Top Stocks for 2021

In this episode of Industry Focus: Wildcard, our theme week continues as host Jason Moser and Motley Fool Ventures Vice President Brendan Mathews dive into two more stocks they think investors should have at the top of their list for 2021. Find out what's to like about them, their targeted markets, risks, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on January 6, 2021.

Jason Moser: It's Wednesday, January 6th. I'm your host, Jason Moser. Theme Week on Industry Focus continues as we're talking top stocks for 2021. I am very happy to have with me today the Vice President of Motley Fool Ventures. Before that, he was researching and picking stocks with us on the investing team here at The Fool. It's Mr. Brendan Matthews. Brendan, how's everything going?

Brendan Mathews: Hey, Jason. Great.

Moser: It's been a long time. Glad to have you back here on the microphone for a little bit. Always loved talking stock with you.

Mathews: Absolutely.

Moser: [laughs] As you know, this is our Theme Week for Industry Focus as we kick off a new year. We thought it'd be a fun idea to throw out some top stock ideas for our listeners this week. This week, today's Wildcard Wednesday Show, we can take it really in any direction we want. Brendan, I gave you creative freedom, carte blanche, as they say, to come in here with whatever idea you wanted. I liked the idea you have here for listeners. I don't know a heck of a lot about the name here, so I'm going to enjoy learning about it. But why don't you go ahead with the big reveal? What is your top stock here for 2021?

Mathews: My top stock is Workday (WDAY 0.52%).

Moser: Workday?

Mathews: Simple W-D-A-Y.

Moser: Okay. Now, I've heard of this company and I know that it is a company many of our members are familiar with. Talk a little bit about what Workday does.

Mathews: Workday is a Cloud based software for businesses. What they do, they do a few things. The one that they're most known for is human capital management. Maybe a little bit of a digression here on what software is for big companies. Unless you've worked for a really big company, it's hard to conceptualize all the software that goes into keeping track of what's going on at a big company. That typically falls into the umbrella of ERP or enterprise resource planning. In the '90s, 2000, that was a big piece of packaged software you would put on your servers, and it covers various functional areas. One would be keeping track of your employees, keeping track of your customers, keeping track of your finance and accounting, keeping track of products, inventory, the whole gamut of things that at a small business might not necessarily seem that complicated. But once you get really big, it's hard to keep track of all that software. What Workday does is they do that in the Cloud. They started focused on human capital management, basically keeping a list of who your employees are. Now, you might say, that sounds pretty simple [laughs]. But then, say, you've got 200,000 employees. You got to know everyone's address, you got to know who their manager is, how much they get paid. If their salary changes or their address changes or they sieve to a different job or you hire or fire people, it starts to get pretty complicated. That's where Workday started. They've since expanded on that. They offer a financials package, they offer a procurement solution, a planning solution, but it's all in the Cloud.

Moser: It's all in the Cloud, like most things these days. Does this qualify as a SaaS business? That was what drove 2020 I think for a lot of investors, was that SaaS business model and all of these businesses now figuring out ways to be something as a service. It sounds like this is at least something similar to that model. Is that right?

Mathews: This is absolutely a SaaS company. This is one of the OGs of SaaS businesses. Thinking back to the 2000s, when people used to have software installed on machines and they would pay a license, the one company that broke out, and is still the king today is Salesforce (CRM 1.27%). They do a bunch of things, but it started out managing your customer data. Workday, same thing, but instead of managing your customer data, they manage our employee data.

Moser: Got you. With a SaaS business, the beauty of that is a subscription. Now, I know that sometimes there can be longer-term contracts that get locked in. This does seem to me like a business where, once you sign up with a provider, you probably are looking to stick with them for a while. Switching from Workday to another provider, to then another provider, that doesn't really seem ideal. I would imagine, as time goes on, assuming Workday is doing a good job, there probably are some switching costs here that come into play as time goes on.

Mathews: Yeah. Enterprise software, especially when selling to the really big companies, tends to be very sticky. Workday will typically sign three to five year contracts. But their gross retention is in excess of 95%. Their net retention is over 100%. So, they get more money from existing customers every year than they lose. It's so difficult. It takes years to choose, implement one of these big software packages, and flipping it out is a huge potential source of effort, but then also business disruption. Yeah, it is super sticky. That's one of the things I really like about it. As I was thinking about what's my top stock for 2021, of course, I'm attracted to the things that I deal with on a day-to-day basis that are really growing at huge multiples. But I think where we are with the market and with uncertainty around COVID, I wanted something safe.

Moser: Yeah.

Mathews: You might say, well, what's safe about a money-losing software company that [laughs] trades in excess of 10 times sales? Well, that's what I'm hoping to unpack today. [laughs]

Moser: 10 times sales is cheap in this environment. It's cheap [laughs].

