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(Source: Pixabay image and Author text)

Software companies have been experiencing a fantastic period of growth (even pre-COVID-19). With their model of low margins and exponential scaling potential, the market has been realizing just how valuable some of these companies can be. The onset of COVID-19 and the need for more remote work and reliance on software to get work done has only fuelled a massive rally (until the recent sell-off and volatility over the last few weeks).

To traditional value investors, software companies (and by extension hyper growth companies) are an oddity and are to be avoided. That said, in recent years, there have been countless stories of value investors disregarding software companies, or even making short cases, and missing out on some significant gains.

Appreciating that hindsight is 20/20, value investor Whitney Tilson made the short case for Salesforce (CRM) back in 2011 based on traditional value investor valuation methods (not profitable, net insider selling, excessive stock options for employees).

(Source)

The outcome 9 years later?

(Source: Portfolio123, Author Multi-chart)

Salesforce went on to return more than 600% from May 2011 to today. For context, the S&P 500 (SPY) and Berkshire Hathaway BRK.B (value proxy) both returned less than 1/3rd of the performance of Salesforce over the same period. This is an isolated yet very illustrative example, but in general, software companies are a different animal than traditional businesses.

As an investor who started off as a “pure value” guy, I have adopted a more pragmatic approach to investing in recent years. Software has truly captured my attention, and I believe it is prudent to look closer at this potentially lucrative opportunity.

Software as a service (SaaS) firms are an incredibly important piece of the economy going forward, and even more critical in the post-COVID-19 environment. For a great primer on SaaS companies, I urge readers to listen to the episode of Patrick O’Shaughnessy’s podcast “Invest Like the Best” episode in which he chats with Eric Vishria on the history and future opportunities of SaaS firms.

In this piece, I aim not so much to delve into the future and opportunities of SaaS, but instead, focus on looking at potential quantitative methods to pick out the winners in this fertile area.

The “Rule of 40”

Due to several effects, including scalability and low margins, successful software companies can experience exponential growth. As I hinted in the introduction, many investors are wary of high growth; however, the fact remains that the growth factor is key in software firms.

So, how does one assess high growth safely as it relates to software companies? In this piece, we will look at the “Rule of 40”.

Rule of 40 Origins

In a famous blog post entitled “The Rule of 40% for a Healthy SAAS Company” from 2015, famous software startup and angel investor Brad Feld popularized “The Rule of 40”. The rule essentially states that a healthy SAAS company should be able to balance its sales growth and profitability such that the sum of both values should be at least 40%, and the proportion of each will depend on the stage of the company.

In Feld’s words:

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

(Source: “The Rule of 40% for a Healthy SAAS Company”, Brad Feld)

One of the key ideas here is that the Rule of 40 allows a “healthy” software company to be unprofitable! As long as the firm has sufficient sales growth of at least 40%, profitability is not a concern. This rule implies that with sufficient sales growth, profitability will come in the future.

A few other details were covered in Feld’s post. He originally got the idea for the Rule of 40 from a late-stage investor while he was in a board meeting. The investor used the rule for software companies “at scale” (i.e., with at least $50 million in revenue). Feld states in his post that the rule is also appropriate for less-mature companies with $1 million in sales.

Rule of 40 Formula

To measure sales growth, Feld suggests year-over-year growth, based on MRR (monthly recurring revenue). He also recommends that gross margins be checked over the period as well to make sure they are consistently proportional (more or less) to the revenue.

Profitability can be measured in a variety of ways, i.e., gross profitability, net, operating, free cash flow profitability or even by EBITDA. Feld’s preference is to use EBITDA profitability, but he explains that the most appropriate type of profitability will depend on the type of software firm:

If you (software company) are running on AWS (Amazon Web Services) or the cloud, this (EBITDA) should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense”

(Source: “The Rule of 40% for a Healthy SAAS Company”, Brad Feld)

In other words, the ideal profitability measure depends on how the software company is structured and the associated operating expenses.

