The financial markets are in some stage of collapse. We can argue about how long and how bad this downturn will be, but good investors are always looking ahead. Famously, academic research shows that the most important determinant of the success of a private equity or venture fund is the year of its inception. Starting a fund in the middle of Bear Market is hard to do, but often yields the best returns. So at some point, conditions will stabilize and eventually the markets will turn positive again. So the question of the moment for us is how to position for that eventual turnaround.

A common refrain we hear is that the worst hit stocks now are the very large bucket of Software as a Service (SaaS) companies who have seen their valuation multiples crushed despite generally steady results. Yesterday’s high flyers are often the lowest of the low in downturns. We argue that this downturn marks more than a cyclical re-rating of hot growth stocks. History shows that stable, ‘value’ stocks tend to outperform during a downturn, but then growth stocks rebound more strongly whenever the market bottoms. That being said, this time around we think the bigger opportunity for growth will come not from software but from other areas of “Growth”, and the sector we are most interested in is “DeepTech” – hardware, semis and the complex systems combining those with software.

Tracking this from venture data is almost impossible, so we thought we would like at public markets as a workable proxy. Below is a time series of data comprised of all members of the Nasdaq 100 who have been continuously public since 1999. We broke the stocks into buckets of Consumer & Retail, Hardware & Semis, Healthcare and Biotech, Software & Internet, Telecom and Media, Transportation, and Industrial/Energy/Other. The vertical axis is scaled with the starting point (May 1998) set to 100. So a stock that scores 1,000 is up 10x over this period.

There is a lot going on here. For almost this entire period, Software and Internet have outperformed. Hardware has done pretty well, except for one factor – Apple. Apple has so thoroughly outperformed every other stock in this selection that it skews the results considerably. After all, the data goes back to the days when Apple was on the verge of bankruptcy. So let’s strip them out.

Here, the outperformance of Software is much clearer. Also note that our data runs through May 2022, so the recent fall-off is even worse, but the sector is still ahead of the pack considerably.

Let’s look more closely at the downturns. The following two graphs show the 2-3 year period from the market bottom after the 2001 crash and the 2009 crash.

In both cases there is a fairly clear pattern. In the first year after the market bottom, ‘growth’ sectors outperform, but after a year to a year and a half, those gains start to falter. The period in the early 2000’s is a bit different as it marks the rise of Software Eating the World and the growth of the Internet giants. That being said, from this data we think there is a strong case to be made for jumping into tech stocks at the point of maximum fear in the market.

Returning to the first two graphs, we think there are signs of another important trend. For twenty years or so, Software has been eating the world, but there are signs of that topping out. Pretty much every way we cut the numbers, the long-term outperformance of software over hardware started to evaporate some time around 2019. Crucially, this predates the pandemic and the world’s realization that semis are a scarce resource. We think this trend will continue and that there is a good likelihood that Hardware, Semis, Deep Tech will outperform in coming years.