Two hundred years ago, coal and iron ore were the most valuable resources in the world. A century ago, it was oil that determined the world's power brokers. But the last 20 years have changed all that. Today, data is the king maker. Those who have it thrive; those without it die.

That's why the Vanguard Information Technology ETF has returned 500% over the past decade, far outpacing the broader market. The companies in the ETF help organizations capture massive amounts of data and use that data to gain a leg up on the competition.

Businessman holding tablet and showing a growing hologram of statistics.

Image source: Getty Images.

What is an "information technology" stock?

"Information technology" companies basically break down into three groups:

  1. Software companies
  2. Hardware companies -- such as computer chips or even lasers
  3. Companies that provide consulting on technology-related issues

All five of the companies we'll be talking about today fit within the first group: They all, at their core, provide software. Several use the software-as-a-service (SaaS) business model to boot, which has many advantages.

Why software companies beat hardware and consulting

It might seem odd that I'm not including any hardware players in this article. Intel, for instance, is a stalwart in the chipmaking industry. It's been around for decades and has been offering a dividend for more than 20 years.

And no graphics company got investors quite as excited from 2016 through 2018 as NVIDIA. The company's GPUs were a hot commodity for games, autonomous driving, and cryptocurrency mining. Its stock jumped 1,000% in just 20 months ending October 2018.

Legacy providers of switches and modems like Cisco -- and the company that's disrupting it, Arista Networks -- were also left off the list.

There are two big reasons for this. The first is that hardware has a tendency to become a commodity. If your company doesn't come out with the best-performing technology every upgrade cycle, you're out of luck. To get an idea of what I mean, look at how quickly industry leaders have changed place in GPUs since 2004.

The second reason is that these companies tend to rely on just a few customers for a huge proportion of sales in any given year. Cirrus Logic, for instance, counted on Apple for more than 80% of sales in fiscal 2018! Should such a large customer decide to go elsewhere for its part, the hardware maker could crumble over night.

And when it comes to consulting services for IT, the industry is relatively small and dominated by a few publicly traded big names. Booz Allen Hamilton and Accenture, for instance, are behemoths in the consulting business. But the areas in which they provide help expand beyond IT. And given their size, I think there's less upside potential than in the five companies I've selected.

When there's an investment option like SaaS companies, which don't share these risks or have bigger opportunities, I simply think it's more prudent to put your money elsewhere.

How do SaaS companies make money?

It's worth digging into how SaaS companies work to understand why these five IT companies represent such compelling investments.

Instead of providing a CD-ROM that needs to be installed on site, today's SaaS companies provide access to specific software via the cloud. Instead of one-off purchases, these businesses run based on subscriptions. For customers, this makes trying out a software solution less risky. But once they bring customers into their software ecosystems, the SaaS companies get much more revenue over time than they did before the cloud.

Such dynamics are important for three big reasons:

  1. As customers integrate a software solution more and more into their everyday functions, the costs they would incur to switch to a rival service soar. This creates a wide moat -- a large, sustainable competitive advantage.
  2. Over time, software companies collect more and more data about their customers. This lets them create new products that solve unique problems others wouldn't know about. In a way, this becomes a secondary moat in the form of the network effect: the more people use the existing software, the more data gets collected, and the better the new software is.
  3. Because customers are already using a company's software, it costs these companies far less to upsell customers on new products over time.

The up-front expenses can be enormous. But once a company's software has been proven, it costs next to nothing to service each additional customer. That leads to enormous margins in the long run.

There is, however, a downside to the SaaS model: Because it relies on high switching costs, it also requires the SaaS players to overcome the high switching costs involved in getting customers to switch to their service from someone else's.

Admittedly, this is sometimes easier than others. Shopify, for instance, offers an e-commerce platform for merchants. Such platforms didn't exist en masse 10 years ago. Shopify is grabbing market share for the long-term keeping.

In other cases, however, these IT companies need to convince customers to switch away from legacy providers. It can be like trying to roll a snowball down a hill: At the start, it is difficult and cumbersome. It doesn't seem like any progress is being made. Sometimes, however, a company generates enough momentum to reach a tipping point, and it becomes the de facto leader in its niche.

I believe all five companies on our list either now have or could soon hit that inflection point.

How do you measure SaaS stocks' success?

