2 Top Picks for Investing in the Cybersecurity Industry – Morningstar

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In an increasingly dangerous digital world, cybersecurity firms are more indispensable than ever.
Amid a growing number of cybersecurity threats, the shift to cloud storage, and the artificial intelligence boom, we expect the cybersecurity industry to outgrow overall IT spending and match software industry growth.
In particular, we believe firms offering solutions in newer areas of cybersecurity will spearhead growth for the coming years.
Over the next five years, we believe the security market is going to see marked growth in areas such as identity, infrastructure, application, and data. While traditional bastions of security spending such as network, services, and consumer are also slated for growth, we believe even within these end markets, the drivers of growth will be cloud-native security solutions.
Here, we outline our expectations for the cybersecurity industry and the companies that are best positioned to succeed amid this environment.
Our outlook for the cybersecurity industry is centered on three key industry themes:
As firms secure their businesses against nefarious activity in a cloud-first world, we believe that newer, more nascent areas such as cloud, endpoint, and data are all projected to grow meaningfully. Meanwhile, traditional security end markets such as security services, consumer, and network are projected to expand at a slower pace.
As the broader cybersecurity market grows, we expect the companies under our coverage to drive operating leverage throughout their businesses and expand profitability. This ability to tone down sales and research spending as a percentage of revenue is particularly evident in moaty cybersecurity companies that enjoy higher customer switching costs and thus are able to decelerate some operating expenses without risking customer churn. For our no-moat cohort, we expect adjusted margins to remain roughly flat over the next five years.

That said, we don’t believe that industry growth will be distributed equally. Cybersecurity is an incredibly fragmented market. While there are both macro and industry-specific reasons for the level of fragmentation in the space, we don’t see this as a permanent state. We hold the view that buyers are increasingly interested in consolidating their security spending on a smaller group of security vendors. We expect enterprises will buy a larger number of tools from fewer vendors, thereby making platform vendors the long-term winners. We expect this trend will be long term in nature, playing out over the next decade-plus.
We also believe that AI will be a new demand driver for the industry. AI will cause an increase in the number and sophistication of cyberattacks as attacks become more automated, personalized, and scalable. As the attack frequency and intensity increase, so will demand for cybersecurity solutions. AI-driven attacks will also likely cause new types of attacks and strategies, which will demand innovation within cybersecurity.
Morningstar covers 14 cybersecurity companies with market capitalizations ranging from $2 billion to nearly $115 billion. Because of the fast-paced nature of the industry and the constant threat of disruption, Morningstar Uncertainty ratings are typically High or Very High for cybersecurity firms.
Only two companies under our coverage merit a wide moat, largely because of their more complete platforms of security solutions that insulate their businesses from future disruption. They are:
Palo Alto Networks
We believe that Palo Alto Networks stands to materially benefit from secular tailwinds across its three key end markets as cloud migrations, shifts to zero-trust security, and expanded automation in cybersecurity increase the firm’s proposition to its clients.
We are encouraged by Palo Alto’s ability to sell more of its solutions to its customers. The firm’s success in cross-selling existing/new customers its three security platforms spanning network, cloud, and security operations is evidence of vendor consolidation—a trend that we see as likely to continue. As Palo Alto up/cross-sells its customers more solutions, we also see the entrenchment in its clients’ ecosystems increasing, driving retention rates and customer lifetime values higher.
Fortinet
In our view, the firm’s established customer switching costs, buttressed by its increasingly potent network effect, will allow Fortinet to continuously gain and expand its number of clients and has already enabled it to build a wide economic moat around its business.
While Fortinet’s build-versus-buy mentality has allowed it to expand its footprint in network security, we expect the firm to engage in inorganic methods to bolster its offerings in high-growth verticals such as security operations. In the long run, we expect these verticals to be key portions of an enterprise’s security spending, which Fortinet can tap into.
This article was compiled by Emelia Fredlick.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person’s sole basis for making an investment decision. Please contact your financial professional before making an investment decision.
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