Software Stock Universe

I was updating a copy of my Software Stock Universe Spreadsheet today (attached below) and it got me thinking about the past year. In October of 2002 I used this same spreadsheet to try and find some PIPE ideas for Mobius. At that point, a large number of the small-cap enterprise software stocks were selling at or below tangible book value and I figured that a number of them would make good investments given, as Benjamin Graham might put it, the high margin of safety embedded in the stocks.

My investment criteria at the time was pretty simply: 1) it had to be trading near or below tangible book 2) it had to have at least 6 quarters of cash in bank 3) it had to have only marginally negative cash flow, i.e. by the time the cycle turned it would still have a lot of cash 4) it had to have an enterprise value to tangible book ratio of less than 1.5. and 5) It had to be in a business that I thought had long term promise. Using that criteria we whittled a list of 300+ names down to just 23 candidates. Unfortunately for Mobius, in turned out that companies that met these criteria weren’t really great PIPE candidates, so we ended up shelving the idea of doing any PIPEs at Mobius at the time.

I did however put together a list of the 23 stocks we felt were most promising at the time entitled "Pipe Dreams" and I was thinking of that list as I updated the spreadsheet today. Specifically, the list included AGIL, ARTG, CALP, CHRD, CRA, CRGN, CTRA, DCLK, ECLP, ET, IDXC, LWSN, NETE, NGEN, NOVL, NYFX, PRSE, PRXL, QTRN, QVDX, RCOM, TPRS, and TTEC. As you can see, there were a couple healthcare related companies in there because the guy I worked with on putting the list together also looked at healthcare related deals. There were also a couple Internet-related names that looked particularly attractive.

Taken as a whole, if you had invested an equal amount in each stock on the list you would have generated a return of 220%+ since 10/29/04. That compares with about a 64% return (before fees) if you had just invested in a NASDAQ index fund or QQQ.

The lowest performing stock and the only loser was Tripos (TRPS) at -29% (open source bioinformatics software is killing them), but the next worse performer was RoweCom (RCOM) and that was up 79%. The best performer was Netegrity (NETE), up almost 730%!

What's more amazing about this performance is that in most cases, these companies did not see dramatic changes in their operating businesses. Today many are still either losing money or have marginally positive cash flow and most had flat to slightly positive revenue growth in 2003.

What accounts for their fantastic performance then? Several things: 1) When a company trades below tangible book the market is essentially leaving it for dead. Thus, most of the companies on our list had been left for dead and when it became apparent that they were in fact not dead, the market responded by giving them a multiple more in line with their market comparables 2) Most of these companies had large cash balances and once it was clear that they would not be burning through all this cash, the market began to look at the enterprise value of these deals 3) As the market rallied the poor liquidity in these stocks help drive them higher because there wasn't a lot of stock for sale and small increases in bid-side volumes thus resulted in large price gains.

The natural question is: are there any stocks today that look similarly attractive to the ones you singled out in 10/02. Unfortunately, at first glace it looks like the answer right now is no. Almost all of these stocks have had incredible run-ups in the last 12 months. I am beginning to see some interesting short ideas, but I don't know if I have the stomach to short stocks into this rally as the rally looks to be more liquidity driven than anything else.

Another natural question you might have: sure you made a list of stocks in 10/02 but did you actually buy any of them. As I said, we didn't actually buy any of them at Mobius as most of these companies didn't need any private placements of capital, but I did buy two of the stocks for my personal portfolio. The first was E*Trade, a company I covered on wall street. At the time E*Trade was trading at below tangible book and while I knew it didn't have the upside of a pure software/internet stock, I knew that almost any bank in the country will acquire another bank for 1.2-1.5 tangible book, so I saw the stock as a very low risk play. E*Trade did very well, up 279%, 7th best out of the 23 stocks on the list. I sold my E*Trade stock at about $10/share last year as soon as I got cap gains treatment though, so I missed out on it's most recent run to $14. The other stock I bought was Netegrity, the top performer on the list. Unfortunately I also sold that last year as soon as I got cap gains treatment as well (about $5/Share) and I missed out on much of the run-up. In both cases I sold because I felt the stocks were fully valued, only to see both of them run-up considerably higher. There are two lessons I have taken away from that 1) Never underestimate the market's momentum 2) In personal investing always issue stop-loss trading instructions and walk them up behind the stock!

I am only holding onto one long position in enterprise software right now and that’s Interwoven, a company I know well from my Wall Street days. I bought IWOV at $5.80/share shortly before we did the PIPE analysis in 2002 using pretty much the same investment thesis and then bought some more in Q1 03. It no longer matches up with my valuation thesis, but I haven’t sold yet because I still like the company/space and I learned from my prior mistakes and have simply set a stop loss. Stock was up almost 3% today so it looks like I made the right choice!