In a previous post, I discussed the evolving IT security landscape. In part two of this series, I'll discuss investment opportunities and how we evaluate IT security stocks.
In my view, IT security stocks are like all-weather tires—you can always build a case for owning them. That's because the need for security rarely decreases; rather, it shifts to address emerging risks.
In aggregate, legacy IT security companies have underperformed the broader software sector for the last three years through April 2018, as highlighted by a recent Morgan Stanley study.
One reason for the underperformance is investor concern over corporate workloads moving to the cloud. Questions that have emerged as this transition occurs include:
- Will companies still need traditional security approaches?
- Will this compress pricing for traditional security vendors? and
- In an innovation-driven space, are barriers to entry too low or are businesses subject to short cycle disruption?
In addition, there are concerns that traditional approaches will not adequately address tomorrow's threats, such as those from insiders or those hidden in clean code that will not be immediately flagged as malicious.
These concerns have created overhangs for some legacy vendors that are not as well positioned to address future threats. These vendors generally have larger market capitalizations and are more heavily weighted in the performance analysis cited above.
However, while this is a risk for some legacy vendors, the change will drive growth in technologies that can better handle perimeter-less networks and/or more effectively address new threat vectors.
Some of these areas include:
|Advanced data analysis (rebirth of SIEM)||Security information and event management (SIEM) software and services combine security information management (SIM) and security event management (SEM) to provide real-time analysis of security alerts generated by network hardware and applications. While this technology has been in use for well over a decade, the ability to monitor more comprehensive data sets brought in from a greater number of sensors with advance detection techniques makes today's SIEMs more effective.|
|Artificial intelligence/machine learning||Leveraging large data sets and machine learning algorithms to improve detection while lowering false positives. Like behavioral analysis, it can be additive to most forms of security.|
|Automated incidence response||As soon as a security breach is detected and an alarm is raised, a company's system automatically responds—by quarantining infected machines, for example—without the assistance of scarce network security technicians.|
|Behavioral analysis||Monitoring network traffic and noting departures from normal operations to detect malicious activity. Behavioral analysis can be additive to most forms of security.|
|Cloud access security brokers (CASB)||Cloud access security brokers—software solutions that sit between a company's on-site infrastructure and a cloud provider’s —allow organizations to extend the reach of their security policies to outside vendors, ensuring security consistency as employees access cloud resources. CASB can also add visibility into shadow IT instances.|
|Identity and access management (IAM)||Identity and access management systems help manage digital identities, helping ensure that the right individuals are accessing the right resources at the right times for the right reasons. In addition, they help reduce the time and effort to provision new users and to turn off unneeded user accounts.|
|Internet of things protection||Today many products and devices monitor usage characteristics to improve the customer experience. These connected devices (sensors on home appliances such as heating and cooling systems, industrial equipment including locomotives, airplane engines, power tools, and even sports equipment, such as tennis rackets) pass information through the web to both centralized and decentralized locations. While most of this activity is innocuous and has little value, certain data such as confidential medical information needs to be secured in a cost-efficient manner.|
|Mobile security||Solutions that separate and secure corporate information on mobile devices without seeing the employee's personal information. It also allows for quick deletion of corporate files in a lost device or employee departure situation.|
|New antivirus (AV) approaches||At over $6 billion, the AV market is substantial. Traditional signature-based antivirus solutions are helpful for blocking previously discovered malware, but they struggle with undiscovered strands and/or malicious code that can morph. Today, companies are replacing old solutions with next-generation antivirus platforms that can stop modern attacks by incorporating behavioral analysis, greater application activity monitoring, analysis across larger data sets, and other methodologies to help catch malicious code and payloads before they are activated.|
|User and entity behavior analytics (UEBA)||Insider threats are a significant concern that historically were not a focus of CISOs. Newer technologies can help lock down sensitive files as well as alert security teams when insiders are acting in a malicious fashion.|
IT vendors that offer solutions incorporating these technologies are likely to benefit from strong secular end-market tailwinds.
When evaluating IT security investment opportunities, we look for the same criteria as with all technology investments, including:
- a large addressable market
- a great value proposition to the customer
- strong competitive barriers
- a valuation that presents an attractive balance between risk and reward
However, with security companies, we also place heavy importance on several additional factors:
- A non-technology-oriented “edge” is highly valuable. IT security investments carry a high degree of leapfrog risk, since what works well today is often quickly rendered obsolete by tomorrow's technology. To extend revenue growth duration, the product needs an edge beyond just “better technology,” be it some sort of network effect (such as collecting attack data at scale and using that to better protect all customers), a better distribution network or pricing model, a competitor exiting the market, or a functional tie-in with a separate non-security IT vendor, which increases the value proposition of both products.
- Second, the company's product or service should be “future proof,” meaning it can work in current and future technology architectures, and will not require a complete rewrite as technology advances. Few technology products are truly future proof, since the pace of change requires consistent investment to remain relevant. But products that are addressing core threats and management teams that have demonstrated an ability to remain relevant despite shifting technology paradigms will typically garner much higher implied terminal valuations than those that cannot.
- Third, we look for companies that offer not just one product but product suites. Platform vendors capture value from multiple products, have lower sales-and-marketing expense, and are generally much stickier, leading to stronger competitive barriers and higher and/or longer duration of earnings growth.
- Last, we seek long-term (versus short-term) profit potential. Companies that are investing in their research, technology, and salesforce often have less-than-optimal margins in the near term, but are positioning themselves to create substantial long-term value. If we have confidence in the longevity of growth and margin expansion potential, we are usually willing to trade off the potential for small profits today for an opportunity for substantially larger profits tomorrow.
In conclusion, IT security offers both challenges and opportunities. We believe our framework will help us to successfully navigate both, which we believe may yield outperformance for our clients.
Partner and Research Analyst
William Blair Investment Management
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