Get a job. Earn money. Spend. Save the remaining amount. This has been taught to kids growing up in the USA. When they start saving money, they prefer to invest that to generate better returns. One such investment option is mutual fund. Mutual funds invest money across multiple companies and diverse industries thereby reducing the risk associated with the investments. Investors need not have to spend a lot of time on understanding individual companies as this has been handled by the fund managers for a standard fee. Let us see how mutual funds have performed over the last few years and why does it make sense to invest a part of your savings in the booming SaaS industry?
Dow Jones and a decade of Under-Performance:
Let’s consider Dow Jones, the largest index listed in the USA. Over the last ten years, Dow has underperformed with a CAGR of 6.53%. A $1000 invested would now have become just $1882. Remember, this return is after the 2008 crisis. Had we considered one more year, then the return goes down to 5.69%? If we consider a five year data, it is slightly better with a CAGR of 10.25%. A $1000 invested five years back in the index would have become $1628.89.
Source: Yahoo Finance
Mutual Fund Performance over the Years:
Source: All mutual funds related data are taken from Morning Star. Data as of June 2018
This is the average overall return generated by mutual funds across different market cap segments. Small cap mutual funds have a high risk reward ratio. But they seem to have under-performed in the last 5 years. Large growth funds have given the highest return of 15.08% but otherwise, none of the other funds seem to have generated extra ordinary returns. So, if a person has invested $1000 five years back in a small growth fund, it would have generated $895 thereby moving the overall value to $1895.
Top Performing Mutual Funds:
Ten Year Performance:
Below table lists the top 20 mutual funds over the last ten years and five years based on performance.
Internet Funds are leading the charts from a ten year perspective. An interesting pattern here is that out of these top 20 funds, 14 have been sector based funds such as internet, healthcare, biotechnology, consumer services etc. Investors need not have to choose only sector funds. But while choosing mutual funds, there is a need to choose a few sector funds that can improve your overall returns.
Tech Mutual Funds Performance:
Technology plays a vital role in today’s economy. Tech mutual funds are funds that invest in technology related stocks. This includes different companies from hardware to software. Some of the innovations in technology could change the world upside down. For example, smart phones have disrupted the ecosystem. There are so many exciting things happening in the tech world in the form of automation, machine learning, digitization, analytics and cloud. Hence, fund managers have to stay on their toes to understand rapid changes and ensure better returns for their investors. Below is a list of top 20 technology funds based on last ten years’ performance. Fidelity has 10 funds out of these top 20 funds. Hence, Fidelity seems to have a competitive edge over all other mutual fund houses when it comes to tech funds.
Best Performing Tech Funds in the last 5 years:
Top SaaS companies in the listed space and their performance:
Here is a list of some of the top public SaaS companies in terms of market cap. While the top performing tech mutual fund has given around 28% CAGR in the last five years and around 20% CAGR in the last ten years, SaaS companies have given better returns. Nineteen out of these twenty two public SaaS companies have generated more than 30% CAGR since their IPO.
Share Price of SaaS stocks since IPO:
In foresight based on past returns, public SaaS companies look like an extremely interesting opportunity to invest your money to generate better returns. Let us dig deep to find out whether parking a part of your savings in this fast-growing industry is an absolute must.
SaaS industry & its potential:
1. Huge Opportunity Size
SaaS industry has just started to explode and there is a huge migration happening from traditional systems to cloud based applications. Hence, the opportunity size is huge and companies providing SaaS products are expected to show robust growth. Public cloud market is expected to grow to $236 Billion in 2020. SaaS companies are expected to achieve $147 Billion in revenues. According to Gartner study, enterprise cloud spending is likely to witness eight fold growth from $100 Billion in 2017 to $800 Billion in 2027 (at 20-25% CAGR) whereas overall IT spend is likely to grow at a CAGR of 2-4% from $1 Trillion in 2017 to $1.35 Trillion in 2027. This gives us a clear picture of multiple years of strong growth lying ahead for these listed SaaS firms.
As shown in the above graph, SaaS industry is expected to show consistent growth over the next few years. 50% of total sale is likely to happen to SMB customers. There are more than 600 million SMBs in the world. North America is expected to dominate the SaaS industry. Several businesses have just started using small cloud based applications. Number of small businesses in North America has increased 50% since the 1980s. 62% businesses in USA have less than 5 employees. Hence, such companies require products with limited number of users instead of a large enterprise product. Since these SaaS firms cater to all types of segments from small sized companies to mid market and enterprise customers with different pricing plans, it is an under-served market and the market share of cloud based products is expected to go up in the overall IT space.
