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. 

 


 

Leave a Comment:

RELATED ARTICLES

The shift to the cloud

banner

Most viewed in recent weeks

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Latest Updates

Superannuation

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

Superannuation

Less than 1% of wealthy families will struggle to pay super tax: study

An ANU study has found that families with at least one super balance over $3 million have average wealth exceeding $19 million - suggesting most are well placed to absorb taxes on unrealised capital gains.   

Superannuation

Are SMSFs getting too much of a free ride?

SMSFs have managed to match, or even outperform, larger super funds despite adopting more conservative investment strategies. This looks at how they've done it - and the potential policy implications.  

Property

A developer's take on Australia's housing issues

Stockland’s development chief discusses supply constraints, government initiatives and the impact of Japanese-owned homebuilders on the industry. He also talks of green shoots in a troubled property market.

Economy

Lessons from 100 years of growing US debt

As the US debt ceiling looms, the usual warnings about a potential crash in bond and equity markets have started to appear. Investors can take confidence from history but should keep an eye on two main indicators.

Investment strategies

Investors might be paying too much for familiarity

US mega-cap tech stocks have dominated recent returns - but is familiarity distorting judgement? Like the Monty Hall problem, investing success often comes from switching when it feels hardest to do so.

Latest from Morningstar

A winning investment strategy sitting right under your nose

How does a strategy built around systematically buying-and-holding a basket of the market's biggest losers perform? It turns out pretty well, so why don't more investors do it?

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.