I first heard of Xero from a friend, an executive management team member of a US tech giant. [Think a direct report of the CEO of Google, Microsort, Intel or Apple or similar.] He had invested about a fifth of his (not inconsiderable) personal wealth in an obscure software company in of all places New Zealand.

Needless to say I purchased some (albeit way too little) and then investigated.

Xero is a cloud accounting software company - essentially doing what Intuit or Sage do but entirely in the cloud. Cloud software in this case obviates the need for a server, computer support or any problems with scalability.

But when I purchased the stock the valuation was absurd - the stock was trading at roughly 200 times revenue. The company also had large losses.

Our core test was to try Xero for our own business: we like it. More on the excellence of the product later.

Anyway the stock started going up fairly hard.

The next time I heard of Xero was when I met a woman from the New Zealand Sovereign Wealth Fund in Singapore. She was a charming woman born in China who disarmed me with her perfect New Zealand accent. [I used to live in Wellington New Zealand, love the place and miss the strange way they count to "six"...]

She told me that every single New Zealand fund manager they used had underperformed the index because they had not held Xero, something they thought was absurdly valued but which had gone up sharply and then up some more.

About this time three separate New Zealand fund managers contacted me (a known Antipodean short-seller) and suggested I short-sell Xero. I told at least one of these managers that I owned Xero which somewhat shocked him. I have also had this conversation with some smaller Australian fund managers. Notably none of these fund managers had tried to use the product or had talked to anyone who did use the product. 

As I said, I have, and the product is life-changing good. I feel stronger about this product than (say) the first smart-phone I used.

Its a dead-easy, simple to set-up version of Intuit or Sage or MYOB. It does your accounting, links to your bank accounts and allows you to manage your transactions. The set-up makes Intuit look ungodly-complicated. And, most tellingly, it winds up superior in every way to the "in-the-server-box solution".

One example suffices.

Bronte Capital Management by law has to pay roughly 10 percent of my salary to a superannuation plan (that is a private, regulated pension plan). I chose to put it in a plan set up for me by my old employer simply because it was there and I was comfortable with the way it was invested. When setting up the payment I tested deliberately putting in the wrong bank account numbers for the recipient. The computer immediately knew I had put the wrong number in. Why? Because maybe 50 people had previously put the right number in. The error systems were crowd-sourced.

This sort of thing happens all the way through Xero. The system gets better and better. Changes developed for one party who has say an issue (cross border taxation complications for instance) wind up being available for all new parties.

And the excellence shows in the growth rate for the company (revenue grows well over 100 percent) and fervour of the users. This is an accounting app and it gets Twitter comments like this:

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For a New Zealand fund manager (or a short-seller) the possible end valuations of a Xero are frightening. Because of the crowd-sourcing aspects of cloud accounting there is a reasonable chance the business winds up as a sort of global natural monopoly. [This is not that unusual in technology. Tech produces powerful global natural monopolies which are vulnerable to disruptive new players with radically different technology.]

The market cap of Intuit is 21 billion. Sage is a further 6 billion. Add in MYOB (which is now private) and you get a global market cap for the sector well north of 30 billion.

But the near-monopoly cloud player should be able to capture more value than this because they also displace the servers and computer support needed for an "in-the-box" solution. My guess is that fifteen years from now there will be a totally dominant cloud accounting software company with a value north of $50 billion.

I have no idea whether Xero is the eventual winner of this game - but with the backing it has and its current head start it is as likely a winner as any. I would not want to be short this. [Long I admit is also a risky proposition. The valuation is absurd versus any current revenue or earnings metrics. This is the most expensive stock I have ever owned - and there is a reason we own it in tiny quantity.]
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Needless to say Xero stock has continued to go up and its putting New Zealand fund managers on the spot. Their underperformance has gone from notable to embarrassing.

Because they can't win this game they want to redefine victory: they are lobbying to get Xero taken out of the index. After all Xero is dramatically different from the rest of New Zealand which has an economy based on soft commodities (dairy, meat, wool and timber).

And I understand their problem. It is the problem Canadian fund managers have had. Canada has had two globally important technology companies with huge market caps and a huge percentage of the index that have imploded. These were Nortel and Blackberry respectively. The former actually went to zero having been a quarter of the index.

If a Canadian fund manager was underweight Nortel or Blackberry they had embarrassing under performance on the way up. If they were long for the collapse they had terrible absolute performance. For Canadian fund managers it was a tricky situation.

But I am not going to cede this argument to the precious (under performing) petals of New Zealand funds management. Indeed I want to argue the opposite.

New Zealand has produced many great people over the past century but until recently all the great ones had to leave New Zealand to show their greatness. Arguably the greatest three never went via Australia (Sir Ernest Rutherford, Sir Keith Park, and Sir Edmund Hillary) however most the rest went via Sydney and we claim them as Australians because it was the Australian infrastructure and social settings that allowed them to thrive. [Example: most people think that Russell Crowe is an Australian actor.]

But the internet and globalization have flattened the structure. It is possible to become a world leader and stay in Wellington or Christchurch these days. See Peter Jackson for an example. And it is possible to run a world-beating software company from Wellington too, but only if it can be funded from Wellington and only if the local market is outward focussed enough to make this possible.

Xero is not the only example. Jade is an important company based in Christchurch but it is privately held.

In arguing for taking Xero out of the index the New Zealand fund managers are demanding that the globally aware outward looking and creative people leave New Zealand to get funded.

As an Australian I like that idea. The best of New Zealand talent will continue to come here to our great benefit. Kiwis can (vainly) claim them as their own - but it won't matter. Their economic contribution will be to Australia.

What the New Zealand fund managers are arguing for is an insular old New Zealand. A startlingly beautiful but somewhat backward place for Australians to visit when we can bother to put up with the inferior Kiwi weather.

My recommendation

Those that determine the mix of the New Zealand index should simply ignore the hurt-feelings and lame excuses of under-performing fund managers.

And to the Sovereign wealth fund. If your fund manager had underperformed the index because they did not own market weight in Xero (i.e. all of them) and they have not explored the software extensively themselves fire them. You should also fire them if they have argued for removing Xero from the benchmark. They are representative of the old, inward looking New Zealand that you should be leaving behind.

At the rate the New Zealand tech industry is growing, especially with companies like Xero, there is a chance than Kiwis will start to see Australia as a slightly backward place with good beaches and sunny weather. Personally I like it when the really entrepreneurial Kiwis come here. So maybe, for Australia's sake, I should reverse the recommendations above.