The purpose of this weekly is to share thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision making, takeaways from the past week, and random thoughts that arise.

This week:

1. Software and the dawn of AI, the industry with the most to gain and the most to lose?Every software vendor of any consequence will need to have an AI value proposition, not just a strategy or offering. Some will need to blow up their business in order to survive and thrive in the Data / AI Era.
2. Walking through the decision process after a massive valuation resetThis is the art that is embedded in investing, especially in companies trying to shape the future. This type of decision cannot be found in a spreadsheet or an AI model….

Software and the Dawn of AI: Is software the industry where there is the most to gain and the most to lose with AI?

I recently have had a few conversations with other investors about this question. I am very intrigued by this, especially in light of the results of a few software companies this past earnings reporting period. I discussed Paycom (PAYC), a holding for Arrowside Capital in Volume 1. There were others, such as Confluent (CFLT), not a holding of Arrowside Capital. Are these companies getting ahead of this transformational change or are they simply experiencing some of the downsides of AI.

A few things that could make the software industry the most to gain and the most to lose with AI:

Positive:

The software vendors, the ones that are cloud based, house all of the client data for their specific application. The client owns the data, but the software vendor has the

data that is needed for the insights that their application uses to add value. Many vendors have the ability to share data across customers (anonymized) and therein lies the potential benefit from AI. If you are a software vendor and you can add AI on top of your application, with intelligence and insights from across your entire customer base, this could present a very unique and intriguing value proposition.

Think about it this way. The software vendor has the data, and the customer wants more insights, ones that produce more revenue and efficiency. Assuming that these insights will mean more revenue and increased customer retention for the software vendor, there is a lot to gain.

Negative:

AI allows for code to be written or suggested, in a matter of seconds. There could be new applications written that allow for the customers to more easily become free agents, taking their data to the best solution for their problem. There is also the Innovators Dilemma, which for the incumbent vendors is always at play. For AI, the speed of new solutions could make the advances made in the cloud seem really slow and antiquated.

One example is the case of Chegg (CHGG), not a holding of Arrowside Capital. A subscription service for students, they saw many subscribers drop off the service because they discovered that Chat GPT was able to provide the content that they needed for free.

It is fair to expect more of these cases in the coming year or two as LLMs reach more broad adoption. It also will present opportunities for the positives above to manifest into increased competitive advantage, especially for larger incumbents.

It is my view that after a decade of upward bias to both growth and stock prices, the software industry is going to show a large divergence going forward. This is very common when transformative change in introduced. When cloud solutions were introduced, many on premises vendors were on notice due to this transformational change. This change is similar, but it will move much faster in my opinion. Much evidence is out there for those choosing to see it, such as the explosive growth at Nvidia, who is growing the company at growth rates not seen before for a company its size.

Every software vendor of any consequence will need to have an AI value proposition, not just a strategy or offering. Some will need to blow up their business in order to survive and thrive in the Data / AI Era.

Making a decision after a valuation reset; Paycom as the example

Thanks to everyone that read the piece a few weeks back and gave me feedback, specifically on Paycom (PAYC). I got pushback about the explanation of why the stock reacted the way it did. So, to complete that thought, investors were spooked by both the slowdown in the growth rate and the disclosure of the amount of reliance the company had in service revenue. The service revenue took a hit due to the release of the newer version and its advances in reducing errors in payroll. That is an important addition to the discussion.

This week, I want to walk through how I think through a valuation reset for a fast growing company that has enjoyed “darling” status. More than 30 years of observing and making decisions in these circumstances guides my process.

First, whatever happened had to be a major surprise, a 40% decline is certainly an indication. While this is apt to happen to companies that are fast growers with high valuations, it can happen to any company, if the surprise is large enough to potentially affect the business going forward.

I view these decisions as being some of the most important decisions that investors have to make. They can be emotional and carry risk on both sides of the coin. Here, I lay out a few possible reactions to the type of decision that one has to make in a case like Paycom.

“The management is not forthright, so I cannot stay invested.”

This is an important thought to process. We all do not like to be surprised; it produces a flight response for our brains. I have had this viewpoint for other resets, and it is not unfair. I have come to appreciate though that in many cases, management knows what could happen, but it is really hard to predict with precision. Also, as investors, there are things that we don’t know to ask about. It does not mean that we are being irresponsible, nor does it mean that management is being dishonest. I truly believe that the company set out to innovate and make their product better and it had a negative consequence for the short term.

“This is too uncertain, I will move to the sidelines and watch.”

I have come to this conclusion many times as well. In this case, after a reset with change coming from AI looming, and not knowing what it will do to the business, I can see this decision. I do agree that there are questions, but I see what they did as an unintended consequence of improving their product offering. The uncertainty regarding AI would be there anyway, as is the case for all software vendors right now. (see above) The downside to making this decision as an investor is that typically, we will be reluctant to revisit the company and even more reluctant to repurchase the stock given all of the biases that creep into our mind.

“Taking this big a hit is not fun and disappointing, but I trust that the management team will figure it out.”

I am more in this camp than the others, but I will be curious to hear and see what happens in the middle of next year. I will personally be following this with a skeptical eye and a show me mentality.

“This is brilliant and an opportunity to buy more.”

I was reminded recently about how Netflix blew up their business years ago, only to come back stronger. I see a path for Paycom to take this change in their product to gain even more market share as potential customers want to get a zero error rate in their HCM solution.

There are quite a few more ways to view this, I’m sure. These are a few, and I come out in the more positive camp. I wanted to share a few of these to get a window into the decision-making process that investors must go through.

I think it is important to think of this type of decision with risk on both sides.

If I sell, it will feel better right now, but will I miss an important inflection in the business that had not only been a time to not have sold, but to have added?

If I hold or buy more today, am I giving too much latitude to the management team and I may incur further losses? After all, a stock can get cut in half an infinite number of times…

This is the art that is embedded in investing, especially in companies trying to shape the future. This type of decision cannot be found in a spreadsheet or an AI model….

I wish you all a Happy and Safe Thanksgiving!

My story

I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital, based in Boston. I have more than 30 years of experience in the investment business, investing in mostly small and mid- sized companies, all geared toward innovation and growth. The blog is named The Zen Innovation Investor because I believe it is so important to remain calm and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought provoking.

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