The Trigonometry of (Collapsing) Market Multiples
The recent SaaS/Cloud market downturn has shaken investor confidence, causing many to ask, what’s going to happen next? On the SaaS side, Joseph Floyd wrote a great post titled “Was Black Friday a DiSaaSter or Simply Reversion to the Mean?” In it, he argued that the ratio of Enterprise Value to Forward Revenue has contracted materially from 2013 and perhaps has over-corrected compared to historic norms.
While this over-correction may be the case, we see evidence that the SaaS and Cloud Software markets are maturing. As such, we believe these segments will increasingly become “stock picker” markets and not “sector picker” markets. Entrepreneurs and investors shouldn’t count on future frothy rising tides lifting all company boats. Only the best ones will rise.
In drawing this conclusion, we took a closer look at data provided by Byron Deeter at Bessemer Venture Partners. Every week, Byron publishes his Cloud Index which tracks public cloud software stock performance against the U.S. market indices. I’ve taken the liberty to republish his most recent BVP Cloud Index graph, which he broadly distributes. I added vertical grey boxes to his chart to mark the peaks of the BVP Cloud Index that occurred prior to an Index correction of 20% or more:
As you can see from the chart above, there have been four material downturns (greater than 20%) in the BVP Cloud Index since January 2011. The first downturn took 7 months to get back to the prior peak, the second downturn required 6 months, and the third downturn needed 12 months. While these recovery periods may look unrelated to each other, they actually follow the characteristics of a maturing market. If true, that would imply that the fourth correction will take much longer than 12 months to recover.
The role of the arctan
How might you model a maturing market to be able to draw this conclusion? Well, for sectors or individual stocks, you’ll often see investment performance shaped like an extended “S”. Or if you’re nerdy like me, you see an arctangent shape.
To more easily visualize this arctangent shape in the BVP Index, I added red rectangles (below) to mark the peak-to-floor of the four corrections. From here, I drew a curve that started at the intersection of the x and y axis which moved through the midpoints of the four rectangles. I picked the midpoints of the rectangles because those points would correspond to the average of the high and the low for those corrections.
Above, you can see that the fitted curve to the BVP Cloud Index is relatively flat until July 2011. The curve’s slope accelerates until July 2013 and then starts to decelerate. After the correction in April 2014, the Index continues to grow, but at a slower rate. It’s our hypothesis that after the current correction, the Index will grow in 2016 but at a slower rate than it had in the period from April 2014 through December 2015. Such is the typical (arctangent) property of a maturing sector or market.
What strikes me most about the above graph is how well public cloud companies performed from October 2012 through April 2014. That performance echoed the multiple expansion reported by Joseph, above, for SaaS companies. Assuming the arctangent model, this steep positive slope is the rapid rising part of the curve. This is the period where sector bets pay off incredibly well. It’s also the period that ends abruptly because investors often bid up prices too far in advance of expected future corporate performance.
In contrast, the prior and subsequent periods look relatively flatter. They appear to have poorer Sharpe ratios (and negative alphas). And during the whole period of the graph (1/1/2011–2/12/2016), the overall Public Cloud Index Sharpe ratio now appears worse than that of the NASDAQ. Once again, what that suggests to me is that we’re entering the maturing part of the market. It’s now much more about stock selection rather than sector selection.
What might this mean?
The main takeaway is that you shouldn’t expect former multiples to return. The 2013 peak isn’t actually surprising. Rising multiples are symptomatic of emerging sectors which grow with an arctangent shape. These peaks come but they don’t return — until another discontinuity or innovation causes the cycle to start again. Once past the midpoint of the curve, capital going forward becomes increasingly more expensive.
At the same time, this arctangent model by no means suggests that opportunities in a given sector go away. While true that all sectors ultimately mature and multiples regress to the mean, it is equally true that there are proven, profitable ways to navigate this part of the maturity curve.
Perhaps the major difference operating in this part of the curve is that there’s an increased premium in delighting customers using a business model that is profitable at scale. During these maturing times, the stronger operators rise, and those teams with the better business models gap above the rest of the crowd. In some ways, the fate of a company is more under the control of the entrepreneur versus in the hands of perhaps an unsustainable funding strategy.
Other differences abound as well. Companies can choose to innovate deeply within a sub-sector; pursue fast-follower models, knowingly recruiting stronger teams under less competitive pressure; or simply take the time to optimize the business model before scaling out.
Conceivably Salesforce.com, Facebook and Atlassian represent archetypes for each of these three different approaches. Salesforce.com was founded 13 months before the NASDAQ peaked in 2000, at a time when its major direct competitor Siebel was at a $1 billion revenue run rate. Facebook was following Friendster and MySpace. Atlassian was founded in the year of the largest NASDAQ abyss, where $8 trillion of wealth had been wiped out from the index’s prior peak.
Are maturing times actually inauspicious? Maybe the answer boils down to the proper matching of corporate strategy against the sector climate.
Being mindful in trying times
So what is going to happen next? For those who ask: I suggest that rather than yearn to know, we focus on what we can know. And that is, what is happening right now. What’s poorly understood is that seeing reality clearly is a competitive advantage. In these shifting times, I would counsel you to ask, “What do I see clearly?” and “How do I know?” Then triangulate with others and trust your conclusions. I do sense if you genuinely ask and answer these questions, you’ll know. And you’ll be served well.
Best wishes in these volatile times. I do trust you’ll know what to do.