A few years ago, we highlighted the software-as-a-service (SaaS) model as a key growth theme that would drive outperformance, especially with the US economy struggling to shake off the hangover from the Great Recession and expand at typical recovery rates. (See Add Some SaaS to Your Portfolio.)
The appeal of SaaS solutions to corporate clients is simple: operational efficiency and lower costs.
This approach limits customers’ need to invest in data storage and server infrastructure and yields a highly scalable solution that doesn’t require massive capital spending to support new users or applications. Given these savings, uptake of these solutions has been particularly strong among small and midsize businesses.
Central hosting also ensures that all users within the organization can access the most up-to-date version of the software, relieving IT departments from the time-consuming process of updating the programs on each individual computer.
And delivering software applications over the Internet meets users’ increasing demand for access to mission-critical data and functions on smartphones and tablets.
This business model also has compelling advantages for software providers.
Rather than creating new applications and functionalities and then bundling them into a new version of an established product, the software company can introduce incremental enhancements to its offerings and immediately deliver those changes to the entire user base.
In other words, every subscriber will always have the newest version with the most up-to-date features.
In the past, not every customer would upgrade to the latest release; some preferred to save money and stick with older versions. By transitioning to this new model, the software industry swaps periodic, lumpy revenue for the consistency of recurring subscriptions.
The market has come around to this growth theme, with many of the stocks that we profiled trading at frothy levels that have priced in perfection.
Investors seeking exposure to this trend would be better served waiting for a pullback—they happen when quarterly earnings fall short of lofty expectations—or targeting legacy software names that might not get as much credit for making the transition to the cloud. Germany-based enterprise software provider SAP (Frankfurt: SAP, NYSE: SAP) comes to mind.
But our favorite software play stands to benefit from its ongoing transition to a SaaS model and its impressive leverage to growing adoption of the internet of things, a powerful growth theme that my colleague Jason Koepke highlighted in Aging Gracefully.