The Rule Of 40 For SaaS Companies – They Can’t All Be ‘Healthy’ – Part 2

(Source: Pixabay image and Author text)

In 2015, software angel investor Brad Feld penned the blog post “The Rule of 40 for a Healthy SaaS Company”, where he describes a rule of thumb to assess the health of a software as a service (SaaS) company. The Rule of 40 attempts to balance two key metrics for SaaS companies, namely sales growth and profitability, the sum of which should be at least 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}. Since Feld published this post, the Rule of 40 has become a very popular SaaS metric.

According to Feld:

So, if you are growing at 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} (sales), you should be generating a profit of 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}. If you are growing at 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}, you should be generating a 0{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} profit. If you are growing at 50{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}, you can lose 10{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}. If you are doing better than the 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} rule, that’s awesome.

Source

In Part 1 of this series, we looked at variations of this rule and tested the performance of a portfolio all stocks passing the Rule of 40 over various time periods.

In this installment, we will breakdown the Rule of 40 in an effort to find out what makes the difference between the winners (“healthy” according to Feld) and the losers.

In Part 3, we will drill down even further into the fundamentals of Rule of 40 stocks in an effort to weed out the losers.

The Rule of 40, So Far

In Part 1, we looked at Rule of 40 stocks based on sales growth (trailing twelve months compared to previous trailing twelve months) plus different variations of profitability (gross margin, free cash flow, unlevered free cash flow and EBITDA margin).

The most consistent variation, in terms of performance and alpha, was the free cash flow profitability, or FCF, version of the rule. This also produces a decent number of stocks (at the time of writing, 52 out of 250 software stocks).

For this installment, we will focus in on the FCF version of the Rule of 40.

Our testing universe includes all software stocks, with a minimum annual sales of $50M and $100,000 in median daily trading volume (to ensure liquidity for trading).

Summary performance for all software stocks passing the Rule of 40, rebalanced quarterly:

Source: Portfolio123data, Author Table

For the sake of brevity, I will refer to all stocks passing the Rule of 40 as R40 stocks. The R40 score refers to the total sales growth and FCF profitability, as a percentage. All R40 stocks have a minimum score of 40.

As with Part 1, all tests shown have been done through Portfolio123. I have made a public screener available there for Rule of 40 stocks (you can sign up for a trial membership to access if you are not currently a member):

Rule of 40 for SaaS Companies, Stock Screen

Opening up the R40 Black Box

Credit: Medium.com and Author Text

When using quantitative models, it is often tempting to run a backtest until one obtains the results s/he is looking for and take the “black box” as is. A simple, yet often overlooked step, is to look at the actual stocks and associated values that the screen or backtest has produced.

With that said, let’s now open the R40 Black Box.

2019 was a positive return year for R40 stocks at 27{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}, however, they trailed the SP1500 IT index (43{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}). Below are all stocks that would have been purchased on 01 Jan 2019 based on the Rule of 40, and filtered those that produced a negative return over the year:

Source: Portfolio123 data, Author Table

A few notable takeaways here:

• Of the 59 stocks passing the Rule of 40 in January of 2019, 12 ended with negative returns, with Exela Technologies (NASDAQ:XELA) and ANGI Homeservices (NASDAQ:ANGI) returning -91{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} & -47{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} respectively. According to the Rule of 40, these stocks should be healthy, but those returns are certainly very unhealthy.
• 4 of these stocks had an R40 score in the triple digits (most of which is driven by sales growth, a key factor which we will discuss later).
• On the whole, these negative return stocks had an average R40 score of 118 at the time of purchase in Jan 2019.

Now, compare the performance and R40 score of the above losers to the R40 winners of 2019:

Source: Portfolio123 data, Author Table

Simply stated, for 2019, stocks with higher R40 scores returned less than those with lower R40 scores.

This is not exactly what we’re looking for, so let’s dig deeper into the Rule of 40 and its two constituents, sales growth and profitability.

Rule of 40 Stocks, Ranked Performance

Instead of just looking at winners and losers of 2019, we can rank all R40 stocks by R40 score (higher the better), and divide into 5 “buckets” (or quintiles).

The bucket rank plot below breaks down performance of all R40 stocks on 01 Jan 2019 and holding for a year. Performance of the highest 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} scoring R40 stocks is shown on the far right (magenta), and the lowest 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} are second from the left (in blue). Furthest left (red) is the performance of the SP1500-IT index over 2019.

