The Rule Of 40 Portfolio Q1 2022: The Highest Quality SaaS Companies

The Rule Of 40 Portfolio Q1 2022: The Highest Quality SaaS Companies

Melpomenem/iStock via Getty Images Thesis

The Rule of 40 is a quantitative way to measure how well a software-as-a-service company balances growth and profitability. The best performing SaaS companies typically pass the Rule of 40, but not all companies that pass the Rule of 40 perform well. Investors can use this portfolio as a starting point but should also consider valuation and qualitative factors when picking stocks. Introduction

The Rule of 40 simply states that a SaaS company’s growth rate plus (or minus) its profit should add up to at least 40. This rule – in addition to other metrics such as low debt and cyclicality that SaaS companies typically score well on – is a way of measuring the quality of a company. Companies that do well on the Rule of 40 typically have strong pricing power and a product that’s in high demand. For more details about why I believe that a high Rule of 40 score can be an indicator of long-term outperformance, refer to my first post in this series.

Starting with this iteration, I’ve made one change to the rules, which is to remove the requirement for >20% revenue growth. This allows some more stable stocks like Microsoft (NASDAQ: MSFT ) and VeriSign (NASDAQ: VRSN ) to enter the portfolio, which should help to reduce its volatility.

I initially developed this growth requirement based on a frequently cited study that claims all top performing stocks have high revenue growth. However, after looking at the study’s methodology, I found that it used a short period in the stock market where the beginning and ending S&P 500 P/E multiple was the same and that it allowed positive and negative multiple changes to cancel each other out. So, I no longer place much faith in that study. The Portfolio

Company Score Growth Margin P/S Price DOCS 101 67 34 30 49.87 DDOG 82 84 -2 42 137.74 ZI 79 59 21 31 57.43 VRSN 72 6 65 18 212.66 MSFT 63 22 42 12 295.22 ADBE 57 20 37 13 444.36 DCBO 57 68 -12 15 47.52 NLOK 54 10 44 5 25.93 CRWD 53 63 -9 32 204.13 PAYC 53 29 24 20 343.11 FTNT 52 33 19 15 303.48 ENFN 51 47 5 16 14.81 VEEV 50 22 27 16 191.76 MNDY 50 91 -41 21 149.79 LAW 49 67 -18 15 30.24 ZM 49 21 28 8 111.29 CHKP 48 6 42 8 138.52 QLYS 44 16 28 12 130.05 PCTY 43 34 9 15 203.32 SNOW 43 101 -59 52 208.85 EVCM 43 47 -5 6 12.60 HUBS 42 47 -4 17 467.34 DT 41 32 10 14 43.22 Source: The Author

For posterity, SPY’s price at the time of publication is $441.07 and SKYY’s price is $85.81.

This iteration of the portfolio has a nice mix of established blue chips, quality growth stocks, and smaller caps that are higher risk/higher reward. At 23 stocks, this is the largest version of this portfolio, with the additions being due to a few factors: The change to the growth requirements mentioned previously.

Suggestions from readers about smaller/lesser known stocks to add.

A generally good earnings season across the SaaS sector.

Speaking to the last point, the previous iteration of the portfolio had 11 stocks and 10 of the 11 had good enough quarterly earnings to remain on the list. The only stock taken off was Atlassian (NASDAQ: TEAM ), which still has a score of 39.

I’ll now highlight a few companies that had interesting developments this quarter. VeriSign, NortonLifeLock, Check Point

These slower growing companies were added to this iteration of the portfolio after I removed the requirement for 20% growth. They will probably remain comfortably in the portfolio for the foreseeable future seeing as their operating margins alone allow them to quality.

NortonLifeLock and Check Point add to the portfolio’s already strong cybersecurity presence. I continue to believe that cybersecurity is one of the best investment opportunities in software so it’s encouraging to see the portfolio indicate this as well. However, I prefer some faster growing options.

VeriSign is an interesting company that has a contracted monopoly on .com domain registration. This means that they operate as a tollbooth on every website registered with a .com domain. Unlike most stocks listed, the company is conservative in its investments and spends most of its earnings on buybacks. It’s one of the safer picks, although a cyberattack could cause it to lose its monopoly status and the increasing popularity of .com alternatives […]

source The Rule Of 40 Portfolio Q1 2022: The Highest Quality SaaS Companies

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