I was reviewing some of Benjamin Graham’s old lecture notes at Columbia University in which he warned his students that “it is the good ideas that do you in.” If something is a bad idea on its face, everyone knows it’s a bad idea and there is no risk to you because you wouldn’t dedicate money towards it in the first place. After all, no one is reading blogs about how to invest in pay phone companies.
But failing in the specifics of the pursuit of a generally good idea is where many of us can make our mistakes. For instance, over the past few years, many of us have come to realize that software as a service companies have the ability to scale up their businesses quickly to go from 1x to 10x revenues in just a matter of years (in fact, if you look at the “quick” fortunes that were made over the past twenty years or less, a disproportionate number of them come from software and nearly all share the common characteristic of easy scalability).
The difference between executing well with this strategy and being “done in” by poor execution is realizing that a software firm is valuable to the extent that it cannot be replaced by some other some other guy drawing up a similar code and bringing the same product to the market at a lower price.
For instance, over the past couple of years, several software stocks have become publicly traded that provide services relating to GPS-location or even order sequencing for restaurants. These types of software investments contain no “moat” because there is no competitive advantage there. Heck, it is possible to even rig services from Apple and Google to effectuate many of the same things that GPS and order-sequencing apps offer. It’s not an investable asset because there is no reason to be using the same software provider twenty years from now.
On the other hand, there are software firms that provide SAAS services to government and commercial entities where the information is “mission critical” and privacy concerns are at stake. For instance, in Missouri, the court systems rely upon a service called CaseNet to manage the records for all of its case management systems. CaseNet is a subsidiary of Centene (CNC). As a result, Centene’s business model is well-protected against competition because it has a twenty-year contract in place with the State of Missouri to administer to its case management loading systems. It is responsible for the correct storage and processing of over 500 million documents and it is able to raise its prices for its services in a predictable manner.
As a result, I’m a junkie for software as a service companies that deal with the storage and processing of government documents (particularly legal and police records), electronic health records, and similar underlying data that cannot be compromised. In these arrangements, it is not merely about the capability to process the requested data, but to store voluminous amounts of it and keep it secured. The software as a service companies that are able to do that are the ones that will end up delivering double-digit returns to their shareholders. On the other hand, if the business is the product of mere “coding convenience”, then I would argue that the software company is a passing fad that hasn’t proven itself worthy of a conservative investment yet.