Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 172

The silver lining really is in the cloud

The appeal of companies that can deliver sustainable and attractive earnings growth in difficult economic conditions seems obvious. But has this appeal pushed their valuations to unsustainable levels?

Broadening the definition of ‘quality’

Many global consumer stocks have outperformed the market and now appear expensive. Companies such as Colgate Palmolive and Unilever, for example, are trading at historically high valuation multiples. To find value in quality stocks today, investors need to broaden the definition of what makes a quality company beyond just a brand.

Our definition of quality refers to what we call ‘economic franchises’. These are companies with characteristics such as market-leading positions, a long history of stable financial returns, relatively low leverage, and large, sustainable competitive advantages.

Franchises in the past built their competitive advantages (or ‘moats’) from intangible, industry- or product-related features such as brands, intellectual property, network effects, or high customer switching costs.

These companies are by definition rare, and we believe there are roughly 250 of them globally. This includes consumer staples companies, but also many businesses operating in sectors such as information technology, consumer discretionary, health care, materials, infrastructure, and industrials.

Quality stocks can be cheap or expensive

All stocks in our franchise universe are ranked according to our estimation of their potential upside, with reference to the differential between their ascribed ‘intrinsic value’, as determined by our fundamental analysis, and the current prevailing market price. In the table below, each of the lines represents a particular company in our universe. The red lines are consumer staples, and based on our analysis, they look expensive, with expected returns below zero. However, many IT franchises, the green lines in the table, offer high expected returns and look attractive.

IT vs Consumer Staples, Expected Return

Compared with the consumer staples sector, certain IT companies offer higher returns on capital and higher growth at materially lower earnings multiples (see table below).

The appeal of technology

Start-ups would not qualify for our franchise universe, but within the IT space there are long-established companies with leading market positions that do. In the software sector, Microsoft, SAP, and Oracle have dominant market shares with products that make it difficult or costly to switch to an alternative vendor. In addition, the marginal cost of production for a software product is close to zero, underpinning operating margins of 35–45%, returns on tangible capital of 300–400%, and huge amounts of free cash flow every year. As a result, software companies are currently some of the most profitable businesses in our franchise universe.

Many dominant software companies now appear cheap, partly due to market fears that cloud computing will erode their economic moats. In most cases, we believe the reverse is actually more likely. The value proposition to customers is primarily the cost savings and flexibility they can achieve through replacing on-site servers, IT staff, and ongoing maintenance, with off-site cloud hosting. Importantly, that will typically enable the software vendor to charge more for their cloud-based products while still saving their customers money.

Since cloud-based software (often called ‘software as a service’) is sold by subscription rather than periodic licence renewals, software vendors’ total revenue over time increases by effectively compressing traditional renewal cycles of 3–5 years into much shorter periods. Customers can no longer defer upgrades, as non-renewal means no more software.

It is true that the transition to the cloud may give new entrants a foot in the door in some market niches. However, overall we see the revenue upside far outweighing any market share losses for incumbent software vendors with their vast installed customer bases, strong brands, and proven technology. Moreover, the switching costs that underpin their competitive advantage appear at least as high in the cloud, since the upgrade events which traditionally trigger tenders become a thing of the past.

It’s still early days, but the evidence to date indicates that the dominant software vendors are succeeding in their transition to the cloud.

Investors face a quandary at the moment. Global bonds offer close to zero yield, and some equity markets have hit multi-year highs. Developed economies appear fragile and political uncertainty continues to shake confidence. The appeal of quality companies is clear, but only at the right price and the right multiple. When shopping for quality, you may want to update your software while avoiding the toothpaste aisle.

 

Warryn Robertson is a Portfolio Manager at Lazard Asset Management. This article is general information and does not consider the circumstances of any individual. Disclosure: Graham Hand is Editor of Cuffelinks and participates on a Lazard committee. 

 

  •   8 September 2016
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

The shift to the cloud

banner

Most viewed in recent weeks

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 636 with weekend update

A new academic study shows that almost all Australians agree that there is a housing crisis yet we can’t agree on how to fix it and are sharply divided along generational and ideological lines.

  • 6 November 2025
  • 26
Taxation

13 ways to save money on your tax - legally

Thoughtful tax planning is a cornerstone of successful investing. This highlights 13 legal ways that you can reduce tax, preserve capital, and enhance long-term wealth across super, property, and shares.

Taxation

Taking from the young, giving to the old

Despite soaring retiree wealth, public spending on older Australians continues to rise. The result: retirees now out-earn the young, exposing structural flaws in the tax system and challenges for fiscal sustainability.

Investment strategies

An obsessive focus on costs may be costing investors

As a relentless fee war grips Australia’s ETF market, investors may be missing the real battleground. Beyond basis points, index design itself - not cost - may be the most powerful driver of returns.

Taxation

Clearing up confusion on how franking credits work

It seems the mere mention of franking credits generates a lot of heat but not much light. Here's a guide to how franking credits work, and the impact they have on both companies and shareholders.

Investment strategies

Are the good times about to end?

As the bull market revs up, some investors worry about a possible correction. History shows the real question isn’t timing the top, but whether you have the time and liquidity to ride out inevitable downturns.

Superannuation

Australia slips in global pension ranking

The 2025 Mercer CFA Institute Global Pension Index shows Australia has dropped to its lowest ranking in the 17 years of the index. This explores why we're falling and what can be done about it.

Property

Where wine country meets real estate

High-profile wine regions don’t always see strong property growth - volume, exports, and infrastructure investment often matter more than reputation in driving regional property markets.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.