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) plunging by nearly 30% in just two months’ time. Instantly, unemployment soared, and the economy plunged into a recession with lightning speed.

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) 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.

COVID-19 Added Fuel to the Fire

Cloudflare (NET), 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.

Why is Software a “Baby with the Bathwater” Scenario?

Reasonable Valuations

Software companies like Twilio, Shopify (SHOP), 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).

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), and Twilio.

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.

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.

Invesco QQQ (QQQ): ETF Research Reports

Workday, Inc. (WDAY): Free Stock Analysis Report

Shopify Inc. (SHOP): Free Stock Analysis Report

Twilio Inc. (TWLO): Free Stock Analysis Report

Cloudflare, Inc. (NET): Free Stock Analysis Report

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