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Steven Chen
Steven Chen
Articles (106)  | Author's Website |

Urbem’s ‘Megatrend’ Series: Digitalization

In this domain, we have to sift through the economic moat carefully and apply a pick-and-shovel strategy where necessary

We believe that digitalization will be playing an increasingly significant role in our economy as businesses, consumers and public sectors keep seeking automation and efficiency. The megatrend can generate a long-lasting tailwind, along with enormous business opportunities, for the right companies.

However, as always, we are far from being convinced that a booming space would make stock picking any easier. On the contrary, considering the never-ending fierce competition in the technology world, we have to pay particular attention to business quality in terms of the durability of any competitive advantage and apply a pick-and-shovel strategy where necessary.

Software-as-a-Service (referred to “SaaS”) is one of our favorite business models for being relatively “defensive” thanks to its high-margin, cash-rich, predictable, recurring sales stream. Also, research shows that by 2021, SaaS subscriptions will share over one-third of the total software market.

Take a look at Technology One (ASX:TNE), the leading enterprise software supplier in Australia. The management estimates that more than 70% of the company’s sales are recurring, with a nearly half-half split between SaaS and license revenue at the moment. However, we observe that the SaaS business is growing year-over-year at more than 40%. The solutions and platforms of Technology One are deeply embedded in the day-to-day, mission-critical operations of its clients, which include the government, universities and financial institutes, creating a high switching cost. This factor resonates with the top-notch 99% retention rate as well as the consistently superior returns on capital (see below). Some of the other rising SaaS stars include Intuit (NASDAQ:INTU), which develops financial and compliance management software, and Paychex (NASDAQ:PAYX), a leading provider of human capital management platforms. As with Technology One, both businesses earn consistently high returns (see below), while being focused on their respective niches (e.g., small- and medium-sized enterprises), which we think even widens the moat compared with their Australian counterpart.

The online classifieds platform presents another case of a substantial moat in the technology sector. The concept here is simple – a classic two-sided network effect, where buyers would prefer to visit the site with the most listings, while sellers would prefer to advertise on the site with the most traffic. This critical factor enables businesses to fend off competitions, possess pricing power and scale up organically. Two examples on the top of our mind are Rightmove (LSE:RMV), UK’s leading real estate portal, and Carsales.com (ASX:CAR), Australia’s number one classifieds network. Check out their track record of growth below.

Last but not least, we consider a pick-and-shovel strategy attractively balanced when it comes to spaces that become too “foggy” for us to foresee the winner. For instance, Manhattan Associates (NASDAQ:MANH), as a market-leading provider of supply chain and omnichannel technology, benefits from the trend that our shopping experience becomes increasingly digitalized. Its shareholders should care little about which retailer is winning the e-commerce war.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Technology One, Rightmove, and Paychex.

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About the author:

Steven Chen
Steven CHEN is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital), and Urbem Capital, the research boutique that focuses on the highest-quality 0.1% of all public companies worldwide.

Steven can be reached at [email protected] or through LinkedIn.

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