It has been a rocky nine months for software stocks. After soaring 47.6% in 2013, the S&P Software and Services Select Industry Index1 was down 4.85% year-to-date as of September 30, 2014, and down 9.1% since its peak on March 5, 2014. In contrast, the S&P 500 Index was up 8% year-to-date as of September 30, outpacing software by roughly 10%.
U.S. equity markets experienced a sudden reversal in sentiment in late March and early April, sparked by concerns over interest rates and geopolitical unrest. Investors swiftly rotated away from high growth, smaller cap stocks into larger cap “value” stocks in a “flight to safety.” The impact was particularly acute in stocks that had been strong performers, as investors took profits and redeployed their assets elsewhere. Software-as-a service (SaaS) stocks, which had enjoyed an extraordinary runup in 2013, bore the brunt of this reversal in sentiment. Many had been trading at high valuations under non-traditional valuation metrics, in which multiples were being based on revenue instead of earnings, given the large addressable markets of these companies and the significant reinvestments they were making into their businesses. With high growth suddenly out of favor, investors turned to more traditional EBITDA, EPS and cash flow-based metrics and found valuations stretched given minimal near-term expectations of profitability.
Software valuations bottomed and bounced since the March/April pullback, with average valuations trending more toward historical levels. Despite the bounce back, the vast majority of software stocks were still down year-to-date as of September 30. From a high level perspective, while the NASDAQ Index is up 8% year-to-date as of September 30, nearly a fourth of its constituents are down more than 20%.
Explosive Growth
Even with the recent market volatility, we consider software to be one of the most fertile hunting grounds for growth stocks today. This is an industry that has seen phenomenal growth over the past few decades, and in the course of its growth, irreversibly altered our way of life. The average smartphone has more computer power than all of NASA back in 1969 when it sent two astronauts to the moon. A $300 Sony Playstation has the power of a 1997 military supercomputer, which cost millions of dollars. We see no signs of this growth trajectory slowing down. Although it may seem as if everything has become digitized, there are many areas – both business and consumer – that software has just begun to penetrate. At Baron, we think about which areas are transforming, and where we see the best opportunities for sustainable growth.
As an investor in growth companies, Baron has been an owner of software stocks for many years. As of September 30, 2014, our software & services holdings represent 16.6% ($4.2 billion) of our portfolios.
As with all of our investments, Baron looks for software stocks that we believe have significant long-term growth opportunities, sustainable competitive advantages, and visionary management, at an attractive valuation. With regard to valuation, we consider stock prices in the context of our assessment of a company’s growth and cash flow potential, because we want to invest at a price that enables us to make the returns we are looking for over the long term. At the times of our initial investment and any follow-up investments we may make, the company must be priced such that we can expect the stock to double in four to five years (for some of our portfolio managers), or grow by 50% in two to three years (for others).
Of course, our expectations may not be met. Market sentiment is not a factor in our evaluation of a company’s intrinsic value. While the valuations of many of our software investments compressed over the past six months, our assessment of business fundamentals and our expectations for long-term performance remain unchanged.
We believe that, as a group, the SaaS businesses in particular are benefiting from a generational change in computing that is providing a powerful tailwind to revenue growth. SaaS companies license centrally hosted software on a subscription basis to customers who access the software over a network, typically the Internet. In other words, customers lease rather than buy the software, allowing them to outsource support costs to the SaaS provider, and to make smaller, recurring “rental” payments rather than a large, lump sum purchase. This helps to minimize the upfront cash outlay and provides predicrtability in the customer’s IT expenses. Since the software is centrally hosted, all customers operate on the same version, which means that the SaaS provider can enhance the software continuously and instantly upgrade all of its customers. SaaS is part of the movement to cloud computing, in which remote servers are networked to allow centralized data storage and online access to computer services or resources. This movement is still in its early stages. Spending on SaaS is less than 10% of total global software revenue, but is growing almost four times faster.
Up in the Cloud
Many of our SaaS holdings are enterprisefocused. Because of their subscription-based structure and the key role they play in the different aspects of running a business, these SaaS platforms become a critical part of the end users’ day-to-day workflow, creating a sticky business model with high levels of recurring revenue and visibility.
