Our key observation is that there has been a divergence of the tech economy versus the real-asset economy and increasingly so in recent years (for e.g., real-asset economy will include restaurants, retail, industrials, etc., sectors that rely upon supply chains, generally has debt on balance sheets and are more driven by in-person interactions).
Since the start of COVID, we believe that the real-asset economy completely decoupled from the technology sector economy. The technology sector went through a substantial boom as people were not able to get out of the houses and spending picked up to enable the virtual world, while the real economy suered tremendously. After about a year as the reopening happened, the real economy started to pick back up, though, it was further disrupted because of the supply chain shortages and other factors, which extended the cyclical upturn in the real economy companies.
For the last 18+ months, we have had the tech economy slow down substantially (some people might even say software has been in a recession) as it gave up the gains from COVID. All this while the real-asset economy was still in a cyclical upturn and doing great because of pricing power, supply chain shortages, strong consumer balance sheets etc. Only recently in 2023, we have now started to see the reverse, which is that the real economy is now slowing down while the tech economy is just bouncing around the bottom (no acceleration, but it has stabilized).
We do see now that the slowdown in the real economy is inevitable both because of the normalization of COVID excesses and also because of the delayed impact of the rapid rise in interest rates.
As the current shorter-term cycle likely ends in about six months’ timeframe, largely driven by the slowdown in real-asset economy companies, this will also complete a four-year cycle since the start of COVID. Our hope is that it probably removes most of the excesses that we’ve had built due to the COVID disruption. The first one, within technology, has mostly been taken out already, while the second one, the real economy, has now started to deflate.
What this also means is that after this current cyclical correction, it is likely both the technology cycle and the real economy cycle could probably realign themselves again and hopefully we could see an upturn once the excess has been taken out.
There are a few corollaries to the above if you do believe in the described framework – the first one is that the technology companies, especially in the software area, are trading at much lower valuations, and are finding a bottom in terms of their growth rates. There might still be a little bit of downside remaining because of the second order eects of the slowdown in the real economy, but we do see some of that future downside already being baked into valuations of small-mid cap software (largely driven by their factor exposure to small-mid cap and less profitability).
The second point here is that there’s definitively going to be more shorting opportunities in the real-asset economy companies, especially the ones that are tied to financing, are asset heavy, or have seen a huge upsurge in the last 1-2 years due to the cyclical upturn we discussed above.
We believe the above framework, perhaps describes the most accurate way we could see things shape out, and this is why we are very excited about our strategy: identifying higher quality undervalued software companies that are going through some sort of stabilization or a positive rate of change and those can be acquired by private equity funds.