On-Demand Software Stocks: The Bottom or More Pain?

Momentum is fun on the rise but not so much fun on the decline. The clichés like “this time it is different” used to justify investing in companies solely for a trend, i.e. the latest hyped technology, seemed prophetic on the upside but a little naïve on the downside. Business 101 is not suspended in the long-run meaning companies need a solid business model that they execute well with customers and profits both growing.

When a company is young it may be investing in growing the business so it burns through cash and does not make a profit. During that period venture capitalists or their proxies are providing the cash for investment. If a start-up is lucky enough to go public during a Bull market then their stock price will soar when they go public. Unfortunately the inflated stock prices in a hyped technology sector sometimes fools people – employees, investors and even customers – into believing that business success is assured.

On the flip side, when we are in a Bear market the hyped technology companies are now grouped together and their stock prices get hit significantly. On the downside, people also disregard the business model and punish all the firms.

The On-Demand Index is down approximately 30% YTD (as of 03-17-2008) and the individual stocks are down approximately 45% from their 52 week high. The Dow is down 9.74% YTD, Nasdaq Composite index is down 17.92% and the iShares S&P GSTI Software Index Fund (IGV) is down 15.87%.

The ODI companies not start-ups looking for their first customers and dreaming of the catching the IPO train. They have already proven themselves enough with customers, sales and a business model to justify being a publicly traded company. But almost half of the companies are not profitable yet and the rest sport high P/Es (Price/Earnings) and even P/Ss (Price/Sales) ratios. High multiples are accompanied by high expectations. As some investors have discovered this earnings season, a company can have strong sales growth but still have its stock price drop significantly does not matter if it merely meet Wall Street expectations.

When examining whether to invest in these companies disregard the on-demand software hype and look at:

• What business applications the company offers
• What market segment is targeted:
  • Industry-focused, e.g. healthcare, or cross-industry such as CRM (customer relationship management), talent management, salary administration
  • Large company versus SMB (small to medium size business)
  • Domestic versus foreign
• Customers
• Competitors, both current and future prospects
• Potential acquirers
• Expectations
• Management and business execution

These companies are growth and sometimes hyper-growth story stocks. You have to be some faith in many things clicking in those companies but not blind faith. They are not the classic buy-and-hold stocks (maybe there is not any more of these anyways. If you buy maybe buy some options or stop losses to limit downside. Invest smartly.

fyi: The index is calculated on an equal-weight representation based on closing prices as of 12/31/07.

Disclosure: I have no current stock positions in any of the companies listed in this index and no current business partnerships.

Comments

[Lexxy]

Rick, so what do you think about LOOP now that it is hovering around $11?