Navigating the SaaS Storm: Identifying Companies Built to Last
The software sector has experienced a dramatic downturn, with many businesses once lauded for their rapid growth now facing significant scrutiny. At its zenith in late 2025, the market was characterised by extremely optimistic valuations for software companies. Performance metrics often leaned heavily on revenue growth, with less emphasis placed on profitability. Furthermore, a substantial expense item – the generous issuance of company shares to staff as compensation – was frequently overlooked in these profitability assessments. The prevailing sentiment was that software economics possessed inherent structural advantages and were largely impervious to disruption. This optimistic outlook, however, proved to be overly ambitious.
The narrative has since swung decisively in the opposite direction, with the market’s reaction over the past six months earning the moniker “Saaspocolypse.”
The financial press is increasingly featuring stories about companies developing their own internal tools to reduce software expenditure. Developers are showcasing the speed at which functional alternatives to established products can be created using AI coding agents. A growing consensus suggests that artificial intelligence, at best, will compress profit margins for many existing software products, and at worst, could fundamentally disrupt them, much like the internet reshaped the newspaper industry.
Amidst this prevailing pessimism, Forager has been actively refining its investment strategies and has already made new acquisitions for its portfolios. Periods of market pessimism are often where significant investment opportunities arise. The challenge lies in discerning whether this pessimism is justified or excessive. However, it is precisely this pessimism that can unlock exceptional investment bargains.
The key strategy isn’t to dismiss the emerging risks; many are legitimate and will likely materialise. The real opportunity lies in identifying a select group of businesses where these risks are either overstated or have already been factored into their current valuations.
Forager focuses on four key characteristics when evaluating software companies in the current market climate:
1. High Value, Low Cost
The first characteristic is software that is deeply integrated into a customer’s daily operations but constitutes a relatively small portion of their overall expenditure.
Accounting software platforms, such as Xero (ASX:XRO), MYOB, and Sage (LSE:SGE), serve as prime examples. These products typically cost small businesses a modest amount each month and are central to their financial operations, managing everything from invoicing and payroll to compliance and reporting.
The economic rationale for customers is clear: the absolute cost is low, while the operational importance is paramount. The prospect of replacing these integral systems introduces significant risk and disruption for minimal financial gain. This dynamic is reflected in their underlying financial performance. Xero has historically demonstrated robust revenue growth with gross margins exceeding 80% and low customer churn. Sage, a recent addition to the Forager International Shares Fund, serves over six million customers globally and consistently generates free cash flow with operating margins above 20%. Software that is inexpensive, mission-critical, and priced based on business size rather than user count tends to face limited pricing pressure, even as development costs decline.
2. Structural Switching Costs
The second crucial characteristic is the presence of high switching costs. Software rarely operates in isolation. Over time, it becomes intertwined with multiple other systems, accumulates vast amounts of data, and shapes internal business processes. Consequently, the cost of replacement extends far beyond the price of a competing product, encompassing the time, expense, and operational risks associated with transitioning.
Bravura Solutions (ASX:BVS) exemplifies this situation. Its software forms the backbone of core functions for wealth management firms and superannuation funds – industries subject to stringent regulatory requirements and with a very low tolerance for operational failures. The process of replacing such systems can take years and involve substantial financial investment. In this environment, the ease of developing new software becomes less relevant than the inherent difficulty of displacing established systems. Customer inertia, bolstered by genuine switching costs, remains a significant factor contributing to business resilience.
3. Moats Beyond Software
A third area of focus involves businesses where the competitive advantage is not derived from the software itself, but from other factors.
CAR Group (ASX:CAR) presents a compelling illustration. The company’s current market capitalisation exceeds $8 billion, even after a notable decline in its share price. One could argue that even with the most advanced AI coding tools, replicating a platform like carsales.com.au would be achievable for a fraction of that cost. The true value, therefore, is not in the code. Carsales derives its worth from its entrenched position within the automotive ecosystem, effectively connecting a vast audience of potential buyers with a wide array of dealers and private sellers.
This network effect has been meticulously built over decades and is amplified by its sheer scale. High traffic volumes attract more listings, which in turn draws in even greater traffic. Auto Trader (LSE:AUTO) in the UK exhibits similar characteristics, achieving pre-tax profit margins above 60% in a business where the technical barrier to entry is relatively modest. These competitive advantages are not static; they depend on sustained user engagement and relevance. While user attention could potentially shift to AI models, or AI agents could automate more of the search process, these established moats are not easily or quickly eroded by incremental advancements in software development capabilities.
4. Value, The Sooner The Better
Our conclusion is that the stock market’s “Saaspocolypse” is unlikely to translate into an industry-wide operational crisis. While some companies will undoubtedly face difficulties, others may well benefit from the emergence of new AI tools. However, this doesn’t simplify the investment landscape to merely identifying survivors.
Even after significant de-ratings, certain segments of the software sector remain far from attractively priced. Furthermore, the practice of excessive stock-based compensation, where companies issue more shares to compensate staff for a declining share price, appears to be persisting.
Our investment approach prioritises stocks that are trading at a discount. The more value we can realise in the near term, the more favourable the investment proposition becomes. Bond investors utilise a concept called “duration” to gauge a bond’s sensitivity to interest rate changes. It represents the weighted average life of a bond’s cash flows; a 30-year bond, for instance, has a much higher duration than a 2-year bond. When interest rates rise, the present value of those longer-dated cash flows diminishes.
A similar principle applies to the stock market. This is why “growth” assets typically underperform in a rising interest rate environment – their valuation is heavily reliant on cash flows projected far into the future. This concept also extends to operational risk. Businesses valued on long-duration assumptions require a high degree of certainty regarding their ability to maintain growth and competitive standing over extended periods. Such confidence is increasingly difficult to justify in a rapidly evolving technological landscape.
In contrast, companies that generate substantial cash flow today and have the capacity to return a significant portion of their market value within the next decade offer a more balanced risk profile. Sage and Auto Trader are examples where, based on current earnings and projected growth, a substantial part of their present valuation could be returned to shareholders through free cash flow over a ten-year horizon. This approach reduces reliance on distant forecasts and limits exposure to potential future disruptions.
Forager’s Investment Strategy in Action
Forager’s International Shares Fund already held substantial investments in Japanese software companies. These businesses continue to experience rapid growth, are highly profitable, and crucially, do not engage in the excessive stock-based compensation practices seen with some of their US counterparts. Despite this, their share prices have been negatively impacted in recent months, making it an opportune time to increase existing holdings.
Beyond Japan, Forager has strategically added several undervalued UK and Australian stocks to its portfolios and has established a framework for further analysis. The significant shift in the software sector narrative, from one of “structural superiority” to one of “imminent disruption,” has already created attractive investment prospects. Lower share prices, coupled with an increased emphasis on shareholder returns, would provide the confidence to expand these positions further. The Forager investment team continues to monitor a broad range of software companies for potential opportunities.
