More Thoughts on the Long Large Cap SW / Short Industrial Trade

The valuation gap between large cap software and industrials has been evident for awhile now and only recently began to close a bit. Below is a snapshot of the divergence. This is just a templated run so im sure some figures are not perfect but is directionally accurate.

• Software estimates have come down over the last quarter but during the last month, overall industrial EPS estimates have fallen by less than 1%; This together with share appreciation leaves industrial valuation elevated above long term median

• Large cap software by virtue of business model will be much more resilient. While both sectors have high top-line visibility, the low capital requirements in software lends itself to cutting opex much faster (i.e. new bookings come down, S&M is cut).

• Software at more than double the operating margins, generally cleaner cap structure, are trading at a discount on EBIT and roughly the same P/E.

• Historically, when ISM is in contraction, industrials tend to outperform the S&P by a tiny margin; However, this time around, industrials have outperformed S&P by 12%. I think part of this is due to hopes of Chinese economic recovery and re-opening but there’s been no data so suggest the recovery will be a rapid one to warrant the outpeformance

• The other argument is then the de-globalization trend will favor domestic capital flowing increasingly towards industrial firms. I’d argue that is a long and complicated web to parse through the entire supply chain. (i.e. potential benefits on topline could be easily offset by cost increases as supply chain moves into higher cost regions), not the mention I see this as a 10+ year gradual migration.

In any case, I fundamentally believe the market continues to underestimate the earnings resilience on large cap software (i.e. EPS can grow faster than consensus even during a recession) and overestimate that of industrials.

Will revisit in 3-6 months…