In the ongoing battle between long- and short-duration assets, the performance divergence within the same industries has been particularly pronounced in the software application sector over the past few years. Established businesses have generally performed in line with or above market expectations, while their less profitable counterparts—those with negative earnings and projected profits further in the future—have significantly underperformed.

With a negative spread [on equal weight] exceeding 50% on a 3-year horizon and an easing monetary policy on the horizon, is there an opportunity in sight?

Fig 1: Performance 1YR Horizon

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Fig 2: Sales Growth [1YR Rolling]

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In addition to rising interest rates, several other headwinds have contributed to market underperformance. Misplaced extrapolations of sales growth following the pandemic-driven boom in companies like Zoom Video Communications, the rapid advent of AI and its impact on the software sector, and continually disappointing guidance updates have weighed on the industry.

Moreover, margin contraction is likely as companies integrate AI features into existing products. In some cases, AI-powered functionalities in large language models (LLMs) are rendering core capabilities of long-established software products obsolete.

However, some of these negative impacts could be offset by gains in operating margins from automation of skilled tasks, such as coding. For more established companies, these headwinds have been less severe. Over the past three years, businesses like SAP SE, ServiceNow Inc., and Intuit Inc. have largely kept pace with the broader market, with gains of 53%, 23%, and 10%, respectively.

In contrast, the industry as a whole is down 40% on an equal-weight basis. This discrepancy is also evident in their fundamentals.

Fig 3: Operating Margin [1YR Rolling]

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Fig 4: Free-Cash-Flow To Sales [1YR Rolling]

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While the median net income margin has been negative for most companies in the sector over the past four years, it has remained positive for the aforementioned firms. As monetary policy begins to shift toward an easing cycle, there may be an arbitrage opportunity.

Valuation adjustments tied to future earnings will disproportionately affect companies within the software industry, creating potential for investors to capitalize on the mispricing of long- and short-duration assets.

Fig 5: Net Income Margin [1YR Rolling]

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Fig 6: Performance [1YR]

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Fig 7: Dividend Yield

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Fig 8: Net Debt To Ebitda [1YR Rolling]

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