Back in December, I wrote an article on how to pick winning cloud software stocks. I began by pointing out how – on average – cloud software companies have reported 10 to 20 times better revenue growth compared to S&P 500 Index companies, most of which grew at an average rate of 5.2% in the last quarter.

Those are certainly impressive numbers, but investors weren’t interested in growth. What they wanted were companies that posted positive EPS numbers, particularly those that have at least 10% forward growth. This was the market’s response to cloud software stocks with high valuations in 2019, and I believe that it will carry over this year.

I first noticed the trend when investors began leaving cloud software stocks due to a combination of low profitability and high valuations. This was puzzling because cloud shares had beaten most analyst estimates.

A few examples of the trend favoring positive EPS include:

• Microsoft has positive EPS, with acceptable growth and a reasonable enterprise-value-to-sales (EV/sales) ratio of 8.4. The company’s stock price is up 51% this year, more than double that of the cloud ETF.
• Splunk also gained ground recently and is up 19% since Nov. 15, suggesting the stock was undervalued previously, given its positive and growing EPS. Five9 also meets the criteria of positive EPS, with guidance for 11% growth. The stock is up 50% this year.

Examples of the trend penalizing negative EPS include:

• CrowdStrike is an example of negative EPS combined with a high EV/sales valuation. The stock is down 51% from its high of $99 and is down 24% from its opening IPO price of $63.50. The company currently has one of the highest EV/sales of the companies in the table above, and at its peak in August and July, had a whopping EV/sales ratio of 61.
• Yext is a cautionary tale of a company with negative EPS that the market abandoned at the first sign of weakness. The company is trading 35% lower from its high in July.
• PagerDuty  has tumbled 60% from a high in June and is down 38% from its IPO opening price of $36.75.

So what happened?

In the article, I explained that start-ups are designed to grow fast; with the average company forecasted to grow 178% in revenue during their first year. The trouble is when these companies need to transition from fast sales growth to stable, consistent profits. Furthermore, SaaS companies, on both private and public markets, use different metrics based on their business model, further complicating the situation.

Investors dealt with these issues by focusing on EPS growth rather than raw revenue numbers. Not only did this strategy allow them to find cloud software companies that deliver steady, consistent growth, it also simplified different variables by rewarding companies that have positive and healthy EPS growth.

Read the full article here.