Rule of 40 Performance

While there is much written about the Rule of 40, I have not been able to find any testing or verification of its ability to find healthy SAAS companies. As a quantitative rule, the Rule of 40 is a prime candidate for backtesting to see how effective it has been at selecting “healthy” software companies, and by extension, winning software companies. In this piece, I will test variations of the Rule of 40 to see how well it has performed as an investing strategy, in hopes of forecasting future performance.

For sales growth, we will look at growth from the trailing twelve months compared to the previous trailing twelve months.

As profitability can vary depending on the specific business infrastructure as Feld described, the maturity of the business, and a multitude of other factors, at any given time a firm could be profitable on one measure but not on another. We will look at 4 different types of profitability (all based on trailing twelve months to match the sales growth value):

  • Gross profitability (gross income/sales)
  • Free cash flow profitability (FCF/sales)
  • Unlevered free cash flow (unlevered FCF/sales)
  • EBITDA profitability (EBITDA/sales)

In summary, our 4 Rule of 40 formulae are as follows:

  • Sales growth (PTM/TTM) + Gross profitability (gross income TTM/sales TTM)
  • Sales growth (PTM/TTM) + Free cash flow profitability (FCF ttm/sales TTM)
  • Sales growth (PTM/TTM) + Unlevered free cash flow profitability (unlevered FCF TTM/sales TTM)
  • Sales growth (PTM/TTM) + EBITDA profitability (EBITDA TTM/sales TTM)

As an example of variations in profitability measures, see below for sales growth and various profitability measures for Adobe (ADBE), Activision Blizzard (ATVI), DocuSign (DOCU), Electronic Arts (EA) and Snap Inc. (SNAP).

(Source: Portfolio123 data, Author Table)

Activision had a slight contraction in sales (negative sales growth), but sported a very high gross margin, surpassing the Rule of 40 at 75.77. On the other hand, on all other measures of profitability, ATVI did not pass. Similarly, SNAP had a very high gross margin but scored very low on all other profitability measures. ADBE and EA beat the Rule of 40 on all measures.

Data behind The Rule of 40

More broadly, just how common is it for software firms to meet the Rule of 40? The plot below shows the proportion of firms within the “All Software Stocks” universe (described below) that meet or exceed the rule of 40 (gross margin) over the last 15 years:

(Source: Portfolio123, Author Custom Series)

While the total number of firms that meet or exceed the Rule of 40 (gross margin) varies over time, there is still a very high proportion of firms in the universe that meet the rule (min 84%, max 94%). This may suggest that the Rule of 40 (gross margin) is not a very high bar for software firms in the universe, and that any performance of stocks meeting the rule should not be very different than the All Software Stocks universe.

Meeting the Rule of 40 in terms of free cash flow is a much higher bar, however:

(Source: Portfolio123, Author Custom Series)

In recent years, only roughly 20-25% of firms have been able to achieve the Rule of 40 (Free Cash Flow margin), suggesting this is a more significant achievement for software firms.

This is even more pronounced with unlevered free cash flow margin:

(Source: Portfolio123, Author Custom Series)

And finally, EBITDA margin (Feld’s preferred profitability measure) is about as common as the free cash flow version of the rule, with roughly 25% of the universe today meeting the rule:

(Source: Portfolio123, Author Custom Series)

In summary, as of this writing, the total number of stocks per Rule of 40 variation compared to the All Software Stocks universe:

(Source: Portfolio123 data, Author Table)

Now let’s see how passing the Rule of 40 translate into returns.

Rule of 40 Testing

I use Portfolio123 to design and test all of my live strategies. I will take advantage of its capabilities for testing the Rule of 40 as well.

Our testing universe, the “All Software Stocks” universe, will include all US publicly traded software stocks that have a minimum of $50 million annual sales (as originally intended by Feld’s investor). To ensure we’re dealing with stocks that are tradeable, we will assume a minimum median daily volume of $100k over the last 4 weeks. Any ADRs that pass these criteria are also included.

