Three-Quarters of the Way through 2023—Is Artificial Intelligence or Cybersecurity the Strategy with the Performance Lead?

While the “Magnificent 7” and large-cap tech are undoubtedly the main story for U.S. equities in the first three quarters of 2023, excitement around artificial intelligence (AI) has been a critical driver. Nvidia delivered truly historic business results and earnings in 2023,¹ and it is perceived to be the key company providing necessary hardware to power the coming AI revolution.

And yet, the WisdomTree Artificial Intelligence and Innovation Fund (WTAI) was not even WisdomTree’s strongest-performing thematic strategy for the first nine months—and a little part of October so far—for 2023.

The top-performer was actually the WisdomTree Cybersecurity Fund (WCBR).

Figure 1a: Standardized Returns

For current holdings, 30-Day SEC Yield, SEC Standardized Return, and the most recent month-end performance click the respective ticker: WCBR, WTAI.

Figure 1b: For the First Three Quarters of 2023 (and a little bit)—WCBR Has Actually BEATEN WTAI on a Total Return Basis

For 30-Day SEC Yield, SEC Standardized Return, and the most recent month-end performance click the respective ticker: WCBR, WTAI.

Pay Attention to Merger & Acquisition Activity

There are a lot more cybersecurity companies than you may realize. This also represents an opportunity for disruption, in that if a company emerges to provide strong enough security solutions across an entire technology stack, many chief information security officers (CISOs) would prefer to work with a smaller array of vendors.

In 2022, we saw a lot of deal activity from more financially oriented players, such as Thoma Bravo and Vista Equity partners. We believe that there could be value in assembling cybersecurity functionality to build multi-purpose platforms that customers can subscribe to.

In late September 2023, we saw the more traditional M&A, and a larger tech company purchased a smaller cybersecurity company to integrate cybersecurity services into its existing offering. A past example of this was Alphabet purchasing Mandiant.² 

On September 21, 2023, Cisco announced it was spending $157 per share to acquire Splunk at a 31% premium to the prior close—a total value of $28 billion. The leadership teams of Splunk and Cisco emphasized helping Cisco’s customers better understand their data to provide more services—like those defined by generative AI—to utilize insights from that data.³ Alphabet’s purchase of Mandiant similarly focused on Google Cloud expanding its provided services such that customers could, at least potentially, subscribe to fewer software-as-a-service (SaaS) platforms.

Show Me the Fundamentals!

It is not challenging to convince people of the ever growing need for cybersecurity—investors get it. Every time a new technology in any megatrend area is introduced, it needs to be secured. Hackers are always probing and improving and defenses must do the same. We may not know which cybersecurity providers will become the largest, but we know that individuals and businesses will each need their own strategy for cyber defense.

Many of these companies are newer, recently partaking of the public markets. They have strong sales growth metrics, but they don’t yet have positive earnings and even if they are not as expensive as they were in late 2021…we cannot make the case that they are cheap. It tends to be very difficult to show recently public software companies as cheap. 

Sometimes companies can deliver growth commensurate with higher valuations, and it’s also the case that sometimes focusing too much on valuation may lead to investments solely in, for instance, older energy companies and never being exposed to any new software companies. “Always” and “never” are also tricky, because we haven’t yet found any strategy that always leads to higher returns.

In figure 2, we take a look at both trailing sales growth, which has already happened, and estimated sales growth, for four distinct groups of stocks to be as fair as possible. We also start from a Russell 3000 Index universe to ensure we are not only including large caps or more established, profitable companies.

• The WisdomTree Cybersecurity Fund (WCBR), which tracks the returns of the WisdomTree Team8 Cybersecurity Index and represents an exposure to companies focused on providing cybersecurity solutions.

• The Application Software and Systems Software companies (GICS Sub-Industries) from within the Russell 3000 Index so as to provide a fair comparison to software companies that do tend toward higher revenue growth rates than just general U.S. equities.

• The broader Russell 3000 Index to show the overall baseline so we have a sense of the market’s past sales growth and estimated future sales growth.

Figure 2: Is Sales Growth at Cybersecurity Companies Holding Up Relative to the Market or Other Software Sales Growth?

Even if economic conditions become more challenging, software spending on cybersecurity should hold up even if broader software spending does indeed slow. 

• Cybersecurity revenue growth and generative AI revenue growth should be higher relative to general software, but we have to recognize that there are not really pure-play generative AI companies that we can use yet for this analysis.

• The past 12 months have seen faster revenue growth from WCBR relative to broader software or U.S. equities. Forecasted revenue growth for cybersecurity companies is also higher.

Conclusion: What Theme Is More Necessary than Cybersecurity?

Think about that question. If we are thinking about renewable energy companies, space companies, metaverse companies, fintech companies, AI companies…the list goes on. What is a common theme they all need to have a strategy on? The answer: cybersecurity.

Every company, really every person (unless able to get completely off of the grid) needs to have a cybersecurity strategy. It’s hard to think of any other theme for which that is true. We think that the quality pure-play cybersecurity companies have a lot of prospects. If it was last year, we likely would have been mentioning Thoma Bravo buying a series of identity-focused companies. What’s clear is that even in an environment where M&A is not trending straight upward, we’re still seeing actions in cybersecurity.

WCBR is focused on these pure-play, quality cyber firms that have potential as solutions to the cybersecurity questions of tomorrow.

¹ Source: https://investor.nvidia.com/news/press-release-details/2023/NVIDIA-Announces-Financial-Results-for-First-Quarter-Fiscal-2024/default.aspx
² Source: https://www.mandiant.com/company/press-releases/google-acquire-mandiant
³ Source: https://investor.cisco.com/news/news-details/2023/Cisco-to-Acquire-Splunk-to-Help-Make-Organizations-More-Secure-and-Resilient-in-an-AI-Powered-World/default.aspx