Every company will have its own unique metrics to watch. In the long run, nothing is more important than earnings growth. But if you want to keep a close eye on how a company is performing on a quarter-by-quarter basis, my favorite metric is the dollar-based net expansion rate (DBNE). Sometimes this is also referred to as the revenue retention rate.

While there are slight variations depending on which one a company uses, the basic idea is this.

  • Take all of the subscription revenue from all customers in Year One.
  • Compare it to all the revenue the same cohort of customers spends in Year Two.

By filtering out the effect of new customers, we learn two important things:

  1. Whether a company is keeping its subscribers on board and
  2. If those subscribers stay, are they spending more on software solutions over time?

If the DBNE is at or near 100%, that means that most customers are -- on average -- staying with the company. It is a sign of a moat via high switching costs.

If the rate is above 100%, it means that not only are customers staying, but they are paying more year after year. Often, I view this as evidence of network effects as well: The SaaS IT company is gaining more insight into customers via data and creating solutions they are willing to pay for.

Since the competition doesn't have access to that same data, it creates an advantage that's difficult to overcome.

It should be stated, however, that not every SaaS company -- let alone IT company -- uses DBNE as a metric. When that's not the case, we'll look at the important metrics on a case-by-case basis below.

What are the biggest risks in the IT sector?

After a 10-year bull market, the IT sector is richly valued. And SaaS stocks are probably even more richly valued. As such, investing in any of these five stocks isn't for those with weak stomachs.

As of April 2019, the average (non-GAAP) price-to-earnings ratio (P/E) of the five stocks I'm suggesting ranged from 27 to 1,300. Taken together, the average sits just above 400.

Let's put this in perspective. The long-term average P/E for the S&P 500 is 15.7. The average for the S&P 500 as of April 2019 was 21. That means this basket of stocks was trading at prices between 20 and 25 times more expensive that what you'd normally find. And when multiples get that high, it goes without saying that any obstacle that shows up -- whether macroeconomic or company specific -- could cause a dramatic drop in share price.

That said, long-term investors (we're talking decades-long time frames here) shouldn't be too concerned about valuation. You can buy small portions of a stock over time to take advantage of periods when the stock might dip.

Of greater long-term concern are lowered switching costs. If a rival were able to offer a better service for a cheaper price -- and offer to pay for migration of data and training for rock-bottom prices -- that would create a serious threat to the business model of all five of these companies.

For the time being, that's not a major concern, as doing so would be prohibitively expensive for whoever was offering so much for so little. But we shouldn't discount it altogether.

Finally, we need to remember that information technology companies are always at risk of being hacked. If, for instance, it turned out that a company's legal clients had sensitive information stolen from servers, it would present a huge existential threat to the business. These risks are hard to quantify but important to be aware of.

Who should be investing in IT stocks?

Because data is so important in today's business landscape, I believe every investor would benefit from exposure to IT stocks. The type of IT stock you select, however, would vary depending on your own investing style.

If, for instance, you are near retirement, you don't like volatility, or you want dividends, then investing in larger stalwarts like Microsoft is for you. You can also invest in an ETF like the Vanguard Information Technology ETF to give you exposure to the sector while reducing stomach-churning jumps and dives.

On the other hand, if you are younger, don't mind taking extra risks, and can buy to hold for the long run, then some of the smaller stocks -- like the other four included here -- are right for you.

Having covered those basics, let's investigate the five IT companies we're talking about today.

The top 5 IT stocks to buy in 2019

Company What It Offers Customers
Microsoft (NASDAQ:MSFT) Office Suite (Word, Excel, etc.) and cloud-computing tools
Shopify (NYSE:SHOP) E-commerce platform as well as payment and shipping solutions
Twilio (NYSE:TWLO) Tools to help companies communicate with their clients around the world
Axon Enterprises (NASDAQ:AAXN) Body cameras and a platform for storing footage and filling out paperwork
AppFolio (NASDAQ:APPF) Software to help small legal and property-management companies streamline operations

The universe of tech stocks worthy of investment is huge. By no means is it limited to these five. But I selected these five because this list offers an investment strategy that covers everything from behemoths (Microsoft) to tiny players (AppFolio) and from e-commerce (Shopify) to law enforcement (Axon).

Microsoft

Microsoft is by far the biggest of the five stocks mentioned here, and CEO Satya Nadella's SaaS-centric focus has turned the company around. Its ambitions in cloud computing have also proven fruitful.

