Software Investing
...it's a competitive cyberworld

by Alex Rampell (ARampell@aol.com)

Editor's Introduction: The Fool Port managed a slight advance on this blustery (and volatile) Wednesday, fighting against the wind to gain 0.11% in the face of a modest decline in the S&P. There was no significant news on Fool stocks.

If you look at the Fool Port's holdings, you might notice something missing: an investment in the fast-growing software industry. Despite discussing for months the possibility of investing in the likes of Network Associates, Legato Systems, Peoplesoft, and Adobe Systems -- all software leaders -- the Fool Port has never taken the plunge. The most it has done in the software arena, in fact, was short Quarterdeck with great success. Yet, it's never too late to invest in leaders of a strong industry.

In that light, today's column is written by guest Fool Alex Rampell, a student in Andover, Massachusetts, and a computer programmer working primarily for his own business, Rampell Software, Inc. His company was recently written-up in Forbes magazine. Alex will share some of the qualities that he thinks a Fool should consider when investing in the software industry. We thank Alex... Foolishly.

PALM BEACH, FL (Aug. 19, 1998) -- The cliched term "information revolution" is often used to describe the many technological changes of the present day, but the basis of this revolution is almost all somehow related to software. Computers have become exponentially faster and cheaper (as according to the virtual doctrine set by Moore's Law, which describes how processors will become smaller and more powerful), but that isn't nearly as impressive as the vast new amount of software that can take advantage of such processing power. There are software programs that can recognize and transcribe human speech, accurately design buildings, create life-like special effects in movies, and far more.

Software is powerful, in terms of function and revenue, and thus it might be worthwhile to think about investing in software companies. But what makes a software company (not just its products) successful? Microsoft may have a market capitalization of over $270 billion, making it one of the most valued companies on any stock exchange, but for every Microsoft, there are dozens -- actually hundreds or thousands -- of dead, forgotten companies like Digital Research (the creator of CP/M, competitor to MS-DOS), or VisiCorp (the creator of VisiCalc, the first spreadsheet program). The software industry is a cut-throat business, and constantly changing, making it difficult for any company to be successful in the long run.

The primary reason why long-term success in software is so difficult is that the average life span of any software product is ephemeral. Processors, operating systems, and hardware components change frequently, and software companies must keep up with those changes -- arguably more so than any other group in the computer industry. In order to survive, software companies need to innovate, expand, and stay at the top of their game. Otherwise, some tiny player can enter from nowhere and instantly steal market share.

One of the keys to success in the software industry is the process of upgrades. By writing updates to its software programs, a company can ensure that nothing is out of date or incompatible with the newest computers, can keep its products one step ahead of the competition, and, more importantly, it can receive the benefit of a constant revenue stream (requiring far less marketing) from previous customers. For example, Microsoft, and many other well positioned software companies, benefited enormously from the release of Windows95. If you upgraded to Windows95, you didn't just upgrade your operating system; you would (eventually) need to upgrade most of your other programs as well. Otherwise, you might suffer from the pains of "incompatibility."

Because upgrading and innovation are such important parts of success in the software industry, it generally is not a good idea to buy stock in a company just for its existing products. Even the greatest software products can become wholly obsolete in just a few months. When buying a software stock for the long term, it's a good idea to think of companies that are proven market leaders in terms of innovation, that have shown themselves to be adept at modifying their products, and that do not depend on the success of a single consumer-level product. It is also a better idea to invest in a company whose products can not be easily imitated. For example, Adobe's (ADBE) Photoshop is such a huge, powerful, and popular image editing machine that it could take years to successfully imitate. And a company like Symantec (SYMC) has signed so many bundling deals with computer manufacturers that it, too, could not easily be toppled.

Software companies that specialize in consumer-level software and are not well diversified can be disasters waiting to happen. Quarterdeck (QDEK), one of the Motley Fool's former short positions, has seen its stock plummet from a high of about $40 in Fall of 1995 to a present-day level of 50 cents. Why? Due to the same chronic problems that every software company dreads: its products had fallen out of demand, it couldn't keep up with its competition, and, most importantly, it couldn't cover its costs. Quarterdeck had touched on success because of a few popular software products, but it couldn't keep that success going for the long run.

