We have had the equivalent of a bull market in information technology spending, with global spending in IT above trend over the past few years.
Bernstein Research has been tracking global IT spending over the years and the two most relevant findings for now are that IT spending in 2017-18 was above trend; and that IT spending can be cyclical.
In such an environment, particularly with interest rates close to zero, more companies can grow and prosper in the short term than can be expected to survive in more common trading conditions. The Software as a Service (SaaS) sector has certainly been a beneficiary of the boom, triggering a number of IPOs and pushing “young software” stocks to aggressive enterprise value/sales ratios of 10-20 times.
The important question is how these SaaS companies will cope if/when the robust IT spending environment falters (which it looks like it is currently doing) either due to cyclical or structural factors, and clients decide to:
As a long-term investor, we are looking for solidly profitable companies trading at a reasonable valuation, with a trustworthy management team.
Just as importantly, it needs to be able to be counted on to grow in good and bad times. Can these companies outrun the bad times?
This one special quality sounds simple but it is actually very difficult to do. History is littered with the gravestones of successful companies that looked to diversify but only succeeded in sucking up valuable capital and management attention from their main business.
The hallmark of a great company is the ability to expand beyond its core business and successfully dominate a new or adjacent opportunity. A few examples:
Most of the new generation SaaS companies are focusing on their niches. However, their core markets will mature and growth will slow down as competitors catch up.
Can the current IT stars do the same internal diversification successfully, while still retaining their core markets? Just because a small software company can grow 30 per cent to 50 per cent for 2-3 years in a robust IT spending environment, there is no guarantee that it can dominate its core segment in the long run, let alone execute the most tricky business strategy of all – building and conquering new market opportunities.
And yet, they are already valued like great companies built for long-term success.
Douglas Huey, portfolio manager, PM Capital