation Chart 14Positive Share Price Dynamics Positive Share Price Dynamics Positive Share Price Dynamics Nevertheless, our relative EPS growth models are waving a yellow flag. The SPX is slated to grow profits north of 25% this year, but according to our profit models software will only manage to grow in the single digits, thus trailing the broad market by a wide margin. Encouragingly, this grim relative profit growth backdrop is already reflected in depressed sell side analysts’ forecasts (Chart 15). Finally, while relative valuations are still lofty they recently have corrected back to one standard deviation above the historical mean. Similarly, relative technicals have worked off overbought conditions and have settled down near the recent historical average (Chart 16). Chart 15Risks… Risks… Risks… In sum, rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Bottom Line: Continue to overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. Chart 16…To Monitor …To Monitor …To Monitor   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views January 12, 2021  Stay neutral small over large caps July 27, 2020 Overweight cyclicals over defensives (2.5% rolling stop) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Stick With This Juggernaut Stick With This Juggernaut Software stocks have been on a tear. This defensive-tech index has bested the SPX by 34% year-to-date, and in absolute terms is up a whopping 45%. While such a breakneck pace is clearly unsustainable, and a short-term breather is in order, software stocks have been high-flying as they are trying to satisfy investors’ insatiable appetite for cloud exposure. True, some recent IPO activity is reminiscent of the dotcom bubble excesses (re:BIGC doubled in a mere 5 trading days) as investors are scrambling to gain any cloud exposure at any price. Circling back to the S&P software index, encouragingly this has been a capex-led advance, as software outlays now capture a larger slice of corporate budgets (top panel). As a result, software stocks have rallied along side swelling profits (second panel). Granted, valuations are trading at a large premium versus the broad market, however, the 12-month forward P/E is hovering near the historical average and way below the 1990s peak (middle panel). When corrected for the long-term growth rate, the relative P/E/G ratio is near parity and below the historical mean (bottom & fourth panels).   Bottom Line: While software stocks have run too far too fast, appear expensive to the naked eye and a near-term breather is needed, the earnings-led advance keeps us on the cyclically bullish side. The ticker symbols for the stocks in the S&P software index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. ​​​​​​​

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections ...But Led To Many More Infections ...But Led To Many More Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Chart I-5…And More ##br##Deaths Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare ...Like Healthcare ...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF AUD/CHF AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Software: The Crown Jewel Software: The Crown Jewel Overweight While we are neutral the S&P tech sector, we continue to employ a defensive over aggressive tech strategy and prefer software and services to hardware and equipment. The S&P software index in particular has proven its resilience during the COVID-19 sell-off and recovery and has now broken out to fresh all-time highs both in absolute and relative terms. Upbeat profit fundamentals underpin software buoyancy. Relative capex spending remains in a secular uptrend, spring-boarding the share price ratio. Our relative macro earnings growth model is also gaining steam highlighting that the earnings driven outperformance phase has staying power. Bottom Line: Stay overweight the S&P software index.