Small caps in the Year of the Dragon

Strength, power, and luck needed to exceed the “Rule of 40”

The Year of the Dragon in the Chinese Lunar calendar began on February 10. This mythical creature serves as a perfect mascot for fast-growing companies in the technology sector. In Chinese mythology dragons symbolize good luck, strength, and power. In the highly competitive world of SaaS (software as a service), smaller companies need all these attributes – and more– to gain membership in the coveted 40+ Club.

The concept of the “Rule of 40” came from the world of venture capital as a simple metric to benchmark fast-growing tech businesses, especially in the SaaS sector, regardless of whether they are currently profitable. The “Rule of 40” equation states that a company’s combined revenue growth rate and its profit margin should equal or exceed 40%. This makes it a useful heuristic: Strength in revenue growth can offset weakness in profit margins in the classic “growth/burn” tradeoff faced by younger companies.

Typically, these companies are investing heavily in their businesses to add new revenue streams and grow market share. SaaS companies must take on significant upfront expenses for R&D, marketing, and customer acquisition. There is often a meaningful lag between making a sale and booking the revenue. This results in suppressed earnings or profit margins while the company invests in growth through its income statement. However, as the company grows and gains market share, revenues overtake expenses, margins improve, and the enterprise should evolve into a “Rule of 40” company.

As an investor specializing in the small-cap Canadian technology sector, I often encounter companies with 20%-30% top line growth, which are not yet at full operating scale. With continued growth, the market assigns these companies ever-increasing multiples, and their stock prices rise. This is one reason careful stock selection in this relatively inefficient sector can generate outsize returns, or what the industry calls “multi-baggers.” Research has shown that companies that consistently exceed the “Rule of 40” have generated 56% of the outperformance of the Nasdaq and 124% of the outperformance of the S&P 500 since 2018.

While the “Rule of 40” is a handy shortcut to benchmark different businesses, it is only one tool in the investor’s toolkit. And, like any shortcut, it does not capture important nuances. For example, there are several ways a company can reach the 40% hurdle. Take the case of Company A, which has 55% revenue growth and negative 15% margins. It would achieve 40%. Conversely, if Company B has margins of 35% but low revenue growth of 5%, it could also clear the hurdle. However, the potential value of Company A is far more attractive compared with that of Company B.

As companies mature, research has shown that while growth rate has a compounding impact on value (and stock prices), free-cash-flow (FCF) has a linear impact. Beyond the “Rule of 40” heuristic, an investor must also assess such factors as total addressable market, economic moat, customer quality and retention, access to financing, product pipeline, unit economics, and quality and experience of the management and board of directors, among others. All these factors must paint a coherent picture of a quality business with the potential to compound value over the long term.

David Barr, CFA, is the CEO at PenderFund Capital Management and Portfolio Manager of several Pender funds, including Pender Value Fund. This article first appeared in the Pender commentaries. Used with permission.

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