The 'Entrepreneur's Lesson' Points to This Winning Sector

Editor's note: Today, we're sharing an updated essay from our colleague Bryan Beach. We first published it early last year... before COVID-19 struck the U.S. Since then, the "pandemic economy" has pushed a small subsector of software stocks to incredible heights. In this piece, Bryan explains the powerful secret behind these winners.


Also, the market will be closed on Monday in observance of Martin Luther King Jr. Day. Look for your next issue of DailyWealth on Tuesday, after the Weekend Edition.


I don't have an entrepreneurial bone in my body.

I'm a certified public accountant ("CPA"). And as a CPA, I'm naturally a "numbers guy."

So it fascinates me how Porter Stansberry approaches every investment pitch with an entrepreneur's mindset...

A lot has changed since he founded Stansberry Research in 1999. I joined the company in 2012 – when Porter's office was a converted bedroom in a 19th-century mansion. Because I live in Atlanta, I travel to the office once a month for meetings... So back then, I worked at a desk in the corner of his office when I was in town.

I still recall many of Porter's lessons from those early years.

He would always ask us, "Would you want to own 100% of this business for the rest of your life?" That's how an entrepreneur thinks.

I'm convinced that Porter's appreciation of "capital efficiency" is due in large part to this thinking. Today, I'll show you what that means... and why it's at the heart of one of the market's best-performing sectors.

If you're not familiar, capital-efficient businesses grow rapidly without needing to invest in capital expenditures – like new buildings, factories, and equipment. These types of expenditures drain valuable cash and lower returns on investment.

When looking for capital-efficient companies, Porter and I came at the process from different angles...

By looking only at the "statement of cash flows" in a company's financial statements, I could tell if it was a capital-efficient business by the amount of cash it generated from its operations.

I'd also pore over common metrics – like a company's return on invested capital and how well it generated shareholder returns (stock buybacks, dividends, etc.).

Porter appreciated all those financial metrics as well. But to serial entrepreneurs like him, capital efficiency isn't just a bunch of numbers on a page. It hits much closer to home...

It's cash in your personal bank account.

Porter also asks questions like, "How much cash do I need to spend to grow this business?" and, "How much will it cost me to bring in and satisfy one new customer?" The less cash it takes a business to do these things, the more capital-efficient it is.

That's one of the big lessons I learned from Porter's entrepreneurial mindset – how to find these incredible investments by looking at them like a business owner.

After all, as a business, Stansberry Research is incredibly capital-efficient... If we doubled our subscriber base overnight, we wouldn't have to make significant cash investments to fulfill those obligations.

We already have our team of dozens of analysts and editors in place. There would be no factories to buy... No inventory to sell... We would just need to send twice as many e-mails.

That said, I was already familiar with the power of capital efficiency from working in the software industry...

Before coming to Stansberry Research, I worked in accounting and finance at a publicly traded software company – including four years as the company's controller. Then, I started a small accounting and finance consulting practice that catered only to software clients.

And if you look at the software industry, it shows why these companies have been some of the best places for your money in recent years...

Software companies are highly capital-efficient, like our publishing business. Software is just computer code... so the cost of producing another copy of a program is next to nothing. It's roughly the same whether you produce a single copy or 1 million copies.

Since 2004, software companies have returned 31% per year, on average. The overall market produced an annual return of around 14% over the same span.

That makes software the kind of business you want to own.

But the thing is, you could have done even better with a small sector of the software industry... called Software as a Service ("SaaS").

For decades, the software industry ran under something called the "perpetual license model." The customer buys the software and pays a large, upfront, one-time license fee. Customers must also shell out thousands of dollars more to buy servers or computers to store and run the software... Then, you have installation and maintenance costs to worry about.

The SaaS model changed all that... SaaS customers rent the software, paying only small recurring fees as they use it.

It wasn't until I started studying capital efficiency with Porter that I first thought about software as an entrepreneur – and perhaps more important, as a customer.

Buying under the SaaS model saves precious cash for software customers... as well as the time and back-office headaches of installing and maintaining the software. Instead, these companies can focus on building their businesses and keeping their own customers happy.

The SaaS model is a much more capital-efficient model for customers. That capital efficiency translates into fast growth and big profits.

And it's why investments in pure SaaS companies vastly outperform investments in traditional software companies...

About 400 software companies trade on the public markets in North America. But less than 100 of them are pure SaaS companies that have gone public since 2004.

If you invested in nothing but these pure SaaS companies when they went public, your annual returns would have crushed the return of not only the overall market, but all other software companies.

Since their initial public offerings, SaaS companies have returned an astounding 67% per year on average. That's more than two times higher than the broader software sector... and nearly five times higher than the overall market. No other sector produced results anywhere near that.

SaaS companies are no longer a secret – so it's important for investors to be selective today. Legions of professional money managers have finally figured out what Porter learned simply from running his own businesses...

SaaS is the most capital-efficient sector of the already capital-efficient software space.

Good investing,

Bryan Beach

Editor's note: The COVID-19 crisis has been devastating. Yet as a result, SaaS technology has become essential to our economy – and even our national security – almost overnight. And that reality has accelerated this already-powerful trend... You can learn more about the extraordinary upside potential of this subsector's "hidden gems" right here.

Further Reading

The market loves SaaS companies today – for good reason. These high-flying tech stocks should keep soaring from here. But when "Mr. Market" hands you a beaten-down, bargain-bin opportunity, don't turn your back on it... Read more here.

If you're like a lot of folks, buying the right company at the right time seems like an impossible feat. But a "magic formula" for investing is easier than you might expect. Check out Dr. David Eifrig's five-step process for finding winning stocks right here: The Five-Step Formula for Buying Winning Stocks.

Market Notes
THE PANDEMIC IS BOOSTING SALES FOR THIS HOME-IMPROVEMENT RETAILER

Today, we’re looking at a company that’s riding the home-improvement trend…

With the COVID-19 pandemic forcing people to stay home, many folks have taken on home-improvement projects to improve their surroundings (and kill some time). Companies like Lowe’s (LOW) and Home Depot (HD) have performed well as people stocked up on tools and supplies. And today’s company is also benefiting from this tailwind…

Floor & Decor (FND) is a $10 billion home-improvement retailer. It specializes in hard-surface flooring, including tile, wood, and stone. This company got a massive boost from the pandemic… In the third quarter, Floor & Decor recorded sales of nearly $685 million… up 31% from the same quarter last year. And the company’s comparable store sales jumped 18% year over year as well.

As you can see in today’s chart, FND shares are soaring. The stock is up more than 280% from its March low, and it recently hit a new all-time high. As people continue to spruce up their homes, this stock should continue to perform well…