2. Industry at an inflection point and increase in cloud adoption
Stock pickers consider investing in a segment leader with a significant moat. Most of these listed SaaS companies are market leaders in their space. They have that first mover advantage as they manage to sustain leadership by coming up with better customer experience through innovation and economies of scale. For example, Salesforce is a leader in the SaaS CRM space while Zendesk is a leader in providing SaaS based customer support ticketing systems. Besides, these SaaS companies are expected to show consistent growth as the industry is still at an inflection point.
According to a Bain report, cloud demand is expected to meet 60% of total IT growth. While SaaS is expected to grow at 18% CAGR, IaaS & PaaS are expected to grow higher at a CAGR of 27%. Cloud Adoption Rate graph - Cloud adoption has continued to show exorbitant growth. According to IDC, 60-70% of all IT software spending is expected to happen through cloud by 2020. In 2011, cloud products were predominantly used by SMBs whereas in 2017, 48 out of the top 50 fortune global companies have adapted to cloud or have publicly communicated their intention to implement cloud into their businesses. This is expected to open multiple doors to acquire more clients. There is a clear shift from traditional businesses towards subscription based businesses and is clearly seen in industries and firms who prefer to buy IT solutions. Besides software, this is also visible across other segments and end-users. For example, customers don’t prefer to buy DVDs these days. Instead, they prefer to stream online for monthly subscriptions.
3. Strong Focus on Growth
All these companies are aggressively focused on growth. They also seem to be optimistic about their future growth prospects. Tableau, a cloud based web development company believes that there is a significant opportunity to grow their international business. Hence, it is increasing its sales teams outside the USA and is also keen to invest further to expand these markets. Zendesk (which is a leader in cloud based customer service software) recently opened an EMEA headquarters in Dublin with an investment of $10 Million. This centre is expected to play a key role in its global business strategy. Shopify has a strong focus on rapidly growing its business. So, they continue to make investments to drive future growth and they believe that continuous investments will improve growth rate which is already robust. Another SaaS player Wix expects a 40% revenue growth in 2018 to around $590 million which is humongous. Some of these SaaS firms are not just focused on organic growth but they also have an eye on inorganic growth. For example, Workday recently acquired Adaptive Insights, which provides financial and sales planning software. Splunk purchased VictorOps, a DevOps related Product Company as they find a lot of synergy with acquired companies that will drive the company’s growth in the future. It is clear that all these SaaS leaders continue to have a strong growth strategy to increase the top line in a market that is fast growing.
Minimum 30% Sales CAGR since 2011:
Sales
Could not get data from 2011
Companies have also walked the talk by showing extraordinary sales growth. Out of these 22 companies, 19 have shown more than 30% CAGR in the last four to seven years. From a cumulative point of view, 32% CAGR has been registered since 2011.
4. Cost – low cost, no upfront investment. Payments happen through MRR
Traditional IT incurs a huge upfront investment cost in hardware and software licenses. So, SMBs cannot afford to spend so much money on such products. Low cost acts as one of the primary growth drivers for SaaS companies. Since it works on a shared environment, cost is extremely low. Maintenance expenses are also low because it is the responsibility of SaaS companies. When compared to traditional models, upgrading involves less effort and money. Increase in adoption rate due to an easy delivery model, support and seamless up gradation without incurring a lot of hardware cost as cloud software providers take care of all these aspects. Quick deployment is another key benefit that helps SaaS firms to score over traditional IT firms. So, it is an easy to use plug and play option for customers who can pay as per demand. This acts as another growth driver for SaaS companies. Customers prefer to buy SaaS solutions that offer high security. These top listed firms are spending a lot of money on improving the security of their products.
5. Security
Security has always remained a top concern for SaaS products. A few years back, many enterprise customers preferred traditional IT solutions to SaaS solutions as questions hovered around data security provided by these cloud hosted solutions. This is one of the primary factors that hampered the progress of growth across SaaS firms. But this is slowly changing as clients seem to lose businesses by not implementing cloud. It looks mandatory to implement SaaS solutions to show an uptick in growth trajectory. Enterprises are also focused on deploying employees with the right skill set so that such security issues don’t happen while using solutions that are hosted in cloud. A Gartner study says that by 2022, more than 95% cloud security failures are likely to happen only through customer’s mistakes. Top SaaS companies continue to focus on implementing the latest security protocols to ensure that security doesn’t become a threat to clients using the product. Tokenization and encryption have improved the security levels of SaaS products.
Risks Associated:
1. Negative PAT
SaaS companies compromise on margins to increase top line growth. This is often considered as a huge negative by some of the experts in the market. So, a lot of questions have been asked on the sustainability of these prices as financial ratios such as price to earnings, profit growths etc. have been negative. Companies invest more on growth as SaaS is still an under-penetrated market with a lot of new customers to acquire. Because of this, they tend to have negative margins. Another important reason is a skewed income statement. Cloud based companies tend to incur all the cost in the beginning.
