Investing in small cap stocks isn't for the faint of heart. By their very nature, such companies -- which I'll define as having market caps below $5 billion -- are often up against entrenched, 800-pound gorillas. With fewer resources, these Davids must out-maneuver and out-innovate their Goliaths.
The upshot is that if these small caps are successful, the returns for shareholders can create dynastic wealth. Today I'll introduce three companies that I believe have such potential. In fact, I believe in them so much they already constitute over 10% of my real-life holdings.
| Company | Market Cap | What It Does |
|---|---|---|
| Axon Enterprises (AXON -0.35%) | $3.9 billion | Makes tasers and police body cameras and hosts cloud storage. |
| AppFolio (APPF 0.50%) | $1.8 billion | Software for small property management and legal firms. |
| Zuora (ZUO 0.54%) | $2.4 billion | Powers "Subscription Economy" with back-office billing and collection software. |
Data source: Yahoo! Finance
All three benefit from the powerful Software-as-a-Service (SaaS) business model. This is vitally important, as it helps form a moat around each company that no one -- not even market heavyweights -- will be able to cross easily.
This one is already the Goliath
In Axon Enterprises we have a bit of an anomaly: It is already the 800-pound gorilla in the room. Axon used to be known as TASER International. It had -- and still has -- a firm grip on the stun gun market for police forces. But in early 2017, the company highlighted its shift to body cameras by changing its name to Axon.
With the 2018 acquisition of its only body-camera rival of note, VieVu, Axon has once again achieved near-monopoly status. But Axon isn't resting on its laurels: The company is expanding its market to include fire department and EMT workers. It is also coming out with new services that could be game-changers.
Axon Records, scheduled to be rolled out in late 2019, aims to cut paperwork for police officers dramatically. It will do this by combining police footage with artificial intelligence and machine learning to auto-fill incident reports.
Image source: Getty Images
This, combined with the subscription-based Evidence.com platform that stores and analyzes that footage, creates a powerful moat. Police departments would be loath to switch to a different provider -- not only would it be expensive, but it would be a headache to retrain entire forces on a new interface, and risk losing critical evidence in the process.
Helping small companies in niche industries
AppFolio was formed when California based entrepreneurs Jon Walker and Claus Schauser realized the potential of the SaaS business model. They wanted to find niche industries where software they developed could cut costs and improve efficiency.
AppFolio got its start in property management, and the company's software now powers operations for over 13,000 property management firms. Its two broad offerings include Core Services and Value+ add ons, the former focusing on accounting and business analytics, the latter on marketing help, electronic payments, and risk mitigation.
With the acquisition of MyCase in 2012, the company got a foothold in small legal firms. Using the same Core/Value+ dichotomy, AppFolio now has over 10,000 legal clients using its software.
Most importantly, the company is keeping these customers, and getting them to add more tools over time. This is evidenced by dollar-based net expansion (DBNE) rates of over 110% for each line of business last year. In essence, from year to year customers are not only staying with AppFolio (DBNE of near 100%), but they are paying for more services over time.
As with Axon, this creates a wide moat in terms of high switching-costs over time.
Powering the subscription economy
It's only fitting that we end with Zuora. All three of these picks are SaaS companies, but Zuora focuses on evangelizing the business model. It wants traditional companies that focus on one-off sales to customers to switch to a subscription model. It can then sell its back-office billing and collection services to those customers.
Image source: Getty Images
Zuora founder and CEO Tien Tzuo literally wrote the book on this transition in 2018: Subscribed: Why the Subscription Model Will Be Your Company's Future -- and What to do About It. And this transition isn't limited to tech companies -- Zuora has focused on how everything from porta potty to lawn mowing companies can benefit from the recurring revenue of a subscription model.
But investors should take note: While some SaaS companies have no problem convincing companies to adopt their services, Zuora is in a tough spot. It doesn't have to just sell a service (its billing and collection tools), it also has to sell the conversion to an entirely new business model. That takes more time and money to do. Patience is necessary.
That said, Zuora's DBNE ended last year at 112%, again signifying a service that can organically grow revenue while retaining customers and creating high switching costs. With a long runway for growth ahead of it, I'm more than willing to exercise the necessary patience and reap the rewards decades from now.
What investors should do
Does this mean you should go out and buy all three stocks today? Not exactly -- everyone's portfolio needs to match their risk tolerance, time horizon, and areas of interest. But if you're looking for three small-cap stocks to buy this month, these three represent an excellent place to start your search.