Source: Portfolio123 output, Author Ranking System

We essentially have a “goldilocks” effect for R40 stocks in 2019. Low scoring stocks did poorly, the middle 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} met the benchmark, and the highest scoring 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} stocks did very poorly, as we saw from our stocks list above.

For reference, here are summary stats for the 2019 quintiles:

Source: Portfolio123 data, Author Table

If we rebalance quarterly as we did for our portfolios from Part 1, higher ranked R40 stocks underperform to a greater degree:

Source: Portfolio123 output, Author Ranking System

Keep in mind this is a relative sample size but is very illustrative.

If we expand our rank plot to the last 15 years, with quarterly rebalance, we find a similar long-term trend:

Source: Portfolio123 output, Author Ranking System

And for the last 5 years:

Source: Portfolio123 output, Author Ranking System

So, can you have too much of a good thing? It would appear so. It looks as though lower scoring R40 stocks outperform stocks with a higher R40 score.

Let’s dig down further.

Rule of 40 Performance – Breaking it Down

The Rule of 40 does not discriminate between sales growth and profitability; provided that the two values meet or exceed 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}, the stock passes. As we saw for 2019, many of the losing stocks’ scores were dominated by very high sales growth.

Let’s take a closer look at the two R40 factors, starting with sales growth.

Before we get into factor breakdown for the Rule of 40, recall that we are dealing with a relatively small universe of stocks. As of writing, there are roughly 250 stocks in our “All Software Stocks” universe (described in Part 1), 52 of which pass the Rule of 40.

Compared to a broader universe of stocks, say the Russell 3000 with 3000 stocks, software and R40 stocks are very small sample sizes for testing. When breaking down performance of individual factors, we will also look at the factor performance for the broader R3000 for comparison. Even though the two universes may not be equivalent (i.e. Russell 3000 contains all industries, varying from rapid growth SaaS companies to very established and mature firms), it is not a bad idea to compare factor performance between universes to see if the performance trends (whether similar or different) make logical sense.

Rule of 40 – The Sales Growth Factor

When ranking all stocks in the Russell 3000 universe based on highest sales growth (TTM sales growth compared to previous TTM), with the far most quintile including 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} of stocks with highest sales growth for the last 15 years:

Source: Portfolio123 output, Author Ranking System

Over the long term, the highest sales growth firms underperformed in the R3000, and the remaining 80{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} of stocks.

Whereas in the last 5 years, the sales growth factor has been flat, with virtually no spread between the highest and lowest ranked, and all buckets (on average) underperforming the R3000 index:

Source: Portfolio123 output, Author Ranking System

Software Stocks & Sales Growth

For our All Software Stocks universe (no Rule of 40 applied) from Part 1, sales growth over the last 15 years shows a very different trend from the broader R3000:

Source: Portfolio123 output, Author Ranking System

And the last 5 years:

Source: Portfolio123 output, Author Ranking System

For sales growth, we see a much stronger positive trend for software companies. It appears the higher the sales growth, the better.

But not so fast… if we improve our resolution by increasing the number of buckets from 5 to 20, an interesting trend is revealed:

Source: Portfolio123 output, Author Ranking System and edit

So, while on average the top 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} of stocks ranked by sales growth did the best, within the top 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9}, there is some declining performance with higher R40 score. Which leads us to our R40 stocks…

Rule of 40 Stocks & Sales Growth

Recall that our R40 stocks universe as of today is 52 stocks (roughly 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} of the All Software Stocks universe). This small universe also favours high sales growth companies. So, based on the above rank chart, we should not be surprised to see the rank chart below for R40 stocks based on sales growth for both 15- and 5-year periods:

Source: Portfolio123 output, Author Ranking System

Source: Portfolio123 output, Author Ranking System

Here, we see the same trend in sales growth as we saw for all R40 stocks; the stocks mid-ranked for sales growth perform the best out of the R40 stocks.

Rule of 40 Stocks & Free Cash Flow profitability

Intuitively (at least to me), it would make sense that profitability is always a good thing, the higher the better.

When we rank stocks broadly in the Russell3000 index with higher FCF margin the better, there is little spread between the top 80{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} of the universe (and all about the same return as the R3000 index). The lowest 20{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} underperform by a wide margin.

Source: Portfolio123 output, Author Ranking System

This trend is fairly consistent for our other time periods.

