We use cookies to understand how you use our site and to improve your experience. This includes personalizing content and advertising. To learn more, click here. By continuing to use our site, you accept our use of cookies, revised Privacy Policy and Terms of Service.
You are being directed to ZacksTrade, a division of LBMZ Securities and licensed broker-dealer. ZacksTrade and Zacks.com are separate companies. The web link between the two companies is not a solicitation or offer to invest in a particular security or type of security. ZacksTrade does not endorse or adopt any particular investment strategy, any analyst opinion/rating/report or any approach to evaluating individual securities.
If you wish to go to ZacksTrade, click OK. If you do not, click Cancel.
COVID Fallout - Short-term Pain Morphs into Long-Term Gain
The old saying “throwing out the baby with the bathwater” is an idiom used to describe a situation where someone gets rid of something valuable or necessary while trying to eliminate something undesirable. In other words, it suggests that in their haste or overreaction, they discard both the good and the bad.
Markets are Inefficient
“The Efficient Market Hypothesis” refers to the theory that financial markets reflect all available information, making it impossible to consistently outperform Wall Street by exploiting undervalued or overvalued assets. While the hypothesis sounds good in theory and is often taught in academic settings, it is simply untrue because:
1. Markets participants have access to all information: For example, congressmen and women (who can legally trade stocks) have access to much more information than your average investor.
2. Emotions play a role: Even if you assume everyone has access to the same information, investors use the information differently due to the high emotions and irrational decision-making inherent on Wall Street.
3. Black Swan Events: Finally, even if you assume all investors have access to the same information and make rational and emotionless decisions, unexpected events like COVID-19 can derail them.
COVID-19 Fallout Presents Long-Term Opportunity
The COVID-induced correction of 2020 is a great example of a Black Swan event that led to market inefficiency and the “baby with the bathwater phenomenon.” As news spread about the pandemic, investors panicked – sending the Nasdaq 100 ETF ((QQQ - Free Report) ) plunging by nearly 30% in just two months’ time. Instantly, unemployment soared, and the economy plunged into a recession with lightning speed.
Image Source: Zacks Investment Research
Many investors sold stock in otherwise strong companies due to risk management purposes (stop losses), fear (emotions), or margin calls (too large of positions).
Exploit Crisis for Opportunity
Putting aside COVID-19’s impact on stocks in 2020 for a minute, equity markets were likely to pullback at some point regardless because:
Gravity
Into the pandemic news, the Nasdaq 100 gained ground for five straight months. Even the strongest bull markets must digest.
Bloated Valuations
At the time, software leader Twilio ((TWLO - Free Report) ) was a poster child of the era from a pure price action perspective. However, underneath the surface, its valuation was becoming bloated. At its IPO in 2016, TWLO traded at a price-to-book value of ~10x. By early 2019, the company’s P/B soared to nearly 30x.
Image Source: Zacks Investment Research
COVID-19 Added Fuel to the Fire
Cloudflare ((NET - Free Report) ), another software leader at the time, saw record revenue growth during the COVID-era. However, the stock was pounded as the company swung to a loss due to higher expenses.
Image Source: Zacks Investment Research
Why is Software a “Baby with the Bathwater” Scenario?
Reasonable Valuations
Software companies like Twilio, Shopify ((SHOP - Free Report) ), Cloudflare, and others got pounded. For example, Twilio sank from over $400 a share to under $100 post-COVID. Currently, Twilio’s price to book is lower than its IPO and the lowest in its history at just over 1x (from a high of 30x).
Image Source: Zacks Investment Research
Renewed Growth
Though Twilio and other software companies saw record revenue despite COVID, investors unloaded stocks due to slowing earnings and lower profitability. However, though most of the software group is far off their highs, earnings are expected to print record highs in the coming years in names like NET, SHOP, Workday ((WDAY - Free Report) ), and Twilio.
Image Source: Zacks Investment Research
The “Snapback Phenomenon”
Think of a rubber band being stretched far in one direction – as long it doesn’t snap, the rubber band will snap back hard in the other direction. Though software stocks are well off their 2023 lows, they are still far from their all-time highs. Meanwhile, not only did they avoid snapping, but they also have dirt-cheap valuations and record growth on the horizon.
