By Beth Kindig
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle.” — Warren Buffett, 1995 Berkshire Hathaway shareholder meeting
An economic moat — or lasting competitive advantage — ought to be top of mind for technology investors as momentum stocks are soaring.
Shares of Fastly /zigman2/quotes/212251938/composite FSLY -3.93% , a cutting-edge cloud company, have soared four-fold this year as investors have piled on. That shows that trading on stock price has become popular as the gains have been easy. Identifying moats, on the other hand, requires deep knowledge of the underlying business — and hands investors bigger returns.
There are two fallacies with the idea that everything is accounted for in stock prices.
The first is that investor conviction slips if a stock tanks. A stock can fall for many reasons, including profit taking, an economic slump or a hiccup in earnings.
In fact, from July to September 2019, the drawdown across cloud-software stocks ranged from 23% to 46%, seemingly on no bad news. (I previously covered this topic here.) For some cloud-software companies it was a steeper sell-off than the drawdown between February and March 2020. Therefore, trading on price may not work in the long run as growth stocks can suffer violent declines seemingly out of nowhere.
The second reason that trading on momentum can be harmful: If a tech company truly has a greenfield market with high margins and a runway for growth, competitors will circle quickly. That can erode the addressable market and forward projections.
Most cloud-software companies come with higher switching costs because it’s time-consuming to swap out tools and platforms unless a competitor offers serious, quantifiable advantages.
The market capitalization of the public cloud market stands at $1 trillion. Today, there are more than 140 private and public cloud companies each worth over $1 billion. Yet there are 57,000 software companies nipping at their heels , as estimated by peer-to-peer review site G2, with a substantial portion likely already cloud software or soon to be. When picturing the odds of 140 to 57,000, a locust storm comes to mind.
Although there is no argument over the enormity of the market and the migration of budgets, there isn’t much of a discussion around the limited number of customers that cloud software must appeal to. There is budget to be spent, but I believe every customer will become increasingly more valuable as the migration to cloud accelerates and there are fewer new customers to convert.
Twilio is one of the few software as a service (SaaS) companies that have been in business for at least a decade. The company re-accelerated its revenue from the 40%-50% range to 68%-77% by the end of 2018 . The company later acquired SendGrid and had Covid-19 tailwinds, resulting in year-over-year revenue growth of 57%, even with greater than $1 billion in annual sales. Those numbers are especially impressive compared with peers of similar vintage who are struggling to tread water above 20% revenue growth.