Software stocks are defined as those stocks categorized from the following sectors, industries and subindustries as classified by the RBICS (Revere Business Industry Classification System, as developed by FactSet):

  • 20151530 – Retail Industry Software
  • 303015 – Finance Software and Services
  • 552010 – Internet and Data Services
  • 552015 – Software
  • 60101035/40 – Telecommunications Industry Software and Services

As the table above showed, this is a rather small universe with only 260 stocks. For another frame of reference, at time of writing, of the 3000 stocks within the R3000 index, only 181 stocks fall under the software categories above.

We will test 4 variations of the Rule of 40, based on the different profitability measures above, repeated here:

  • Sales growth (PTM/TTM) + Gross profitability (gross income TTM/sales TTM)
  • Sales growth (PTM/TTM) + Free cash flow profitability (FCF ttm/sales TTM)
  • Sales growth (PTM/TTM) + Unlevered free cash flow profitability (unlevered FCF TTM/sales TTM)
  • Sales growth (PTM/TTM) + EBITDA profitability (EBITDA TTM/sales TTM)

All stocks in the universe passing the respective rule will be purchased. As the Rule of 40 relies only on fundamental data available from quarterly reports, I have assumed a quarterly rebalance. We will test the strategy over different time periods: 15 years, 10 years, 5 years, 3 years, 2 years, 1 year and even the most recent 6 months.

Due to the relatively low turnover, we will look at quarterly returns on a rolling basis (1 month offset) to account for variations due to seasonality and “rebalance timing luck“.

Slippage of 0.5% has been assumed and 1.5% transaction costs (trading commissions).

In terms of performance, we will look at both absolute return and risk-adjusted return.

Rule of 40 Benchmarks

When assessing any strategy, it’s important to measure performance against relevant benchmarks. There is time and expense associated with using quant strategies; if the same or better returns have been achieved through index/ETF investing, then I firmly believe that the given strategy is not worth live implementation.

We will look at several benchmarks for our study:

  • SP1500 IT Index (SP1500ALLIT)
  • Invesco Dynamic Software ETF (PSJ)
  • Vanguard Information Technology ETF (VGT)
  • iShares Expanded Tech-Software Sector ETF (IGV)

Summary stats are shown below for the above indices and ETFs.

Generally speaking, software has been a great bet in the last 15 years, whether measured from the entire software universe, indices, or specific ETFs. The table below shows cumulative average annual rates of return, or CAGR, over various time periods. The Russell 3000, S&P 500, and Nasdaq have been added for reference.

(Source: Portfolio123 data, Author Table)

The All Software Stocks universe has beaten R3000 and S&P 500 over all periods. Each of the software ETFs have, in turn, outperformed the All Software Stocks universe and crushed the broader R3000 and SPY. QQQ has been difficult to beat consistently, however, VGT has come close.

Even if we look at returns on a risk-adjusted basis (measured by alpha, compared to the SP1500 IT index), the software ETFs have generally outperformed (with the exception of PSJ in recent periods):

(Source: Portfolio123 data, Author Table)

The above benchmark performance shows that The Rule of 40 has some stiff competition. Let’s see how it has fared as an investment strategy.

Rule of 40 Test Results

Gross Margin Profitability

Sales growth (PTM/TTM) + Gross profitability (gross income TTM/sales TTM) >= 40

The equity curve for holding all stocks passing the Rule of 40 (gross margin) for the past 15 years is shown below (red curve). The benchmark SP1500 IT index is shown in blue.

(Source: Portfolio123, Author Screen)

Not too bad. Over the entire 15-year period, all stocks passing the Rule of 40 managed to beat the S&P1500 IT index, with slightly higher volatility (standard deviation), and achieved positive alpha.