To get an idea of how the company makes money, it's best to look at the company's three segments:

  • Productivity and business processes: Primarily includes subscription revenue for access to Office 365 (Word, Excel, Outlook, etc.) and LinkedIn
  • Intelligent cloud: Microsoft's Azure cloud hosting platform
  • Personal computing: Encompasses the Windows 10 operating system, Surface tablet, Xbox, and search engine Bing

As you can see, all three have been solid contributors to the company's revenue over the 12 months ending in December 2018.

Revenue by segment at Microsoft

Data source: SEC filings.

Perhaps even more importantly, operating income has shown steady growth in all three segments. And margins in both productivity and business, as well as the intelligent cloud, have superior margins.

This shouldn't be surprising, because both of these segments are able to utilize the benefits of the SaaS model, while personal computing is more concerned with lower-margin hardware sales.

Chart showing growth in operating income by segment at Microsoft

Data source: SEC filings. *2019 figures are for trailing 12 months ending Dec. 31, 2018, which includes only two new fiscal quarters from 2018.

It doesn't take much to infer where Microsoft's moats come from. Companies and individuals that use Office 365 have nearly all of their information on a single platform. Not only would switching introduce learning a new interface (though, admittedly, Google Docs have done a decent job of copying Microsoft Office programs), but you would have to migrate tons of data in the process.

The same type of high switching costs are at play for Azure -- switching cloud hosting can be expensive and a headache. And, finally, Microsoft's LinkedIn segment benefits massively from network effects: As more people join it, it becomes more appealing for job seekers who have yet to sign on.

Unfortunately, Microsoft doesn't have a DBNE-type metric to measure its progress. In its stead, the aforementioned revenue and operating income figures show the company is in a very strong position.

Shopify

Shopify was founded when a German snowboarder in Canada couldn't find an easy way to sell his snowboards online. That led him to develop his own platform. Before long, it became clear that the platform -- not the snowboards -- was what the world really needed. As of early 2019, the platform was home to more than 800,000 merchants worldwide.

Shopify makes money two ways.

  • Subscription services: With five different tiers of subscriptions, merchants can create a website, display products, collect valuable information, and manage social media marketing, all on a single interface.
  • Merchant solutions: Payment and shipping options, among other things, are available on a per-sale basis.

The former is the SaaS part of the business, and it has relatively high operating margins. The latter only grows when merchants are successful and has lower operating margins. But there's a catch: Merchant solutions cost Shopify almost nothing to execute. Subscription services require massive R&D -- as well as sales and marketing -- expenses.

Put that all together, and this is what you get: massive growth.

Chart showing income by segment at Shopify over time

Data source: SEC filings.

Just as important, Shopify benefits from two moats. On the one hand, switching costs are very high. Once vendors -- usually small ones -- are up and running on Shopify, they want to spend their time running their businesses, not worrying about logistics.

But the company is also starting to benefit more and more from the network effect. Shopify allows third-party app developers to create tools and sell them in the Shopify app store. Shopify gets a 20% cut of sales.

More importantly, many of these specific tools are only available on Shopify's platform. There's nowhere else third-party app developers can get instant access to hundreds of thousands of merchants. More merchants draw in more developers, which draw in more merchants in a virtuous cycle.

Over the past four years, Shopify has always disclosed that subscription revenue retention was above 100% but provided no further detail. This year, even that statistic was left out. While that's disappointing, the company's momentum is enough to qualify it as a top IT stock for 2019.

Twilio

You've probably been affected by Twilio on a regular basis without even knowing it. If you've ever received a text saying your Lyft ride was about to arrive or that your table at a restaurant was ready, that's Twilio at work.

Twilio provides a communication platform that developers can use to help their companies seamlessly get in touch with clients. This includes not only text but also video, audio, and, thanks to a recent acquisition, email as well.

Specifically, there are three layers of functionality Twilio offers with a subscription to its usage-based services.

  • Engagement cloud: This helps companies protect account security as well as create contact centers to manage client rosters.
  • Programmable communications cloud: The primary functionality of Twilio resides here. This is where voice, text, audio, and email communications can be managed.
  • Super Network: The Super Network is, quite simply, the vehicle by which Twilio customers can communicate on a global scale with all of their clients.