One such enterprise-focused SaaS is Salesforce.com Inc., the largest pure play cloud company. The company is best known for its on-demand Customer Relationship Management (CRM) solutions, but it also offers applications for service, performance management, marketing, and analytics, and continues to expand its portfolio both organically and through acquisitions. It is becoming an increasingly strategic vendor to clients, and as the leading cloud company, is well positioned to benefit from the growing adoption of cloud-based software solutions by businesses worldwide.
The Ultimate Software Group, Inc. (ULTI, Financial) and Concur Technologies, Inc. are focused on other business functions. Ultimate provides payroll, benefits and other human resources services. Ultimate’s SaaS cloud-based model has significant advantages. For example, Ultimate allows clients to manage their payroll directly, for a flat per-employee fee. The company’s payroll software is integrated with other key human resources applications and includes business intelligence functionality. Ultimate is also known for its high touch customer service. These attributes are helping the company gain market share from outsourced payroll service providers.
Like Ultimate, Concur (CNQR, Financial)’s integrated travel booking and expense reporting product has unique cloud-enabled advantages. For instance, receipts from airlines, hotels and car rental companies are electronically delivered directly into expense reports. The product is simply light years beyond the manual, paper-pushing processes of old. We are not the only ones who have noticed. On September 18, enterprise software company SAP announced an agreement to acquire Concur for $8.3 billion, at a significant premium to the pre-announcement share price.
FactSet Research Systems, Inc. (FDS, Financial) and CoStar Group, Inc. target businesses in discrete industries. FactSet supplies the investment community with financial intelligence. It enjoys a significant advantage over competitors such as ThomsonReuters because it aggregates data from multiple independent sources with its own proprietary data sets, and overlays its unique analytical capabilities. This open approach to content, coupled with its excellent support resources, have resulted in an extremely sticky business model with dollar retention rates over 95%.
CoStar (CSGP, Financial) founder Andrew Florence’s vision was to become the “single source of truth” for the $50 billion commercial real estate industry. The company has built a proprietary database from information collected over a 20-year period that includes details on spaces available for lease, properties for sale, tenants, comparable sales and industry news. CoStar has become the outsourced research department for many of the largest real estate brokerage firms. We believe the company will leverage its unique data set to penetrate its existing markets and create novel products that address other real estate workflows.
Health Care IT
It’s no secret that technology in health care lags far behind that of other industries. For instance, according to a 2013 report by IT provider CDW, health care ranked seventh out of eight industries in cloud adoption.
Progress is being made. In 2009, Congress passed legislation designed to increase the use of electronic health records (EHR) to improve health care quality and lower costs. Since then, according to the U.S. Office of the National Coordinator for Health IT (ONC), the percentage of office-based physicians that have adopted a basic EHR system has increased to 48% in 2013, up from 22% in 2009. In addition, 59% of hospitals have an EHR system with advanced functionalities, quadruple the percentage for 2010.
The rising adoption of EHR bodes well for health care IT companies, since it suggests that health care providers are seeing the benefits that IT can provide. At the same time, we believe this is just the first stage. For instance, according to the ONC, the electronic exchange of health information among physicians is still relatively low – 39% with other providers and just 14% with ambulatory care providers or hospitals outside their network. The government is now prioritizing its efforts to support providers in this next stage of IT adoption. In the coming years, we expect to see increasing industry penetration, sophistication, and cross-provider and cross-function integration of health care IT. We believe health care has a long runway of growth ahead for companies that are able to meet the technology needs of the myriad participants in the system, from single practitioners to hospitals to administrators to consumers.
Athenahealth, Inc. (ATHN, Financial) is capitalizing on the trend toward digitizing the business of medicine, providing SaaS-enabled practice management for doctors – particularly helping them get paid. The company’s flagship product, athenaCollector, automates and manages billing-related functions. It also has an EHR service, an automated communication platform, and a coordination service for order transmission, insurance precertification and patient registration. Given the advantages of the company’s core service offering, which helps doctors get paid faster, we think athenahealth will experience significant adoption in this multi-billion dollar market.
