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Coming in at #8 in our Magic Formula Business Sector Rankings is the Software sector. This sector accounted for 227 stock days tallied by 10 different stocks. The software industry is fairly compact, with few identifiable industry components. They break down as follows:

Morningstar Industry	Stock Days	Unique Stocks
Business Applications	123	6
Development Tools	104	4

In general, I expect Software to be an attractive business to the Magic Formula Investing screen. These companies should be able to generate good returns on tangible invested capital, as the majority of assets are in the form of people, software patents, and existing clients. Software companies don't need large factories to produce products, warehouses to store inventory, or a fleet of trucks and airplanes to deliver it - therefore requiring low capital expenditures. The fact that this sector does not rank high on the MFI screen means either that my assumptions are not correct, or that this sector is generally priced high by the market.

Business Applications

The Business Applications industry represents software that helps various businesses accomplish their tasks quickly and accurately. Magic Formula stocks in this industry include global leaders such as Microsoft (MSFT), Accenture (ACN), and Electronic Data Systems (EDS), as well as smaller niche players like STARLIMS Technologies (LIMS) and American Software Inc. (AMSWA). This is a pretty broad range of providers. Microsoft, of course, makes the ubiquitous Windows operating system and Office productivity software that is used by the vast majority of businesses today. Compare this broad based offering to STARLIMS, which focuses on a very specific niche - laboratory data management.

Business Applications as a sector is difficult to merit. The best opportunities here are either those companies with a large installed base or a very specific niche. MagicDiligence recommends avoiding small software providers that directly compete in segments controlled by the big boys. For example, American Software produces Enterprise Resource Planning (ERP) software, a way for clients to track their resources and allocate them efficiently. However, this market is controlled by software giant SAP (SAP), who has much larger financial resources, name recognition, and client base. For the companies with a large installed base, like Microsoft, switching costs are high because it would require a lot of time and money to re-train employees to use a new system. Additionally, since everyone knows Microsoft tools, the network effect is in place, making adoption of Microsoft's software necessary for smooth sharing of information across business segments or with customers.

Alternatively, small niche players can do well here. Although not a Magic Formula stock, consider the performance of small electronic health records software provider Quality Systems (QSII). This company has produced very attractive returns on capital for the past 6 years while dominating the private practice electronic records market. This market is not attractive to the larger players in this business (like Siemens (SI)), as they prefer to go after the large, hospital size contracts.

Development Tools

Another broad based industry, Development Tools consist of software that is used primarily for product development and management, as opposed to business process management. Companies in this industry are usually focused towards one type of product. Magic Formula stocks here include Cadence Design Systems (CDNS), a provider of semiconductor design tools, and Logility (LGTY), which provides inventory management systems.

In truth, the line between Development Tools and Business Applications is not well defined to me. A stock like Autodesk (ADSK) is classified by Morningstar as a Business Applications company, but in truth it's AutoCAD software is used in product development. On the other hand, Adobe (ADBE) is correctly identified as a Development Tools company. In any case, Development Tools is a less attractive sub-sector. Here, technology can wipe out any competitive advantages. New methods or advances in product design can lead to quicker development times, cheaper production costs, etc. As in Business Applications, the best way to build a lasting competitive advantage is to become an industry standard. Take Adobe for example. Although there exist many Photoshop clones, some free and almost all cheaper, there is little risk to Adobe. Graphics professionals are trained to use Photoshop in school, are comfortable with it, and do not want to take the time to learn something else unless it provides a very significant advantage.

Software - Summary

In this article, I've shown that Software should have a very attractive economic model to the Magic Formula screen, but in fact very few Software companies make it into the screen. Only the very largest and established software providers have a truly durable competitive advantage, due to switching costs and the network effect. Unfortunately, the market recognizes this and prices these stocks too high to be considered for the Magic Formula screen. Additionally, software companies in general pay pitiful dividends, and dividends are an important component of investor returns. Microsoft may be a potential MFI candidate, but the unknowns surrounding it's bid for Yahoo! make it a less attractive pick. If that bid falls through, Microsoft would be a very serious candidate for a MagicDiligence Top Buy coronation.

Choose small software companies very carefully. Avoid the ones that compete directly against large competitors. Try to find the ones that operate in a very specific niche that bigger software companies won't bother to compete in.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

Disclosure: Steve owns QSII

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