Over the past thirty years or so, there have been several waves of software innovation, each of which has brought a different set of companies to Wall Street’s center stage. Each wave has lasted a decade or more and radically reshaped our lives. Each has begun to recede, from an outperforming stock point of view, when the bulk of possible buyers already own and are using the products (not a surprise that relative stock performance slows down as the company matures).

Low Tide Now

I think that we’re in between waves now. The next wave is doubtless gathering power, though. ”Cloud computing” is one possibility. Developments with smartphones, maybe with Google’s help, is another. But the next wave could equally well come out of nowhere. The important thing isn’t necessarily to be the first to discover the next trend, but to be aware enough to catch it in the first year or two of its existence.

Past Waves

The most significant software waves in stock market terms seem to me to have been:

1970s-early 1980s relational database management systems–which have become the customary way for storing corporate records of all types. IBM and Oracle are the prominent stock market names.

1980s-1990s personal computer operating systems, productivity software (like spreadsheets or word processing), graphical user interfaces. Propelled by its introduction of the Windows graphical user interface–so you could click on an icon instead of typing in a software command to get something done–Microsoft was the clear winner during this era.

early 1990s-2005(?) enterprise resource planning/supply chain management software The idea is to create a master management control system in as close to real time as possible for a big global firm operating in lots of locations in many countries. In later refinements of the concept, a firm would be able to link into the corresponding software systems of suppliers and customers. So, after perhaps years of installation and billions in investment, the company should be able to see everything about its operations, from its suppliers raw materials on hand, to the number of finished products in its customers’ warehouses or on the shelves of its stores–and the profitability of everything, all in close to real time. (As I’ve written elsewhere, I think the widespread adoption of tools like this, and their use in business decisions, is a central reason for the very sharp decline in economic activity late last year. Ultra-fast response to changes in buying patterns is the way things will be from now on.)

The clear leader in this field has been the German company SAP (Systems Applications and Products in Data Processing). The corporate move to create better management systems has meant business for competitors like IBM or Oracle, as well. There has also been demand for services to make legacy systems work better, and from smaller businesses that didn’t need a full SAP makeover. Better availability of data also put wind into the sails of customer relationship management (CRM) service providers like Peoplesoft, now part of Oracle.

mid 1990 onward the internet (I could be writing until December on this topic!) The point I want to make here, though, is that most of the IT names in the S&P 500 are already mature companies. As a positive investment theme, I think internet 1.0 is pretty much played out. Internet 2.0, social networking, has yet to show it can make a profit. So we can’t look to either for the next wave of innovation.

The rise of internet businesses was a mini-bonanza for the relational database and other “plumbing” companies that provide their infrastructure. Once customers got past their worries about security, the fact that the internet provided speedy and virtually costless communications gave extra life to supply chain management companies as well.

Microsoft, both as a company and as a stock, played a significant part. Microsoft might not always have been the leader, but it had a finger in almost every pie.

Lots of companies had a brief moment in the sun, but were quickly commoditized or lacked enough scale. Many were absorbed into larger companies.

Who were the real winners? My list would be : Adobe, Amazon, eBay, Symantec and Google. Portal companies AOL and Yahoo are still around, but a shadow of what they once were. The dating companies and the online travel agents still exist as well, but in a more competitive environment than they may have expected.

Of the five winners, it seems to me that only Amazon and Google continue to show unusually high growth potential. As for the rest, Adobe has, I think, ensured higher revenue growth with its Macromedia acquisition, but is still subject to the ups and downs of new product launches. eBay is trying to reinvigorate itself after several flattish years and the failure of its acquisition of Skype. After several years of strong revenue growth but erratic profit performance, Symantec’s revenues appear to be flattening out.

My quick summary of internet 1.0 leads me to describe the industry as mature, with a couple of exceptions that look capable of generating high eps growth over the next several years.

What about internet 2.0? We’ve had a period of private market transactions of social networking companies at high prices, but there is as yet little evidence that these firms can generate profits. Facebook may be an exception.

Where to from here?

What will be the next big thing in software? I don’t think anyone knows for sure.

One possibility is “cloud computing.” The idea of “software as a service,” which cloud computing is the latest form of, has been around for a number of years. On the one hand, the customer has computer software available, and pays for use, on an “on demand” basis, without having to own it. Similarly, the customer can rent or lease computing power or storage space instead of buying it. On the other hand, the software maker gets revenue he wouldn’t otherwise have, and obtains customers that for one reason or another his direct and wholesaler sales channels don’t reach.

Software as a service is typically thought of as a small company phenomenon. But it may well have appeal for even very large firms, too. The idea would be to outsource some portion of the firm’s it infrastructure to the cloud operator. The decision to rent rather than buy changes the timing of cash flows in a favorable way. But arguably the more important consideration for large firms is that responsibility for selecting the correct software, and for patches and upgrades shifts to the cloud operator. As with any outsourcing, the staffing expense shifts to the cloud operator, too. So outsourcing may make sense for anyone, except for a firm that believes its own IT is an essential point of competitive advantage. In that case, the firm may even consider selling some of its (older) IT to a cloud operator. The biggest drawback? Outsourcing is hard to reverse. It’s easy to report to the board of directors that you’re saving $20 million a year by outsourcing. It’s much harder to return and ask for $100 million to rehire staff and bring an operation back in-house.

The most interesting aspect of cloud computing is that the industry leaders (in addition to Microsoft–and Google as a dark horse) are Amazon and Yahoo, not companies we tend to think of as IT services providers. Also, Amazon and Microsoft both have turned down an IBM proposal to collaborate on setting cloud computing standards. One could easily regard the proposal is an attempt by a laggard to catch up in a market that is turning out to be more important than it initially thought.

How to play this idea? The safest thing to do for now is to buy a company you’d want to hold anyway, but for which cloud computing success would produce meaningful upside. That would mean Amazon or Google, I think.