A trophy stock out of reach

Financial software group Iress is attractive … but its shares are above intrinsic value.

Summary: The stockmarket and wealth management software group Iress has strong recurring income despite recent earnings weakness. International expansion has become an important growth driver for the company, and will add to earnings over time.
Key take-out: Behind the company’s strong share price is a fortress-like balance sheet that is generating a return on equity of 30%.
Key beneficiaries: General investors. Category: Growth.

There are a number of “trophy companies” I like – extraordinary businesses that I would love to hold in my portfolio if the price were right.

Each possesses the fundamentals that I believe distinguishes a quality business, such as a high rate of return on equity, little or no debt, low capital intensity, and sustainable competitive advantages to name a few.

I have been at pains to sell some of these companies in recent months. I hate to let go of these companies, because of their ability to generate positive earnings during any period of the economic cycle. But when a company’s share price is trading wildly above my estimate of its intrinsic value, I can’t justify my holding and must lock in profits. For investors in the lower tax brackets, the implications of this “take-profit” approach are generally all positive. 

Iress is one such “trophy stock” that has been frustratingly out of my reach. Its share price has been at a material premium to my estimate of its intrinsic value for quite some time, and while the share price has softened in recent months, it will need to fall further before I am compelled to buy. But the premium that has been placed on this company reflects the market’s general ability to get it right in the longer run.

Iress is a supplier of sharemarket and wealth management systems in Australia. Its core product – that bears its name – is the go-to trading platform used in Australian financial markets. While Iress provides tools for stock analysis, the reason clients rely on this platform is because it allows electronic settlement of trades (before Iress, brokers were forced to settle and execute trades via fax). Over the years, Iress has become an essential tool for funds management, which has provided the company with a sustainable competitive advantage.

The IRESS platform has reached maturity in the Australian market, but its subscription base provides a high level of recurring revenue. This is what I love about the business. Think of the advantages of running a business that begins each year with a material amount of its revenue locked in for the next 12 months. This stable base has funded Iress’s expansion internationally, and Asia, South Africa and the United Kingdom have become important growth drivers for the company.

But the primary growth driver for Iress has been its wealth management platform, XPLAN. The service comprises a range of software tools for financial planners, such as documentation, client management and compliance requirements for regulatory reforms.

The XPLAN platform is becoming just as important for financial planners as Iress is for brokers. This is an exciting prospect for the company, as the service could generate higher levels of recurring revenue over time. The service also appears to be scalable and the company appears to be expressing that by establishing itself in overseas markets.

The company’s earnings per share has fallen in recent years due to flattening revenues from Iress’s maturing, yet highly resilient, subscription base in Australia.

While the company’s expansion plans are expected to be accretive to earnings, I am hopeful that the market will focus more on the recent earnings weakness than Iress’s solid financial position. This may be wishful thinking, as it’s hard to ignore a company with a fortress-like balance sheet that is generating a return on equity of 30%. But I will be watching closely, nevertheless.

Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com

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