The Super Network itself is an underappreciated part of Twilio that has a wide and growing moat thanks to network effects. In the company's 2018 annual report, it stated:

With every new message and call, our Super Network becomes more robust, intelligent and efficient. ... [Its] sophistication becomes increasingly difficult for others to replicate over time as it is continually learning, improving and scaling.

In other words, it would take an enormous effort for the competition to match this global scale, winning over customers in droves to gather their data and create something to challenge the Super Network.

One look at the company's DBNE should be enough to convince you that this would be an enormously tall task. Customers are not only staying with Twilio, they are adding an incredible amount of functionality year after year. Switching costs become higher with each passing quarter.

DBNE at Twilio over time

Data source: SEC filings.

Companies will always need to communicate with their customers. This will never change. The mediums through which they do may evolve over time. But I have faith that Twilio will evolve, too. And because of that, these customers are locked in for the long haul.

Axon Enterprises

At first blush, Axon Enterprises is decidedly not an information technology company. For most of its corporate history, it was a manufacturing outfit. Its previous name, TASER International, comes from its eponymous stun guns. Its Axon division isn't really into IT either; it produces body and dash-cam hardware worn by police officers.

But the real story here is Evidence.com, the platform on which all of this footage is stored and analyzed. Once a police department starts putting all of that evidence on the platform, switching costs snowball. Changing providers would be costly, yes, and so would retraining entire police forces. The risk of losing life-altering footage would also come into play.

Right now, here's how sales from the company's three divisions shake out.

Chart showing Axon sales by division over time

Data source: SEC filings.

Clearly, the weapons segment is still important. And sales of body cameras can't be ignored, either. But if you're investing in the company today, it's the cloud services -- the SaaS and IT-related part of the company -- that you should really be paying attention to.

Later this year, the company will be rolling out Axon Records. This tool aims to use AI to take the footage recorded on body cameras and use it to fill out paperwork automatically. Crucially, this frees up officers to spend more time in the community and on the streets.

CEO and founder Patrick Smith announced in early 2019 that Axon's total addressable market was once again growing. More fire departments and EMTs are using body cameras as well. With such a huge opportunity, and without any meaningful competition, I think there's still tons of room for growth at Axon.

AppFolio

Finally, we have the smallest of our five IT companies. AppFolio was founded by two Santa Barbara technology specialists who, in 2005, realized that businesses were lagging consumers in adopting SaaS solutions.

They formed AppFolio to create such tools for very specific industries. So far, that has meant two endeavors: solutions for smaller property-management firms and tools for smaller legal firms. Those might sound like limited niches, but the ambitions are much bigger.

Within each offering, AppFolio has two lines of business:

  • Core solutions: Includes managing all of your information from a single interface. This includes things like managing client (legal) or tenant (property-management) data, accounting, and other information.
  • Value+ services: This adds an additional layer of functionality. It allows AppFolio subscribers to collect billings via wire transfers, pursue leads, host websites, and obtain liability insurance.

Here's how those services have grown over time.

Chart showing revenue growth by division at AppFolio

Data source: SEC filings.

Crucially, AppFolio has a meaningful moat. Last year, DBNE within the property-management business (the bigger of the two) stood at 116%, while the legal channel's DBNE came in at 113%. In both cases, this is indicative of customers staying on and spending more over time.

At the end of 2018, the company had a net cash position of $42 million and free cash flow of $22 million. Given that solid financial footing, I wouldn't be surprised to see AppFolio enter a new vertical (read: niche like small legal or property-management firms) within the next two years.

Investing in IT stocks for 2019 and beyond

While investing in IT stocks for 2019 is exciting, it's important to take the long view. It's entirely possible the stock market could have a down year. If that's the case, these stocks -- which have fairly hefty expectations baked in -- could fall even more.

And that's OK. Investing in such companies is a practice in long-term thinking. And by "long-term" I mean years and decades. The moats that surround these companies, like high switching costs and network effects, are very real. At times, it may take more than a single quarter or even year for the benefits of those moats to show up in stock price appreciation.

That said, I think any investor looking to get a foothold in IT stocks would be well served to begin their due diligence with these five companies. If you, like me, are excited by what you see, start by making small purchases over time. Add to them as each company's performance improves. In 20 or 30 years, you'll be very glad you did.