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From Xero to hero with a 276% return

Investors are often told that to outperform they need to invest away from the crowd. For enterprising investors this often means looking at companies with smaller market capitalisations that are less well followed by the institutions and the rest of the market.

Another place where investors can find some ‘hidden gems’ is amongst dual-listed New Zealand stocks, which often seem to receive less attention that they deserve.

One NZ-based company which doesn’t seem to have garnered much attention despite also being listed on the ASX is online accounting software provider Xero (ASX: XRO). Xero’s shares have soared 276% since their local ASX listing in November 2012. Even more impressive has been the stock’s performance since listing on the NZ stock exchange in June 2007, where the share price has rallied 1558% in just under 6.5 years and now boasts a market capitalisation of over NZ$2 billion!

Xero competes with fellow listed accounting software provider Reckon (ASX: RKN) as well as the now unlisted MYOB. The company today reported an impressive 84% rise in half year revenues to NZ$30.3 million along with a rise in customer numbers to 211,300 from 111,800 at the same time last year.

While on the face of it, Xero looks like an expensive stock, the company is adding customers and revenues at a very fast rate. The economics of a software firm mean that the upfront development costs for the business are usually high, however once development is completed the average cost to serve and the minimal incremental costs involved in adding new customers can make the profit margins exceptional.

Infomedia (ASX: IFM), which provides software to the car after sales and service sector, and Technology One (ASX: TNE) which provides a suite of software solutions to government and business organisations, both have earnings growth and profit margins which are a testament to this.

Foolish takeaway

Investors who focus their attention on investing in industries that have attractive economics are able to screen out a lot of low quality companies, thereby freeing up their time to discover the very best companies with great earnings potential. The software sector is one such industry. The trick is being attentive to and patient for opportunities and careful in determining a reasonable price to pay for the stock.

Software companies are often ‘cash cows’ with more cash than they need. This means they can return profits to shareholders through dividends. Discover The Motley Fool’s favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of “The Motley Fool’s Top Dividend Stock for 2013-2014.”

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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