MoneyTalks is Stockhead’s regular recap of the ASX stocks, sectors and trends that our experts, fund managers and analysts are looking at right now.

Today we hear from Claude Walker, the lovely and legendary founder of A Rich Life.

Claude started young as an investor-with-a-conscience, long before scientists realised you could be one and still have the other. He wore the Motley Fool colours as an analyst and advisor before founding A Rich Life. He is Canberran. It is not a crime.

Claude is an intrepid explorer of the unexpected investment. Anywhere, anything, anytime… but always with an eye (and a bit of head and heart) on what good his investments might have on a universe that needs smart people to consider more than financial return.

What’s your eye on? 

My favourite area of the market is small cap software stocks. At their best, software businesses are sometimes great for investors and can go on winning for decades. Because most software companies are less than 40 years old, we don’t really know how long these businesses can dominate and grow.

A successful software company must (among other things) reduce costs for its customers by increasing productivity. The value of a successful software company depends in part on how much pricing power it can exert on users. One example of software having pricing power is Microsoft Office, which costs more than competitors but is still popular due to ubiquity and consistency.

What do you look for when small capping, Claude?

These five software stocks are lessons from the past, not predictions about the future. Generally speaking, a company cannot endlessly benefit from multiple expansion. The idea for a small cap software investor is to buy a stock when it is on a relatively low multiple of earnings, and sell it when it is on a much higher multiple of earnings. Usually, this multiple re-rate will only occur if the company has been growing strongly during the holding period. The challenge for small cap investors is to continually search for small cap software stocks growing earnings quickly.

The current environment will doubtless see the end of many overhyped, loss-making software story stocks. Ultimately, a business must make a sustainable profit to survive. As the market runs scared from this sector, I hope it will offer profitable growing software stocks at more attractive prices; that is, at lower multiples of earnings.

As a small cap software stock investor I have cash ready for deployment and plan to do so slowly throughout this rate-rising cycle. I am mindful that the current inflation cycle may take a while to play out, so I am investing cautiously. However, I continue my search for the best growing profitable small cap software stocks, because that is where I think the best future winners will be found.

And what are the names you’re looking at now?

Similarly, many of the best radiologists in the world use Visage radiology viewing software. Visage is owned by ASX-listed Pro Medicus (ASX: PME). Today, the list of Pro Medicus customers includes top notch institutions like Yale New Haven Health and Mayo Clinic. However, seven years ago there was no certainty that it would emerge as a leader in the nascent artificial intelligence assisted radiology industry. Pro Medicus investors such as myself took on the risk of failure in hopes of success, and got lucky.

Since 2017, Pro Medicus has increased half year profit over 300% from $4.8m to $20.7m. On top of that, the market is now willing to pay a higher multiple of those earnings, putting the company on a whopping price to earnings ratio of about 124.

The earnings multiple expansion shows that the market is now in love with the stock, and that explains why I have sold the majority of my original holding of Pro Medicus shares, although I still hold plenty. Like the other companies in the chart above, Pro Medicus could fall 50% from here, and still be a great investment, if measured over the long term (five years or more).

Printed circuit board software company Altium (ASX: ALU) has also had a wonderful half decade. The company has found great success selling design software to a wide range of “physical world” creators from Australian Defence Force contractor BAE Systems to Breville. As is so often the case, the sticky software slice of the pie has proved immensely profitable, with half year profit more than doubling from $13m five years ago, to $31.3m, in the most recent half. It too has seen earnings multiple expansion, and that has driven a very solid share price gain of over 300%.

This should give you a hint as to why I don’t just look for software stocks, but also small cap software stocks. Accounting software provider Xero (ASX: XRO), for example, has had a stratospheric rise, and it is now worth more than $14b. Arguably by 2017, the earliest date shown, it was not a small cap software stock. But a decade ago it certainly was; having traded for significantly less than $1b. While I own some Xero shares today, I failed to capitalise properly on the creation of a phenomenal software business, and it is no longer a small cap stock!

Zooming in on the last six months, high quality software stocks have been suffering multiple compression. That’s partly because higher interest rates are bad for growth stocks. This trend means that I am not rushing to buy software stocks at the moment, but just buying gradually. Whatever happens, what is good for the economy is usually good for a software company, somewhere. Lithium miners use software too.

Energy One (ASX: EOL) is a software and services company serving the wholesale energy market participants. I own shares in the company. It has a very high five year share price gain because it recovered from a near death experience, so it had a very low starting point.

Even today, Energy One is still fairly small. It hopes to better serve new renewable energy market participants who need to outsource their energy trading and risk management. That means that Energy One isn’t a pure software company, as some of the others mentioned in this article. But on the bright side, its own services division is able to make use of its software (and inform its development). It has gone from a half year profit of under $140,000 five years ago to over $1.4 million in the most recent half.

Another software stock in my ASX portfolio is Objective Corp (ASX: OCL). You’ve probably never heard of it, but it has offices in every state (plus New Zealand) and it’s likely you’ve interacted with it, without knowing. That’s because Objective helps many government departments and local councils to store, govern and manage information, and empower business or government processes. One of its selling points is its “military-approved levels of security”. You could argue it benefits from increasing cyber threats, and one would hope it makes organisations more efficient, too! In five years, it has grown half year profit from $3.7m to $8.7m.


The views, information, or opinions expressed in the interviews in this article are solely those of the interviewee and do not represent the views of Stockhead.

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