3 Top Credit Suisse Small-Cap to Mid-Cap Software Picks for 2016

Credit Suisse’s top 10 predictions and themes for SMID software in 2016 were described as follows:

In 2015, small-cap software underperformed large-cap for the first time in 5 years; Software ‘Dogs of the Dow’ strategy and lower valuations could drive new investments in the group. For an equal weighted basket of our subscription software companies under coverage, we expect an average 12-month price return of +35% based on our current target prices.

For several reasons small-cap software stocks underperformed large-caps in 2015 (down -8%, below large cap of +11%) after outperforming large-cap over the last five years, with an average annual return of +32% for small-cap vs +20% for large-cap during that period. The small-cap underperformance in 2015 could lead investors to the group as they potentially seek undervalued investment opportunities.

In addition, the average EV/NTM Revenue multiple for subscription vendors (SaaS group) contracted -20% in 2015 to 4.3x, while the NTM revenue growth expectations remained roughly the same. Further, we note that the SaaS group is now trading below its historical average EV/Sales multiple of 4.6x, which, historically, has been a buy signal when fundamentals are stable or improving, potentially leading to a reversion back to the valuation mean. We believe that there are several high quality SaaS names in our coverage that are currently trading at a discounted valuation to peer group based on fundamentals.

This week’s report further said:

2015 was a challenging year overall, including for some in SMID software, but we are bullish on the group’s collective secular growth drivers and business fundamentals, and believe 2016 could be less volatile.

In 2015, SMID cap software stocks underperformed large cap software stocks for the first time in five years (down -8%, below +11% for large caps). However, we believe the setup for SMID software heading into 2016 is attractive and positions the group for outperformance given solid business fundamentals combined with even lower valuations than when entering 2015. Specifically, the EV/NTM Revenue multiple for the SaaS/subscription group contracted -20% in 2015 to 4.3x (from 5.4x on 12/31/2014) while the estimated sales growth stayed roughly the same (consensus NTM revenue growth ests. of +22.8% yeat/year on 12/31/2015 versus +23.1% on 12/31/2014).

With consensus estimates implying business fundamentals remain healthy and with valuation below the group’s historical average EV/Sales multiple of 4.6x, we believe that the risk/reward for SMID software stocks is favorable at current levels. However, we expect 2016 to be more of a stock picker’s market where quality matters more as investors continue to show a bias towards high-quality SaaS names (i.e. high growth AND profits) with attractive end-markets and defensible business models that have the potential to deliver positive surprises/upside to both revenue growth and profitability estimates.