In tabular form over various periods and rolling periods:

(Source: Portfolio123 data, Author Table)

While the equity curve above shows a nice return over a 15-year period, breaking down into smaller periods shows that while stocks passing the Rule of 40 (Gross Margin) beat software stocks (green highlighted cells), it has struggled to keep up in recent years on both on a single period and rolling period basis.

FCF Profitability

Sales growth (PTM/TTM) + Free cash flow profitability (FCF ttm/sales TTM) >= 40

The past 15 years for all stocks passing the Rule of 40, FCF:

(Source: Portfolio123 data, Author Screen)

On a 15-year test, stocks passing the Rule of 40 based on FCF profitability has similar performance to the Gross Margin profitability rule.

On a rolling period basis:

(Source: Portfolio123 data, Author Table)

On a rolling period basis, the Rule of 40 (FCF) is almost the inverse of the gross margin version; the rule struggled to beat the All Software Stocks universe in the early years, but has shown outperformance in recent years.

Unlevered FCF Profitability

Sales growth (PTM/TTM) + Unlevered free cash flow profitability (unlevered FCF TTM/sales TTM) >= 40

(Source: Portfolio123 data, Author Screen)

This version of the Rule of 40 just managed to beat the SP1500 index over the last 15 years. However, note the higher degree of volatility in this curve compared to the SP1500 IT. This is also demonstrated through the very high monthly standard deviation of returns (27.8% vs. 18.3% of the benchmark), and only just positive monthly alpha (0.07%). We will look take a closer look at this in the section below.

Also recall that at times, very few stocks pass the Rule of 40 based on unlevered FCF (as low as only 5% of all software stocks in 2010).

In terms of rolling periods:

(Source: Portfolio123 data, Author Table)

The strategy has done well in nearly all periods in terms of absolute return. As noted above, this is a volatile strategy – see below.

EBITDA Profitability

Sales growth (PTM/TTM) + EBITDA profitability (EBITDA TTM/sales TTM) >= 40

(Source: Portfolio123, Author Screen)

Similar equity curve to our gross margin Rule of 40, beating the SP1500 IT over many different periods on a rolling basis:

(Source: Portfolio123, Author Table)

Rule of 40, Summary Performance

The overall performance of the various Rule of 40 strategies is summarized below in terms of single 15-year returns and on a rolling quarterly basis (green cells indicate the top performer, yellow is a close second):

(Source: Portfolio123 data, Author Table)

On a rolling period basis:

(Source: Portfolio123 data, Author Table)

From the above summary, it appears that the unlevered FCF profitability version of the Rule of 40 has performed the best out of the various Rules of 40. We will now look at performance from another angle.

Rule of 40 Alpha

Up until now, we have only been looking at absolute returns. Let’s now work volatility and alpha into our evaluation. Absolute return is important, but looking at performance on a risk-adjusted basis can help identify if the positive swings are just market volatility or if there is actually something of predictive value to the strategy.

If you’ve been following along so far, most of the R40 versions have produced positive alpha results (using the SP1500 IT index as benchmark). While somewhat more volatile, as all monthly volatility values are higher than the benchmark, positive alpha is still achieved.

Unlevered free cash flow, on the other hand, produces the higher absolute returns but relatively low alpha. The trend continues when tested over the different time periods.

(Source: Portfolio123 data, Author Table)

Of the profitability variations over time periods tested, FCF profitability stocks had the most positive alpha time periods and the second-highest absolute returns on a rolling quarterly basis. Interestingly, Feld’s preferred profitability measure of EBITDA fared the worst in terms of alpha over these periods.

Earlier in this piece, we looked at alpha for the various software ETFs. It looks like our ETFs still come out ahead in terms of consistent positive alpha, however:

(Source: Portfolio123 data, Author Table)

Rule of 40 Stocks List

Below is a list of the 20 largest software stocks passing the Rule of 40 based on FCF margin. Values for EBITDA profitability measures are included as well. All values in %.

Ticker

Name

@salesgrttm

@FCFmgn

@R40_FCFMN

@ebitdamgn

@R40_EBITDAMGN

FB

Facebook Inc.