Image Source: Zacks Investment Research
Conclusion
The unprecedented COVID-correction of 2020 forced investors to “throw out the baby with the bathwater.” Though quality software names continued to produce record revenue growth, short-lived earnings slowdown caused irrational panic. Thus far in 2023, software stocks have run a long way. However, based on their return to profitability, bargain basement valuations, and strong forward growth, they are likely just getting started.
See More Zacks Research for These Tickers
Normally $25 each - click below to receive one report FREE:
Image: Bigstock
Exploit Market Inefficiencies, Buy Software
COVID Fallout - Short-term Pain Morphs into Long-Term Gain
The old saying “throwing out the baby with the bathwater” is an idiom used to describe a situation where someone gets rid of something valuable or necessary while trying to eliminate something undesirable. In other words, it suggests that in their haste or overreaction, they discard both the good and the bad.
Markets are Inefficient
“The Efficient Market Hypothesis” refers to the theory that financial markets reflect all available information, making it impossible to consistently outperform Wall Street by exploiting undervalued or overvalued assets. While the hypothesis sounds good in theory and is often taught in academic settings, it is simply untrue because:
1. Markets participants have access to all information: For example, congressmen and women (who can legally trade stocks) have access to much more information than your average investor.
2. Emotions play a role: Even if you assume everyone has access to the same information, investors use the information differently due to the high emotions and irrational decision-making inherent on Wall Street.
3. Black Swan Events: Finally, even if you assume all investors have access to the same information and make rational and emotionless decisions, unexpected events like COVID-19 can derail them.
COVID-19 Fallout Presents Long-Term Opportunity
The COVID-induced correction of 2020 is a great example of a Black Swan event that led to market inefficiency and the “baby with the bathwater phenomenon.” As news spread about the pandemic, investors panicked – sending the Nasdaq 100 ETF ((QQQ - Free Report) ) plunging by nearly 30% in just two months’ time. Instantly, unemployment soared, and the economy plunged into a recession with lightning speed.
Image Source: Zacks Investment Research
Many investors sold stock in otherwise strong companies due to risk management purposes (stop losses), fear (emotions), or margin calls (too large of positions).
Exploit Crisis for Opportunity
Putting aside COVID-19’s impact on stocks in 2020 for a minute, equity markets were likely to pullback at some point regardless because:
Gravity
Into the pandemic news, the Nasdaq 100 gained ground for five straight months. Even the strongest bull markets must digest.
Bloated Valuations
At the time, software leader Twilio ((TWLO - Free Report) ) was a poster child of the era from a pure price action perspective. However, underneath the surface, its valuation was becoming bloated. At its IPO in 2016, TWLO traded at a price-to-book value of ~10x. By early 2019, the company’s P/B soared to nearly 30x.
Image Source: Zacks Investment Research
COVID-19 Added Fuel to the Fire
Cloudflare ((NET - Free Report) ), another software leader at the time, saw record revenue growth during the COVID-era. However, the stock was pounded as the company swung to a loss due to higher expenses.
Image Source: Zacks Investment Research
Why is Software a “Baby with the Bathwater” Scenario?
Reasonable Valuations
Software companies like Twilio, Shopify ((SHOP - Free Report) ), Cloudflare, and others got pounded. For example, Twilio sank from over $400 a share to under $100 post-COVID. Currently, Twilio’s price to book is lower than its IPO and the lowest in its history at just over 1x (from a high of 30x).
Image Source: Zacks Investment Research
Renewed Growth
Though Twilio and other software companies saw record revenue despite COVID, investors unloaded stocks due to slowing earnings and lower profitability. However, though most of the software group is far off their highs, earnings are expected to print record highs in the coming years in names like NET, SHOP, Workday ((WDAY - Free Report) ), and Twilio.
Image Source: Zacks Investment Research
The “Snapback Phenomenon”
Think of a rubber band being stretched far in one direction – as long it doesn’t snap, the rubber band will snap back hard in the other direction. Though software stocks are well off their 2023 lows, they are still far from their all-time highs. Meanwhile, not only did they avoid snapping, but they also have dirt-cheap valuations and record growth on the horizon.
Image Source: Zacks Investment Research
Conclusion
The unprecedented COVID-correction of 2020 forced investors to “throw out the baby with the bathwater.” Though quality software names continued to produce record revenue growth, short-lived earnings slowdown caused irrational panic. Thus far in 2023, software stocks have run a long way. However, based on their return to profitability, bargain basement valuations, and strong forward growth, they are likely just getting started.