In 2022, I bought a stock called Guidewire Software (NYSE:GWRE), which had some strong growth prospects. Since then, the share price is up 328%, but the story hasn’t been a happy one.
Unfortunately for me, I sold my shares a year after buying them, banking a 20% return and feeling pretty good. But I missed out on another 293% – and there’s an important lesson here.
What is Guidewire Software?
Guidewire Software is a business that provides software to insurance companies. This allows them to do things like manage their claims and policies via an online portal.
The thing that impressed me most back in 2022 was the firm’s market position. There wasn’t really another competitor in sight and the company had never lost a customer to a rival.
Progress in signing up insurers was steady, rather than spectacular. But the prospect of strong margins and a product that had high switching costs for clients looked attractive to me.
Since then, Guidewire has gone from strength to strength. In its latest update, the company reported 33% growth in subscription revenues and a 10-year contract with a major Tier-1 insurer.
In terms of profitability, the firm’s operating income has more than doubled over the last 12 months. Adjusting for non-cash expenses, it now generates over $200m a year.
Overall, my assessment of the business was pretty good – and I think it might even be worth considering at today’s prices. So the obvious question is why did I decide to sell?
Cash flows
A closer look at Guidewire from a financial perspective was the main reason I went off the stock. Back in 2022, it was generating around $93m in free cash flow, but there were two problems.
The first was this wasn’t a big number in the context of a company with a market value of $6.7bn. It represented a 1.3% return at a time when UK interest rates were on their way to 5.25%.
The other issue was this was more than offset by stock-based compensation. So Guidewire had to spend more on share buybacks than it generated in free cash to avoid shareholder dilution.
To some extent, this is still the case. The firm’s $232m in free cash flow is still largely offset by stock-based compensation and offers just a 1.2% return on the current market value.
None of that, however, has stopped the stock doing exceptionally well over the last three years. With sales growing more quickly than shares, investors are in a better position now than before.
I’m still not sure Guidewire’s likely cash flows mean the stock makes much sense as a 10-year investment. But for anyone with a longer time horizon, I think it could be worth considering.
Foolish takeaway
While there might still be an opportunity for me in Guidewire shares, there’s also an important lesson. Finding (and buying) the right stocks is only one part of the investment process.
Just as important is holding on to them for the long term. That’s something I’m looking to get better at in my investing – and I have my experiences with Guidewire to remind me of that.
