I believe this basket of 10 SaaS businesses under $10 billion will do better than the S&P 500 over the next five years.
Image Source: App Economy Insights.
These 10 companies are particularly relevant together as part of a basket strategy and have been hand-selected following a series of KPIs, screeners, and scorecards.
The ingredients of this recipe:
- a wide range of industries and services
- significant addressable markets
- strong leadership teams and culture
- companies still small enough to generate significant returns
- winning SaaS businesses with high retention and expansion rate
- winning stocks with price appreciating over the last 12 months
- undiscovered or under-followed tickers
Consider that you are shooting for 50% accuracy: with a basket approach, you are increasing dramatically your chances to achieve outstanding gains. Chances are at least a few of these fast-growing disruptive SaaS businesses will compound to significant returns -- as long as you can hold on to them. Even if the majority of them turn out to be losers, this should be more than enough to beat the market averages.
Source: Chart by author. Market Cap from Yahoo Finance 1/7/2019.
The key metrics of evaluating SaaS businesses
While investors typically use key metrics such as P/E (Price to earnings ratio) or P/FCF (Price to Free Cash Flow), the story has to be different for young SaaS businesses.
These companies tend to have growth stories that can be hard to evaluate on the long-term and they are re-investing heavily in themselves, making them look richly valued based on traditional metrics.
From RRR (Revenue Retention Rate) to DBNE (Dollar-Based Net Expansion rate), there are many ways to evaluate how healthy a SaaS business is.
Overall, a strong business model should require less and less spending on sales & marketing over time proportionally to revenue.
I have broken down before the three pillars of Cloud businesses:
- Acquisition: How efficiently is the company acquiring new customers? Is that cost increasing or dropping over time? This could depend on TAM or how specific the service provided really is, among other things.
- Retention: Are customers sticking with the product? How many customers from the 2017 cohort are still around? What is the Net Retention on a revenue basis (overall dollar amount made from the same cohort of customers over time).
- Monetization: Are existing customers spending more money on additional products? Are they spending more in year 2 compared to year 1? Is the company providing Life Time Value per customer and how fast is it offsetting Customer Acquisition Costs (LTV/CAC)?
SaaS businesses are rarely a home run on all KPIs, but when they are, their valuations tend to reflect it with a huge premium up to 20+ times sales.
If you are focusing on traditional valuation metrics such as P/E or PEG, you are wasting your time here. There is a leap of faith needed when you invest in a loss-making company growing its revenue more than 50% year-on-year report after report.
Some of them will eventually show cracks in their growth story that can lead to dramatic draw-downs in their share price. Some others will see their growth accelerate and will go on to become the Atlassian (TEAM), Shopify (SHOP), Square (SQ), or even Salesforce.com (CRM) and Oracle (ORCL) of tomorrow.
The common denominators: a screener for the winners
Out of some of the top performing SaaS stocks, some similarities begin to appear in their stories and fundamentals.
Here is a list of commonalities I have found between them:
- They are making half a billion or less in yearly revenue
- They are still losing money
- They are growing fast (25%+)
- They often have high insider holdings (5%+)
- They have low trading volume on average
- They are cash flow positive
- They have outstanding management teams and culture
- They are mostly under-followed by Wall Street (less than ~10 analysts)
- They have high valuations by most standard metrics
- Their price has appreciated over the last 12 months (winners win)
As part of the screening process, I consider the three following as the sine qua non of KPIs in order to filter out companies that would fall out of an acceptable spectrum:
- CEO approval ratings on Glassdoor > 80%
- Fast growing top line > 25%
- Stock price movement over the last 12 months positive
By selecting only companies that deliver at least on the three KPIs above, I am most likely looking at companies that have a strong leadership, fast-growing business, and a winning stock.
What I am truly interested in is a company that could be 10 to 20 times bigger in the next decade. By all means, this is pretty much the opposite of value investing. I want companies that are on their way to the moon, not cigar butts. Although important, traditional valuation metrics become only second in this screening process.
The Small Cap Score Card
Following the 10 criteria above, I have built a Score Card for evaluating small caps in order to identify potential high performers for the years to come.
These criteria add more traditional valuation metrics in the mix such as profitability, PEG, cash flow and also address if the company remains fairly "undiscovered" by Wall Street.
- CEO Approval on Glassdoor > 80%
- Growth > 25%
- Price Appreciation TTM
- Sales TTM < $500M
- Cash Flow > 0
- Insider Holdings > 5%
- Analysts < 10
- Daily trading volume < $25M
- Profit > 7%
- PEG < 1
While the overall score is certainly not an end-all-be-all kind of indicator, it forces me into having a full picture of the pros and cons and comes handy when comparing a large number of companies to see which ones stand out.
With new promising growth stories every other month and head-scratching valuations, I have come to appreciate relying on such a screener.
Companies in the chart: Okta, Paycom Software, The Trade Desk, HubSpot, Elastic, MongoDB, Alteryx, Eventbrite, Appfolio, Zuora.
Source: Chart by author. Financials from Yahoo Finance 1/7/2019 and CEO approval rating from Glassdoor.com
The 10 companies under $10 billion selected today are all high on the scorecard with overall scores ranging from 60% to 100%. As expected, they tend to fall short when it comes to traditional valuation metrics based on earnings but show spectacular results otherwise.