Consumerism of health care is another secular health care trend. Increasingly, employees are being asked to bear a greater percentage of their healthcare costs through higher co-payments and deductibles. Several companies in which we have invested have positioned themselves to benefit from this trend, including Castlight Health Inc. (CSLT, Financial) and HealthEquity, Inc. (HQY, Financial). Castlight was founded by athenahealth co-founder Todd Park, who also served as U.S. Chief Technology Officer from March 2012 to September 2014. Castlight provides tools for large self-insured employers to encourage their employees to make more informed health care purchasing choices, which translates into lower costs for employers. It has 35 of the Fortune 500 as customers, with the potential to grow its customer base substantially. HealthEquity helps consumers manage their Health Savings Accounts (HSAs), which are federal income taxexempt accounts used to pay for qualified medical expenses. The company is banking on the secular shift toward employer-sponsored high deductible health plans combined with HSAs, because these plans incentivize employees to spend less on health care. The Affordable Care Act encourages health care providers to form Accountable Care Organizations in which providers agree to be accountable for the quality, cost and overall care of a population. The Advisory Board Company and Cerner Corp., both of which provide software tools for population risk management, are focused on the secular shift to these and other risk-based payment formulas from the traditional fee-for-service, volume-driven payment arrangement, in which patients pay for medical care regardless of outcome. Under a risk-based arrangement, payments are based on an estimate of the expected costs to treat a particular condition or patient population. The intent is to improve the outcome, quality and cost-efficiency of patient care. At the same time, these payment models are well outside the comfort zone of most medical providers, and require sophisticated and actuarially sound models and analytics. We think the shift toward risk-based payment models will compel health care providers to invest more in the types of population health and other analytics tools offered by Advisory Board and Cerner.
Conclusion
The more things software is able to do, the more uses we will find for it. For instance, Tesla Motors Inc. makes a car that runs largely on software. A standard automobile with an internal combustion engine has 2,000 moving parts. Tesla cars have 18 moving parts. The result is an easier-to-manufacture, more efficient, safer, cleaner, more reliable vehicle.
Wherever software has the capacity to improve a product, a service, or a process, we think it will find its way there. We believe that we are looking at a future in which software will play a Source: IBM 2013 Annual Report far bigger, not smaller, integral role in our lives.
You should consider the investment objectives, risks, charges, and expenses of the Funds carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds and can be obtained from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.
The discussion of market trends and companies throughout this report are not intended as advice to any person regarding the advisability of investing in any particular security. Some of our comments are based on current management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time of the publication of this report and are subject to change any time based on market and other conditions, and we have no obligation to update them. Investing in the stock market is always risky. Baron may not achieve its objective. Portfolio holdings may change over time.
Portfolio holdings as a percentage of net assets as of September 30, 2014 for securities mentioned are as follows: The Ultimate Software Group, Inc. - Baron Small Cap Fund (1.9%); Concur Technologies, Inc. - Baron Growth Fund (1.3%), Baron Opportunity Fund (1.9%*), Baron Focused Growth Fund (0.4%); FactSet Research Systems, Inc. - Baron Asset Fund (2.4%), Baron Partners Fund (3.7%*), Baron Growth Fund (2.5%), Baron Focused Growth Fund (4.7%); CoStar Group, Inc. - Baron Partners Fund (7.3%*), Baron Growth Fund (2.0%), Baron Opportunity Fund (2.1%*), Baron Focused Growth Fund (5.4%); athenahealth, Inc. - Baron Opportunity Fund (1.5%*); Castlight Health Inc. - Baron Growth Fund (0.1%), Baron Opportunity Fund (0.7%*); HealthEquity, Inc. - Baron Small Cap Fund (0.4%), Baron Opportunity Fund (0.5%*), Baron Discovery Fund (1.1%); The Advisory Board Company - Baron Growth Fund (0.3%), Baron Small Cap Fund (0.6%); Cerner Corp. - Baron Asset Fund (0.6%); Tesla Motors Inc. - Baron Partners Fund (8.7%*), Baron Opportunity Fund (2.0%*), Baron Focused Growth Fund (3.2%). * % of Long Positions
