PANW - BUG ETF: A Long-Term Bet On Cybersecurity

2023-10-10 15:12:07 ET

Summary

• The Global X Cybersecurity ETF tracks the performance of the cybersecurity sector, focusing on network security, data protection, and threat detection.
• The BUG ETF consists of 24 holdings, with the majority of investments in the United States, followed by Japan, Canada, the UK, and South Korea.
• BUG ETF has underperformed compared to other thematic cybersecurity ETFs, but its inferior performance may be due to different weighting on its holdings.

Overview

The Global X Cybersecurity ETF ( BUG ) is an exchange-traded fund that seeks to track the performance of the cybersecurity sector. The ETF focuses on companies involved in network security, data protection, and threat detection. It offers investors exposure to both domestic and international players in the cybersecurity industry and aims to provide investment results corresponding to the growth in the cybersecurity industry.

While the index used by BUG employs market capitalization as a basis for weighting its constituents, it implements caps on individual holdings, thus mitigating an excessive concentration in large-cap companies and enhancing exposure to smaller entities. Notably, the index comprises the top 24 cybersecurity firms, and it undergoes a semi-annual reconstitution and re-weighting process to ensure its relevance and effectiveness. The ETF has a relatively low expense ratio of 0.5%, representing the annual management costs when investing in the ETF. It holds $584 million in assets ((AUM)).

Holdings

BUG ETF consists of 24 holdings, primarily focused on the Cybersecurity space.

Geographically, the majority of the ETF's investments are in the United States, representing 82.56% of its allocation. Japan, Canada, the United Kingdom, and South Korea also have smaller allocations at 5.53%, 4.75%, 4.64%, and 2.52%, respectively.

Zscaler ( ZS ): Zscaler, Inc. is a global cloud security company that specializes in providing secure access to external applications, including SaaS applications and internet destinations. The stock is trading 7% higher than last year, as revenue in 2023 grew 48% to $1.6 billion, while Free cash flow ((FCF)) grew to $333.6 million in Fiscal 2023, compared to $231.3 million, in fiscal 2022.

CrowdStrike ( CRWD ): The cybersecurity company delivers cloud-based protection for endpoints, cloud workloads, identity, and data. Their services encompass corporate workload security, vulnerability management, managed security services, IT operations management, threat intelligence, identity protection, and log management. CrowdStrike's shares are trading 12% higher Year-over-Year (YoY), as revenue in Q2'24 grew 37%, while its GAAP loss from operations narrowed to $15.4 million, compared to $48.3 million in the second quarter of fiscal 2023.

Palo Alto Networks ( PANW ): The company is a global provider of cybersecurity solutions. Their offerings include firewall appliances and software, as well as Panorama, a security management solution used for centralized control of the network security platform, available in both virtual and physical appliance forms. Shares advanced 55% YoY, as recent earnings exceeded analysts' estimates. In this regard, revenue in the quarter increased 26% from $1.6 billion a year earlier, while net income climbed to $227.7 million, or 74 cents a share.

Performance

The BUG ETF underperformed the broader technology market ( QQQ ), as large-cap technology stocks such as Nvidia ( NVDA ), Microsoft ( MSFT ) and Meta Platforms ( META ), outperformed smaller and less profitable Technology stocks such as those included in BUG. Moreover, BUG also underperformed comparable thematic cybersecurity ETFs such as iShares Cybersecurity and Tech ETF ( IHAK ) and First Trust NASDAQ Cybersecurity ETF ( CIBR ).

Here, iShares Cybersecurity and Tech ETF ((IHAK)) also includes holdings from the cybersecurity sector, but focuses on different stocks such as Taiwanese Accton Technology Corp, which surged over 90% YoY, thus pulling up the average performance of IHAK ETF. However, the ETF also includes Zscaler and Qualys, yet the weighting is slightly different. IHAK ETF has a slightly lower expense ratio than BUG, with an annual cost of 0.47%.

First Trust NASDAQ Cybersecurity ETF ((CIBR)), also outperformed BUG ETF, as it places a higher weight on companies such as Palo Alto Networks, which outperformed other cybersecurity stocks by a wide margin last year. Geographically, it also places a large emphasis on India as a high growth market for cybersecurity stocks. However, the ETF has a slightly higher expense ratio than BUG, with annual costs of 0.6%. Overall, I believe BUG ETF's inferior performance is solely due to different weighting on its holdings and could therefore catch up to other Cybersecurity ETFs if the top weighted stocks outperform.

Valuations

The stocks included in BUG ETF appear quite pricey based on their forward price to sales (P/S) ratio of around 10x. However, subscription companies in the cybersecurity are capital-light with free cash flow margins of around 30%, meaning their earnings are set to grow at above-market rates. Still, even on a Cash-flow basis, the included stocks are not cheap based on traditional valuation metrics. Here, Palo Alto Networks and Qualys trade at 32 times Price to Free Cash flow and 33x, respectively. However, the companies are also growing at the slowest rate at just 26% and 15% revenue growth, respectively.

This compares to Zscaler and CrowdStrike, which have current growth rates of 37% and 43%, respectively. Thus, their valuations based on free cash flow are also higher, as they are set to grow free cash flow quicker. Nevertheless, I believe it is good diversification that some of the ETF's holdings are already valued based on earnings, or free cash flow, such as in the case of Palo Alto Networks and Qualys. Overall, for growth stocks, I believe that the ETF's holdings are not valued absurdly and could therefore see a valuation expansion if interest rates drop.

Takeaways

BUG ETF presents a compelling investment opportunity due to the escalating challenges posed by the digital economy. As online and mobile interactions surge, the incidence of digital crime is on the rise, resulting in a multitude of attack opportunities. These attacks frequently lead to data breaches that pose substantial threats to individuals and businesses alike. Projections indicate that, at the current growth rate, the annual cost of cyberattacks could reach a staggering $10.5 trillion by 2025-a remarkable 300 percent increase from 2015 levels.

BUG comprises innovative companies experiencing rapid growth, strategically positioned to harness the immense potential of the cybersecurity megatrend. This investment offers a well-diversified portfolio within the cybersecurity industry, which can enhance resilience and potentially drive returns. However, it's crucial to be aware of the associated risks, such as market volatility, regulatory changes, and the ever-evolving nature of cyber threats that could impact the performance of the ETF.

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