Software is an anchor within the Lessep Global Equities portfolio. The sector offers the best long-term risk-adjusted returns available in the asset class. We view software as economic infrastructure. It should be valued as infrastructure.
Information Drives Economic Transactions
Transactions drive economic growth; the more transactions occur, the larger economies can become. Humans transact for resources; physical goods or for another person’s time. Information about products, their availability and price is crucial to making transactions happen. Through history, economies have grown as information availability has improved.
Lewis Mumford identified the clock as crucial to economic growth in the 14th and 15th centuries. It provided the same information to the entire village and allowed social and commercial life to be conducted more efficiently. Generally, however, the pre-industrial economy was a low information economy where transactions were limited by geography.
For instance, in Napoleonic France there were nearly 100 different wheat prices dependent upon location. By the late 19th century, the industrial revolution had created agglomeration and better communication tools. At this point there was one national wheat price, linked to global markets, and countries across Europe could access wheat regardless of the performance of their own crops.
This period reached its apogee in J. K. Galbraith’s New Industrial Economy which prized information centralised within the corporation. Only a corporation could successfully co-ordinate the processes required to manufacture goods for the masses.
The emergence of the internet has ebbed away at the power of the corporation and created a dis-aggregated economy. Software is the infrastructure that enables information to flow in such an economy.
Step Change in Productivity
A core aspect of infrastructure is its ability to create a step-change rather than incremental change in productivity. The Sydney Harbour Bridge is a good example; Sydneysiders went from ferries with limited capacity to abundant and faster capacity by bridge. Software offers similar productivity gains.
Consider, for instance, the film Hidden Figures featuring African-American human computers. These were women who did the work that today is undertaken by Excel. In 1946, at Langley Research (the predecessor to NASA) there were 400 human computers. Today, these women, employed in clerical work, might cost $24 million in wages but instead the work could be completed by a small number of Microsoft Excel accounts. The productivity gains from software, applied to business processes, are enormous.
Software is Unregulated Economic Infrastructure
Software has many of the characteristics of unregulated economic infrastructure. It allows economic activity to occur more efficiently. There is often alternative options for users but none are as efficient. This creates pricing power.
Software and unregulated infrastructure share similar financial models and risks. Assets enjoy stable, steady and predictable revenue growth. There are high, upfront, development costs and low, ongoing, variable costs to deliver access to users. Similarly, both face the risk of superseding technology or a competitor establishing a similar asset (though this is often expensive and difficult).
Importantly, however, software has some advantages. There are no insurmountable capacity constraints to the number of users. Indeed, the more users a software product has, the more the product can improve the user experience and lengthen the advantage over competitors. There is limited regulatory risk, if any. Generally, software companies rely on equity financing and have unconstrained balance sheets.
Good Software is a Unique Asset: It Should Be Valued as Such
The nature of software presents a compelling opportunity to investors. The advantages highlighted above have created businesses with corporate economics that are unmatched in human history. Even the largest companies of yesteryear, The East India Company or The South Seas Company were incapable of generating gross margins of 85% as they had to maintain fleets of ships and standing armies. As a result there are substantial returns still to come from these assets, especially as they mature.
Bill McDermott as CEO of SAP (now CEO of ServiceNow) made this point in 2018:
“Since 2000, there were 4,500 companies in the IT industry that took a Series A investment, only 75 made it to an IPO, only 36 became dominant category winners. Those winners now own 76% of their entire addressable market…”