For software stocks on the other hand:

Source: Portfolio123 output, Author Ranking System

And for 5 years:

Source: Portfolio123 output, Author Ranking System

Note, the middle quintile (yellow) contains the various stocks with a value of ‘NA’ (not applicable) for free cash flow profitability, so the spread between the bottom 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} and top 40{554322552816a46baa129cc1ab31b2aae22be5e23f407658ace83a643d80b0e9} is quite evident here. The lower FCF profitable firms outperform the SP1500-IT index, while the firms with higher profitability underperform, perhaps due to mean reversion as we saw with sales growth.

And now for our R40 stocks:

Source: Portfolio123 output, Author Ranking System

Source: Portfolio123 output, Author Ranking System

Again, the higher the FCF profitability, the lower the returns. Note that even the highest ranked stocks just met the same performance of the benchmark SP1500-IT.

Beware of (the Inevitable) Mean Reversion

This trend of underperformance of the highest ranked stocks is not isolated to our R40 factors only.

Take a look at earnings per share (on a TTM basis) for Russell 3000 stocks over the last 15 years:

Source: Portfolio123 output, Author Ranking System

Or operating income, TTM:

Source: Portfolio123 output, Author Ranking System

And even Return on Equity to a lesser degree (increased number of buckets for improved resolution):

Source: Portfolio123 output, Author Ranking System

This trend of underperformance of the highest ranked stocks for a given factor (or combination of factors) is traditionally attributed to mean reversion. Companies experiencing very high rates of growth eventually hit a slowdown period, or competitors enter the market and eat away at sales growth from the “first movers”. Traditionally, the markets “naively extrapolate” (*) high rates of growth; however, when the firm cannot meet expectations, the market penalizes them, sometimes harshly, resulting in poor long-term performance.

[(*) Term borrowed from Partha Mohanram’s paper on the G-Score, I’ll be writing about this strategy in the near future]

From the research above, it seems that mean reversion is a significant force for high scoring R40 stocks.

Let’s now put it all together. Over the last 15 years, performance trends for Rule of 40, Sales Growth, and FCF margin ranked factors can be summed up broadly as follows:

Source: Author Table

Conclusion

In Part 1 of this series, we saw how on average the Rule of 40 stocks, based on free cash flow profitability, have outperformed the software and broader indices.

In this installment, we opened the Rule of 40 black box and saw how not all R40 stocks are created equal, or in Brad Feld’s words, not all are “healthy” (or at the very least do not produce “healthy” returns). There has been a general negative relationship with the magnitude of the Rule of 40 and future performance over time. Generally, those stocks with excessively high R40 scores tend to underperform.

When looking at the components of the Rule of 40, sales growth, and profitability, we saw that both of these factors tend to be mean reverting for R40 stocks, that is the stocks posting the highest growth and profitability tend to underperform in the future.

In Part 3, we will take a more fundamental look at the high sales growth and profitability values to see how we can address them through understanding the fundamentals of SaaS businesses.

Until then, Happy Investing!

But before we go…

Up until now, we have been looking at Rule of 40 rank charts over the long term, 15- and 5-year periods. The trends were fairly consistent with stocks with very high R40 scores, and by extension very high values for sales growth and profitability, tending to underperform over the long term.

You may have noticed that we have not yet seen the rank chart for R40 stocks for the last year. Well, here it is, with R40 stocks scoring higher (quarterly rebalance):

Source: Portfolio123 output, Author Ranking System

The last year turned our long-term conclusion about R40 stocks upside down. That said, I think most would agree that the COVID crisis has been a significant catalyst for SaaS companies in the last year, with the abrupt move to “work-at-home” and the acceleration of traditional businesses shifting to e-commerce, etc.

Whether this is only temporary and it is only a matter of time before mean reversion rears its ugly head, or whether SaaS is going through a secular shift is anyone’s guess. This goes to show just how unpredictable the markets are and how difficult (and exciting!) investing can be.

For interest, here are the top 20 returning R40 stocks if purchased 6 months ago, and the R40 scores at time of purchase. Keep in mind, the average R40 score of all R40 stocks at the time was 53.7.

Source: Portfolio123 data

Looking forward to bringing you Part 3 of this series, stay tuned.

Disclosure: I am/we are long COUP, CRWD, MDB, TWLO, ZM. 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.

Additional disclosure: This article is for informational purposes only. I am an individual investor and writer, not an investment adviser. Readers should always engage in his or her own research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or specialized attorney before making any investment, income tax, or estate planning decisions.