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Are software shares too risky?

Software stocks have a reputation for being riskier than other types of business. This used to be true, particularly if you look back to the dot com boom and bust almost two decades ago.

However, these days there are lots of businesses that provide software-as-a-service (SaaS). There are a number of businesses on the ASX that fit this description such as Class Ltd (ASX: CL1), Xero FPO NZX (ASX: XRO) and Altium Limited (ASX: ALU).

Each of these businesses have pleasing attributes. In fact, I’d suggest that they make better investments than businesses relying on physical product or service revenue for the following reasons:

Recurring revenue

If a customer pays a subscription to access the software, then this creates strong recurring revenue for the business. This is great for cashflow and planning for the business.

Highly scalable

Once the research and development of the software has been completed, it’s easy to rapidly roll out the product to more customers. It doesn’t need to make an extra item for every product it wants to sell.

This has a very pleasing effect on the profit margins as the business grows larger.

Harder to copy

Aldi and other competitors have shown how easy it is to enter the market with a similar product and offer it for a cheaper price.

There are much higher barriers of entry to any competitors if they want to join the software service market.

The main risk of software companies

The main risk for investors when considering software companies, other than competitors, is the valuation. Software companies usually trade on a much higher multiple because of the growth that’s factored into the price.

Class is trading at 55x FY16’s underlying earnings and Altium is trading at 28x FY17’s earnings. They have to deliver on the growth that is expected of them or the market could punish the share price in the short term.

Foolish takeaway

If you’re willing to take on a little bit more risk, then I think that software companies are definitely worth a place in your portfolio. Out of all the software companies on the ASX, I think Class is currently trading at the best value for a long-term investment.

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Motley Fool contributor Tristan Harrison owns shares of Altium and Class Limited. The Motley Fool Australia owns shares of Altium, Class Limited, and Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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