Want to find good software stocks? Here are 4 important traits you need to look for

Nick Sundich Nick Sundich, May 25, 2023

Software stocks have provided amongst the highest returns of any ASX sector. There have been plenty of success stories in the last decade, led by Xero (ASX:XRO), Pro Medicus (ASX:PME) and WiseTech (ASX:WTC). Just look at the exponential return WiseTech shareholders have made since 2016!

 

WiseTech (ASX:WTC) share price chart, log scale (Source: TradingView)

 

But at the same time, there have been dud software stocks too, like Hiremii (ASX:HMI) and Limeade (ASX:LME). So, how can you sort out the good companies from the bad ones? In this article we recap 4 of the best differentiators.

 

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4 characteristics of good software stocks

 

1. Little competition

As with any sector, a company is better off in a monopoly or an oligopoly position than a state of perfect competition. Good software stocks tend to have little competition or only a handful of (manageable) competitors. Such a situation usually means higher margins for the company and for its shareholders because the company will generate more revenue than it otherwise would with less of a market share. It will also mean higher profits because less money will need to be spent faring off competitors through marketing and ‘moat building‘.

In many cases, they will have limited competition because the software stock’s product satisfies a need for its clients that is unfulfilled or just makes life easier.

 

2. Stand out from peers

All software stocks aim to simplify tasks and processes for their end customers but the best software stocks do it better than others or just have more features.

Take Xero for instance. It is not the only accounting software stock – Reckon (ASX:RKN) is one other example – but Xero has gone beyond just accounting and is now an all-round SME management platform in a way that its peers are not. There is no incentive for a Xero customer to switch to a competing product, because it would be a significant downgrade.

 

3. Good clients

The best software stocks will have several high-end clients and will likely publicise at least some of them. This not only proves that the software stock has a good product, but also that churn is likely to be low because they are less likely to ‘cut back’ spending when times are tough.

Take TechnologyOne (ASX:TNE) for example. A significant portion of its client base are local councils and several of them are named – Noosa and Moreton Bay are just a couple. But it has so many council clients that 73% of Australian and New Zealand residents live in a council are that has hired TNE.

To be fair, not all clients may be named for confidentiality reasons. But in cases like LiveTiles where it boasts of having so many clients but names one of them, you really need to be suspicious.

Here’s just one example of their announcements where they boasted of new clients but couldn’t name many of them.

 

 

4. A healthy revenue model

Good software stocks rely on subscription revenue rather than other sources (particularly transaction revenue). 

Subscription revenue is a great source of income for software companies because it provides them with a predictable and reliable income stream. Unlike other sources of revenue, such as one-time license payments, subscription revenue allows software companies to accurately forecast their future earnings. This makes it much easier for them to plan ahead and invest in new product developments.

Moreover, subscription revenue creates more opportunities for customer loyalty and retention. By providing customers with regular updates and exclusive content, they are more likely to keep their subscriptions active in the long-term. This helps create a steady and dependable source of income for software companies over time.

Furthermore, subscription models enable software companies to have better price control than with traditional pricing structures. For example, they can offer different tiers of service at different prices according to customer needs. This allows them to target different demographics more effectively and maximise their profits from each customer without sacrificing quality or value.

 

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