Technology advancements continue to increase. It can feel like there’s always a new app or software coming out to make our lives easier. But does that make tech a good investment? On behalf of our next gen newsletter, The Fresh Take, Brown Brothers Harriman Senior Relationship Associate Brooke Royer sat down with Vice President and Senior Equity Analyst Chris Stonerook to discuss the latest hot topics in the space.

Brooke Royer: When you look at the tech and software industry, what types of companies are most attractive from an investment standpoint? How do you identify winners?

Chris Stonerook: Our approach to sourcing attractive investments in technology and software isn’t much different from our approach to any other industry. We start with our qualitative investment criteria, which prioritizes companies that:

• Provide essential products and services to their customers
• Exhibit leadership in an attractive market
• Have high degrees of customer loyalty
• Hold durable competitive advantages

When we find businesses that fit those qualitative criteria, the next step is evaluating the management team. It’s crucial that the team responsible for the cash our businesses generate is aligned with our long-term ownership perspective.

From a quantitative perspective, we are looking for businesses that have high and sustainable returns on the cash they deploy in their businesses and have opportunities to reinvest the cash they generate so that they can grow their free cash flow per share.

Applying our criteria to software specifically, it’s immediately apparent that the industry overall is a fertile hunting ground for businesses that we find attractive. Returns on capital and revenue growth in software are in the top decile of all industries, so when we evaluate software investments, we tend to focus on the competitive intensity of the market they are serving. While the industry has high returns on capital and excellent growth, the lack of capital intensity often leads to low barriers to entry in software.

We have found success focusing on vendors that have either:

• A standardization advantage: Their tools have become the industry standard for users in their industry, and there are productivity costs to learning a new application (think Microsoft Excel or Adobe Illustrator).
• A distribution and bundling advantage: Vendors with ubiquitous software that can extend their technology and compete with new entrants by offering similar capabilities at low incremental prices to the broader package they sell customers (think Microsoft Teams competing at a low price compared with Slack or Zoom because of the ubiquity of Microsoft Office).

Fewer competitors and more stable market share are usually indicators that the vendors are behaving rationally and there are higher barriers to entry in that market than there might be in other software markets.

BR: Markets are at an all-time high right now, dominated by large tech companies and artificial intelligence (AI). Within technology, how is software performing and valued?

CS: This is an interesting time for software. Despite the attractiveness of returns on capital and growth for the software industry, stock market performance this year doesn’t reflect those characteristics. Through August 31, the S&P 500 is up 19.5%, and technology generally is up more than 27%. But if you look under the hood, semiconductors are up 63%, and software is only up 10%.

In addition to the more immediate AI revenue impact for semiconductors vs. software, there are fears that AI will disrupt software. The business model is dependent on the number of seats or users that vendors can sell. If AI results in less need for workers, the thinking goes, then there will be less demand for software. We are focused on areas:

• With embedded competitive advantages where we think it will be hard to disrupt the incumbent software vendors
• Where the software applications are industry standards for completing work
• Where the demand dynamics support continued seat growth and aren’t at risk for headcount disruption from AI

We are excited about our semiconductor investments, but we don’t share the same lack of enthusiasm for software that the market has, and we have found that valuations for some of the best positioned software companies have become attractive as investors rotate capital from software stocks to purchase semiconductor stocks.

BR: What are some ways that software companies differentiate, and how are they adding value to their customers by helping them implement AI?

CS: One of the core ways we categorize the software industry is “best-of-breed” vendors vs. “full suite” or “platform” vendors. Best-of-breed software companies offer solutions that solve specific use cases for their customers and tend to have extremely high performance in that niche. Full suite vendors rely on their distribution and the stickiness of their embedded relationships with customers to grow those relationships. While each individual software application a full suite vendor sells may not be as high-performing as a best-of-breed vendor, the sum of the parts tends to be more valuable than the individual pieces because of superior interactivity between applications created by a single vendor, easier commercial relationships, and, typically, a lower price for the full bundle.

Our investment criteria tend to favor full suite vendors because of their distribution advantage, and there is usually less risk in these companies rather than picking winners in emerging software categories. Additionally, the current market dynamic – where customers are closely monitoring their IT budgets and putting more scrutiny on software spend – is to the benefit of platform vendors.

We spoke about Microsoft and its standardization and distribution advantages above. Oracle is another platform software company that offers its customers a full stack of solutions from infrastructure to application. Oracle’s platforms are extremely sticky because it’s difficult to change the underlying database that an application uses. Data is critically important to training and deploying AI, and having it organized so that it’s useful is one of Oracle’s longtime strengths.

Given that database incumbency, Oracle’s strategy of building AI tools and bringing them to where customers keep their data is especially welcome. Oracle is also deploying AI in its healthcare applications to reduce the time doctors spend creating notes in patients’ electronic health records and implementing machine learning in its financial reporting applications to speed customers’ ability to report quarterly financials.

BR: Some fear AI could increase the unemployment rate in certain sectors. Are there any industries where there are actually too few skilled professionals, and AI can serve as an opportunity?

CS: Anywhere where there is a gap between the number of skilled workers and the demand for their labor is an opportunity for AI to help bridge that gap, and we have focused on these areas in our software investments. Creative professionals, for example, are a group where the demand for digital content is growing at a faster pace than knowledge workers with the skills to produce it. Software applications that integrate generative AI to help general knowledge workers create and edit digital marketing campaigns are becoming increasingly important!

Another important and critical area where there are too few professionals relative to the exploding demand for their skills is in software development. There are simply too few software engineers with fluency in programming languages (such as Java, C++, Python, and so forth) relative to the demand for new software applications and editing code within existing software applications. Code repositories like GitHub, GitLab, and Bitbucket have been critical to helping skilled software engineers produce more lines of code and develop software applications faster. Now, by integrating generative AI on top of those code repositories, companies like Microsoft can help workers without software programming experience write, edit, or migrate code. This is a valuable application of generative AI and a place we are really excited to be invested.

BR: What role can tech and software investments play within a holistic portfolio?

CS: Software remains an attractive hunting ground for exceptional businesses that:

• Have durable competitive positions
• Are free cash flow generative
• Have untapped market growth opportunities

Those considerations are critical when we are filling a portfolio of investments, so software companies make up a meaningful and important weight within our portfolio.

Anyone who is focused on free cash flow per share growth and high return on capital businesses would do well to spend some time studying software. Given the overhang of fears regarding AI, we have been selective to try and pick the companies that have an opportunity to benefit from integration and demand growth over time, and the sell-off within software has made the valuations more attractive.

BR: Chris, thank you for your time.