EXCLUSIVE: How To Identify Software Companies That Can Stand The Test Of Time

No one knows when the markets will turn around, but with a majority of stocks well off their highs, it could be a good time to start putting some money to work if you can identify the right opportunities.

Peter Offringa, founder and chief analyst of Software Stack Investing, offered insights on how to identify opportunity in the software sector Friday at the 2022 Fintwit Conference hosted by Benzinga and Lupton Capital.

"I don't know when the recovery will be, but I'm sure there will be one," Offringa said. "I think the key is that companies that demonstrate consistent growth over time will work through any kind of changes in the macro environment."

Durable Growth: Durable growth companies are ones that consistently generate revenue over time while maintaining cash flow, Offringa said.

Durability is key, he said. The market expects growth to marginalize over time, so opportunity lies in the companies that can maintain growth rates over the longer term, he explained.

Offringa used a picks-and-shovels analogy to liken the biggest winners of the gold rush to software companies. The ones who made the most money during the gold rush were those who sold the tools to the miners, he said. Picks-and-shovel software providers are companies that provide the building blocks upon which digital experiences are built. 

"If we focus our attention on those companies that are providing the building blocks to enable those experiences, then it's less critical that we anticipate what consumer behavior is going to be," Offringa said.

For example, Datadog Inc (NASDAQ: DDOG) is a large provider of services for Peloton Interactive Inc (NASDAQ: PTON) and although Peloton has faced significant challenges over the last year, Datadog remains largely unaffected because the company has plenty of other consumer experience businesses that want to utilize its services, he said.

Other picks-and-shovel software providers include Amazon.com (NASDAQ: AMZN), Alphabet Inc (NASDAQ: GOOG), Microsoft Corp (NASDAQ: MSFT) and Snowflake Inc (NYSE: SNOW), he noted.

Identifying Opportunities: The three main factors that contribute to durable growth are addressable market size, release cadence and customer flywheel, Offringa said. 

Durable growth companies are built on a large addressable market foundation, he said. Release cadence refers to rapid innovation, he added.

Investors want to look for companies that release new products frequently and look to expand into adjacent product categories. This also helps to expand a company's total addressable market, Offringa said.

The customer flywheel factor is more simply a company's ability to land new customers and expand customer spending over time, he explained. 

"But at the core of this, of course, is a competitive moat. It's critical that any of these companies ... has a defensible moat. And why is that important? Because it keeps new entrants out of the market," Offringa said. 

See Offringa's full presentation below: 

Photo: Pexels from Pixabay.