For example, they spend a lot of money on product, sales and marketing teams to acquire customers. All these expenses are captured in the income statement during that quarter. Unlike traditional firms that tend to collect most of the payments upfront, SaaS firms receive payments in installments. Revenue is subscription based and is realized through MRR – Monthly Recurring Revenues. MRR is sales revenue which is received as payments month on month from all existing customers. The more the number of customers, the better it is for the companies to realize more revenues in the long run. This is misunderstood while looking at SaaS profitability. To build a sustainable business model, companies must have more customers who want to use this product for a very long period of time. To continue robust growth, companies tend to spend a lot of money upfront which leads to sub-optimal profits. Hence, a negative bottom line should not be considered as a barrier to invest in SaaS firms.
2. Monumental Valuations:
It is always difficult to value tech companies. It is puzzling when top tech companies acquire smaller firms at astronomical valuations which defy traditional M&A valuations. When we look at public SaaS firms, they also trade at King Kong valuations. Mr. Market tends to value high growth SaaS companies at high multiples. Growth seems to remain the key mantra to value these firms that are trading in stock exchanges. But at the same time, operating margin is improving with each and every passing year as companies have started to also focus on bottom line.
Cumulative Operating Margin:
From a cumulative point of view, there is an improvement in operating margin. It is up from -5.62% in 2015 to -2.73% in 2018. This clearly shows that companies have managed to grow at astronomical rates without compromising on their margins – in fact with an improvement in margins. This is likely to continue as SaaS firms continue to add more customers. Valuations may also continue to remain northward as they continue to show consistent growth along with an improved operating margin.
R&D as a % of Sales:
Even though operating margins have improved, companies have not compromised on R&D investments. This has remained steady. In fact, there is a 1.35% increase in R&D spending but still they have managed to increase operating margins which looks quite impressive. Companies get rerated when they show consistent growth in top line and bottom line. Hence, valuations will be scrutinized constantly by experts and investors who focus on SaaS firms.
3. Competition and Churn Rate
SaaS is an extremely crowded market. There are multiple companies in the same segment providing the same set of products. They compete within themselves to provide better features that add a lot of value to customers and they also strive to provide the best customer service. Word of mouth plays a vital role in converting new customers. Hence, a high quality product alone is not enough to convert new clients. Companies need a reliable customer support team to ensure success. When we look at these top public SaaS firms, they are all leaders in their respective segments. Leaders always tend to have a competitive advantage over others. They might have first mover advantage or they might have far better insights about customers for whom they are building products. Hence, investing in the number one player is always safer than investing in lesser ranked companies.
Churn rate is another important metric that plays a vital role in understanding the health of SaaS companies. It is the percentage rate of customers cancelling their subscriptions. It is less expensive to upgrade accounts of existing customers when compared to acquiring new customers. According to a survey by forentrepreneurs.com, it is 4X cheaper to upsell to existing customers than to acquiring new customers. It is 9X cheaper to retain existing customers than acquiring new customers. Low churn rate is extremely important to build a sustainable business model by retaining more number of customers and generating consistent recurring revenues.
Source: SaaS Capital
If the contract value is high, clients tend to stay with existing products. For annual contract values above $150,000, there is a 95% retention rate. Hence, low risk investors can reduce churn related risk by choosing companies that are B2B SaaS firms with primary focus on enterprise customers. Customers tend to remain sticky and stay for long term when they buy products with high cost.
4. COGS growth rate vs Sales growth rate
Growth rate to expense rate is a metric which is generally used to measure the health of a SaaS company. Sales growth rate is often compared to COGS growth rate. If sales growth is higher than COGS growth, then the company is considered extremely stable.
Last 3 Years of Growth Rate:
All these companies together have a Sales CAGR of 31% in the last three years while they only have a 30% COGS growth rate. This suggests that these companies are just about healthy in terms of one of the most important SaaS metrics. If they continue to churn a lot of cash without converting new customers, it could be a huge setback for these public companies.
Only five companies have a COGS CAGR higher than Sales CAGR by more than 5% - LogmeIn, Splunk, Tableau, Box and EllieMae. But this shouldn’t be an issue as all these firms are high growth firms clocking revenue growth above 30%. This number should improve for them in the coming years.
Conclusion:
When we look at all the above data, it clearly shows that listed SaaS leaders have several years of growth lying ahead of them. Investors invest in mutual funds to diversify risk and generate returns that are better than returns from other investment vehicles. Right now, there aren’t any ETFs or mutual funds that focus only on SaaS companies. A collection of top SaaS companies can be considered together as a mutual fund. It can be bought month on month as an SIP (Systematic Investment Planning). When it looks like a compelling opportunity, it makes sense to give it a serious look rather than sitting on the sidelines.