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

Noel Whittaker’s take on the budget

Marketed as a fix for inequality and housing affordability, the latest budget instead delivers a tangle of tax changes that leave everyday Australians worse off.

Australia has no death duties. Technically.

Australia may not levy formal death duties, but a growing web of tax measures is quietly shaping what wealth passes between generations. Now, the 2026 budget adds another layer.

Welcome to Firstlinks Edition 662 with weekend update

The debate over the budget is increasingly shaped by frustration and perceptions of unfairness, rather than clear-eyed assessment of policy outcomes.

How to minimise tax with a will

Inheritance tax implications in Australia may surprise some, as poor estate planning without proper wills or trusts can lead to costly tax bills and delays for beneficiaries.

How inflation is quietly moving the goalposts on retirement

Inflation doesn’t just raise today’s bills - it quietly increases the amount needed to retire, while simultaneously making it harder to save. Three steps to take before June 30th to improve retirement outcomes.

Back to the future - Why indexing CGT is a good idea

A return to indexation of capital gains would be a fairer way to compensate households for the effects of inflation than the current discount. Importantly, it opens the door to future, broader reforms to stop the taxation of inflation.

Latest Updates

Investment strategies

High quality businesses are on sale

Beneath the dominance of the ASX's largest stocks, much of the market has been left behind. High-quality companies are now trading at levels rarely seen, offering opportunities for investors willing to look deeper.

Investment strategies

The whirlwind is upon us

Something unusual is happening in markets. The winners are pulling further ahead at an extraordinary pace. As return dispersion hits extreme levels, volatility is rising and the investing landscape is becoming harder to navigate.

Strategy

Inequality destabilises economies

Extreme wealth concentration is no longer just a side effect of growth. As inequality deepens, its consequences are shifting from a social concern to a broader threat to economic stability and democratic resilience.

Investment strategies

Have AI’s four horsemen arrived?

AI exuberance is colliding with economic reality. Cracks are emerging as spending surges, ROI remains uncertain and enterprise behaviour shifts. The next phase may look less like an expansion and more like a reckoning.

Taxation

Budget tax changes only scratch the surface. Here are 4 reforms Australia needs next

The 2026 budget has reignited Australia’s tax reform debate, but more work remains. Beneath the surface lies a harder question: what structural reforms are needed to make the country's tax system fit for the future?

Taxation

Negative gearing: quarantined, not killed

The Budget's negative gearing changes defer deductions rather than deny them, yet a worked example shows quarantining can halve the tax benefit's present value for buyers of established dwellings.

Investment strategies

Family offices have quietly taken over Australian private capital

In just four years, Australia's private capital landscape has transformed. We are seeing changes across who deploys capital, how deals are structured and why new platforms and investor pathways are rapidly emerging.

Sponsors

Alliances

© 2026 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.