The area of software where success is perhaps the shortest-lived is in computer games. With the exception of market-leaders Electronic Arts (ERTS), Microsoft (MSFT), and perhaps GT Interactive (GTIS), it is VERY difficult to survive in the games market because of the fickle tastes of consumers (and thus the uncertainty of product acceptance), combined with the unfortunate fact that standard "upgrades" aren't possible. A game company can't release -- and expect people to buy -- an "upgrade" to a game that mainly fixes bugs and might add a few new features. Consumers, and retailers, want new games with better graphics, more realism, and new storylines. A game like Myst (produced by Broderbund, BROD) was immensely popular just a few years ago, and now is available at a highly discounted price (if available at all) from the major computer retailers.

A company like MicroProse (MPRS) is the perfect example for demonstrating what can be the short-lived success of a game company. After losing money for several straight quarters, MicroProse (then called Spectrum Holobyte) released two hit products: "Civilization II," and "GrandPrix II." Both of these products topped the charts; several analysts bumped up their ratings on the company, revenues seemed to be increasing almost exponentially and the stock started to perform quite well. MicroProse released another hit or two, but the success of its two dearest products could only last so long.

After GT Interactive first agreed to and then withdrew from an offer to acquire MicroProse in late 1997, the company's stock experienced a freefall, and only a reverse 5-1 stock split allowed MicroProse to keep its listing on the Nasdaq. Can the company be revived? Probably so -- all it needs is another hit. But it might be quite un-Foolish to buy this company, or any other one like it, for the long term. (Note: Hasbro just announced that it would acquire MicroProse at a price of $6 a share.) It's far less risky to buy stock in a company like 3M (MMM) or Exxon (XON) for its past and even current performance than a company like MicroProse or Acclaim (AKLM).

There are -- and there will continue to be -- excellent software companies out there which have the managerial and programming talent to keep going for the long run. But any company that has a couple of hits might soon release more than a couple of misses, and it's very important to bear this in mind when investing in any software company.

--Alex Rampell (http://www.rampell.com/software)

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08/19/98 Close

Stock Change Bid ---------------- AMZN + 1/16 128.75 AOL +1 1/16 111.31 T - 1/16 56.63 DJT + 1/8 5.06 DD - 5/16 55.88 XON + 9/16 70.75 INVX - 11/16 14.31 IP --- 42.81 IOM --- 5.00 KLAC -1 3/8 30.19 LU -1 9/16 88.31 SBUX + 5/16 42.75 COMS + 7/8 30.75 TDFX - 3/8 13.69
Day Month Year History Annualized FOOL +0.11% 2.96% 51.42% 408.18% 49.56% S&P: -0.29% -2.02% 13.15% 139.54% 24.15% NASDAQ: -0.67% -1.59% 17.34% 155.87% 26.19% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 111.31 2961.03% 9/9/97 580 Amazon.com 19.11 128.75 573.70% 5/17/95 1960 Iomega Cor 1.28 5.00 290.50% 10/1/96 84 LucentTech 23.81 88.31 270.93% 8/12/96 130 AT&T 39.58 56.63 43.07% 4/30/97 -1170*Trump* 8.47 5.06 40.22% 2/20/98 200 Exxon 64.09 70.75 10.39% 2/20/98 215 DuPont 59.83 55.88 -6.62% 2/20/98 270 Int'l Pape 47.69 42.81 -10.23% 7/2/98 235 Starbucks 55.91 42.75 -23.54% 8/24/95 130 KLA-Tencor 44.71 30.19 -32.48% 8/13/96 250 3Com Corp. 46.86 30.75 -34.38% 1/8/98 425 3Dfx 25.67 13.69 -46.67% 6/26/97 325 Innovex 27.71 14.31 -48.35% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 79031.88 $76450.01 9/9/97 580 Amazon.com 11084.24 74675.00 $63590.76 5/17/95 1960 Iomega Cor 2509.60 9800.00 $7290.40 10/1/96 84 LucentTech 1999.88 7418.25 $5418.37 4/30/97 -1170*Trump* -9908.50 -5923.13 $3985.38 8/12/96 130 AT&T 5145.11 7361.25 $2216.14 2/20/98 200 Exxon 12818.00 14150.00 $1332.00 2/20/98 215 DuPont 12864.25 12013.13 -$851.13 2/20/98 270 Int'l Pape 12876.75 11559.38 -$1317.38 8/24/95 130 KLA-Tencor 5812.49 3924.38 -$1888.12 7/2/98 235 Starbucks 13138.63 10046.25 -$3092.38 8/13/96 250 3Com Corp. 11715.99 7687.50 -$4028.49 6/26/97 325 Innovex 9005.62 4651.56 -$4354.06 1/8/98 425 3Dfx 10908.63 5817.19 -$5091.44 CASH $11876.47 TOTAL $254089.09

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