20.1

27.2

47.3

45.4

65.4

ADBE

Adobe Inc.

17.3

39.6

56.9

38.0

55.3

CRM

Salesforce.com Inc.

31.6

22.0

53.6

18.6

50.2

ZM

Zoom Video Communications Inc.

190.4

52.6

242.9

22.3

212.7

SHOP

Shopify Inc.

60.5

2.3

62.7

-2.2

58.2

NOW

ServiceNow Inc.

31.3

27.5

58.8

13.4

44.7

SPGI

S&P Global Inc.

12.5

37.7

50.2

54.5

67.0

SQ

Square Inc.

49.0

1.0

50.1

4.7

53.7

VMW

VMware Inc.

17.3

33.3

50.6

22.0

39.3

WDAY

Workday Inc.

22.5

18.8

41.3

-1.7

20.9

ADSK

Autodesk Inc.

20.6

37.4

58.0

18.4

39.0

TEAM

Atlassian Corp Plc

33.4

32.5

65.9

7.8

41.2

DOCU

DocuSign Inc.

40.6

12.8

53.3

-8.4

32.2

EA

Electronic Arts Inc.

15.0

32.9

48.0

27.9

43.0

TWLO

Twilio Inc.

57.9

-0.7

57.3

-16.3

41.7

CSGP

CoStar Group Inc.

17.3

30.9

48.1

30.3

47.6

OTC:CRWD

CrowdStrike Holdings Inc.

86.4

26.6

113.0

-13.6

72.8

MSCI

MSCI Inc.

10.2

33.3

43.6

57.2

67.4

DDOG

Datadog Inc.

80.8

9.4

90.2

4.7

85.5

OKTA

Okta Inc.

44.6

11.5

56.1

-20.9

23.6

(Source: Portfolio123 data, Author Table)

Rule of 40 Screener

I have also created a public screen at Portfolio123 for stocks passing the various Rules of 40. Options are included to play with the various versions discussed in this piece.

Rule of 40 for SaaS Companies, Stock Screen

Conclusion

To sum up, software stocks have performed very well in the last 15 years. Software-based indices and ETFs have handily beat broader indices over many different time periods.

The Rule of 40 is a helpful metric to assess the balance between sales growth and profitability for a SaaS company. Using the Rule of 40 to find those “healthy” software firms has generally shown success at finding the winners and achieve positive alpha over varying periods, with some measures of profitability more successful than others (free cash flow better than EBITDA margin). Software ETFs, however, have managed to outperform the Rule of 40 more consistently on an alpha basis.

So far, we have only looked at all stocks passing the Rule of 40, which includes several hundreds in some cases. This could be an unwieldly number of holdings for some investors (maybe ideal for an ETF – note to self, look into creating new ETF).

Also bear in mind that we have only looked at two metrics: sales growth and profitability. There are a multitude of other factors to consider when valuing any firm, software or not.

In the next installment, we drill down into some of these Rule of 40 winners and see how to build an investable portfolio of 30 stocks. We will also look at some other variations of strategies that build on the Rule of 40 into more complex ranking systems.

Until then, happy investing!

But Before We Go…

Going back in time to 2011 – What if Whitney Tilson knew about the Rule of 40?

Just for fun, let’s go back in time to May 2011 when Whitney Tilson was looking at Salesforce. Keeping in mind Brad Feld didn’t write about the Rule of 40 until 4 years later, how did Salesforce do in terms of the Rule of 40?

Below is data from May 1, 2011:

(Source: Portfolio123 data, Author Table)

Not too bad! In 2011, Salesforce would have been considered extraordinarily healthy in terms of the gross margin profitability Rule of 40. For free cash flow and EBITDA, it didn’t quite make the cut, but pretty close. The Rule of 40 wasn’t as common as it is today, and keeping in mind Tilson didn’t have the advantage of hindsight, but if he had looked at Salesforce from a different angle, he may have come to a different conclusion.

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