While a high score on the card is not sufficient to determine a winner, you will rarely see a loser score high across these KPIs. The screener becomes more of a tool to eliminate a lot of potential losers.
Let's not forget the importance and relevance of the basket approach. Again, you don't have to be right on each individual company when you diversify your investment across a wide range of promising growth stories. While they could all deliver for their own individual compelling reasons, even a 50% success rate will be more than enough to deliver a market-beating performance.
Indeed, high flyers in the SaaS category tend to deliver spectacular returns. All you need is to capture some, one, or two in your fishnet and let them compound.
The biggest challenge in the basket approach is investor behavior. With high volatility come emotions, second-guessing and temptation to bail as soon as the portfolio underperforms for more than a year or even a few months. Only investors with the temperament to go through highs and lows and ability to keep their shares intact for years should consider it.
What else makes these 10 under $10B so special?
Okta is an identity-management service built for the cloud, empowering IT departments to manage any employee's access to any application or device. The company reported a dollar-based retention rate of 120% for the trailing 12 months ending October 31, meaning that not only customers are staying around, but they are also adding more functionality over time.
Paycom Software is offering a platform for all HR-related functions such as paycheck, recruitment, benefits and time management. The company has been able to keep its RRR steady at 91% for the past three years, a very high number considering the failure rate of small businesses, the main market Paycom is serving.
The Trade Desk is a digital ad platform, serving the programmatic ad market. The company is covering the entire digital advertising market: Connected TVs, Mobile, Video, Audio, Displays, Social, Native. The worldwide advertising market is expected to reach about one $1 trillion in 2022. The company is growing at a fast clip and is retaining 95% of its customers. You can find my detailed write-up about The Trade Desk here.
HubSpot might be the next Salesforce.com. They help small and medium-size businesses draw customers in and close sales with its inbound marketing and sales software (SEO, website, marketing automation, social media, landing pages, blogs). Revenue retention rate was over 100% in their last earnings report.
Elastic offers Elasticsearch, the most popular enterprise search engine according to the DB-Engines ranking. They are used in a wide range of applications: from connecting you to your next Uber driver to your next Tinder match. The company's Net Expansion Rate was 142% as of July 31, 2018, making it probably the most promising business of this group.
MongoDB might well be the next Oracle. It is a free and open-source document database designed for ease of development and scaling. It offers a superior option when it comes to storage capacity and speed for the modern databases that requires greater reliability and efficiency. Net expansion rate exceeded 120% in their last reported quarter.
Alteryx is a provider of self-serve data analytics. They empower what they call "data citizens," people without data science or coding experience, to make sense of the overflow of data. Their addressable market is limitless if they can become the go-to analytics tool across IT, data scientists and data analysts. Dollar-based net revenue retention was 131% in their last financial results.
Eventbrite provides online ticketing and event planning services. They have a large TAM thanks to their leading position in the mid-market: "not birthday parties and not Taylor Swift at Madison Square Garden, but everything in between," as CEO Julia Hartz puts it. 95% of customers sign themselves up and 97% of them are still around in year 2. The freemium model is converting 17% of users per the company as disclosed in the S-1. You can find my detailed write-up about Eventbrite here.
Appfolio has its own niche: a focus on small and medium-sized property management and law firms. Better yet, management expects new verticals to be added in the coming years. The company's dollar-based net expansion rate was 133% for property manager customers and 100% for law firm customers. You can find my write up about Appfolio here.
Zuora is helping companies transition to the "subscription economy." The company's applications are designed to automate recurring billing, collections, quoting and revenue recognition. Zuora's dollar-based retention rate has expanded from 100% to 110% since fiscal 2016.
A quick look back
Here is how you would have done investing in these 10 companies over the last five years:
Many of them had their IPO over the last five years, so you are looking at a shorter time-frame for most of them.
Yet, 7 out of 10 companies have outperformed the S&P 500 index price performance over the last five years. If you average the returns above, you'll get an overall return of 237% assuming an investment evenly balanced between the 10 companies.
That number compares to an S&P 500 price index improvement of 40% over the last five years.
Although winners tend to keep on winning, I am by no means saying that past performance should set expectations for the future. I am only showing you how powerful this strategy can be when successful.
A word of caution
These companies are small and many of them have yet to be profitable. Their businesses are subject to disruption with new competitors, regulations or breakthrough innovations around the corner.
Volatility should be expected, with move 50% up or down in a matter of weeks for no apparent reasons. Ask yourself if you can cope with that before considering this kind of investment.
While it may sound less risky to spread an investment across 10 companies, this basket does NOT constitute a diversified portfolio in and of itself. They all belong to the same sector, size, and geography, which makes them likely to move together and be subject to the same risks at a macro level.
This basket strategy should only represent a specific sub-category of your overall portfolio and be understood as an alternative to an investment in a single SaaS company.
2018 was a fantastic year for many Enterprise Software stocks.
Mean regression is always lurking and extreme volatility should be expected for any small growth company. But I believe 2019 remains a great year to start or add to these positions with a long-term horizon in mind.
While nothing is certain in the short-term, particularly on an individual company basis, I am confident that this basket will do very well over a five-year time frame and beyond.
Let's review every year how these 10 companies under $10 billion are getting it done compared to the S&P 500.
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Disclosure: I am/we are long APPF EB HUBS MDB PAYC SHOP SQ TTD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.