Mathews: Well, you've got Zoom is 52X, so I guess if that's your comparison, yeah, it's cheap.

Moser: Well, I like also looking, something Aaron Bush and I talked about a lot over the last several months before we left HQ. Because so many businesses these days are still on that path to profitability, they haven't quite gotten there. Prices-to-sales is obviously a very popular metric. Another interesting one that just I think adds a little bit of context that I like looking at, and Aaron was the one that introduced me to this idea, was looking at something like price-to-gross profit. You love to find those businesses that just bring in those really healthy gross margins. Looking at Workday, one thing I see here is, not only do they have nice, robust gross margins, but that gross margin is continuing to grow here over time. I go back to 2016 and see gross margin around 67.6%. These last 12 months they're reporting 72.3%. I feel like maybe you get a situation here where you talked about switching costs and you talk about something where they're rolling out, I think what they're doing is not easy. Probably some pricing power they can exercise with that model through time as well, wouldn't you say?

Mathews: Yeah, absolutely. We've seen them continue to expand with current customers. I think they definitely have pricing power. They definitely have great margins. A lot of the costs are upfront to acquire customers. There's ongoing development of the software, but part of it is maintenance and new features on the existing software, but a lot of it is funding new areas. They are constantly going into new areas, developing new products, and so that's growth. One thing that is interesting is I definitely like looking at, it's interesting that you and Aaron talked about that, I definitely like looking at your market cap to gross profit. It's really helpful actually in the venture space because we never see a company that is profitable.

Moser: Yeah. [laughs] I can imagine.

Mathews: You can never look at things that we might look at, like price earnings are price to EBITDA, just go right out the window. But looking at gross margin is a good indicator of the future. If you're a software business that has 80%-90% gross margins, it just makes sense to trade at a higher multiple of sales because you think in the long run you're going to have high operating margins, not the 10% that's average for the SMB and have 20%-30% operating margins.

Moser: Yeah. I'm glad that you mentioned Salesforce earlier on, because when I first started looking at this company, that was the first business that came to mind, it was Salesforce. Very similar, tackling a different need, so to speak, but you look at Salesforce today, Salesforce is essentially four times the size of Workday.

Mathews: Right.

Moser: I think it just gives you an idea of these businesses that invest a lot upfront. If they're doing something right, that can really pay off over time. It certainly seems like it's paying off for Workday shareholders so far. Who are their customers? Are their customers just big enterprises like Travelers Insurance or Bank of America size companies? Or are they running the gamut of size, so to speak? Are they covering these small business customers?

Mathews: They do not do small business customers. They do big and super big.

Moser: Yeah [laughs].

Mathews: Of the Fortune 50, I think they have 60% of those.

Moser: Nice.

Mathews: Of the Fortune 500, they have 40%. That's one of the things that I think makes them interesting. These big customers are lucrative. They sign big deals for a lot of money. They're hard to serve. There's not many other people who could do it. A couple of examples of recent customers, Walmart, 1.7 million employees in the Workday system.

Moser: Wow.

Mathews: I think that's the largest cloud-based human capital management system in the world. But then there's other big ones like Accenture, half million employees, and then other big companies like GE, is a good example, Progressive Insurance. It's really out there with these really big companies. They have a few smaller, medium-sized companies. A lot of those have been brought on as they made acquisitions. They acquired a company a couple of years ago called Adaptive Insights, which is a planning company. They brought on some medium-sized customers. But the focus is really the Global 1,000, the biggest of the big.

Moser: Yeah, that makes sense. Let's talk a little bit about management for a minute here because that's always at least part of the story here. You look at a company like Salesforce, for example, and you can see part of the success there of course is because they do something very well, but I would argue that a lot of the success also has to do with Marc Benioff and has this advocacy for the business and for what they do. What do you know about management here? It does look like with Workday, we do have [...] still involved with the business.

Mathews: It's still a founder controlled company. It's actually a really interesting story. If you're a real nerd for enterprise software, I don't know how many are out there.

Moser: Aren't we all? [laughs]

Mathews: If you track the history of this stuff, all the roads almost lead back to Larry Ellison, which he himself is a character. But Benioff was an acolyte of Ellison. The founders of Workday, before they founded Workday, they founded a company called PeopleSoft. It did the same thing. It was keeping track of your employees, but it wasn't in the cloud. They were acquired by Oracle and Larry Ellison in a hostile deal. They did not want to sell, but they were forced to sell. What they did is, after they took some money, they're independently wealthy and they said, "What would we like to do? Let's start the whole thing over but let's build the best HR system we can and we'll build it in the cloud." They started in 2005, essentially took it public in about 2012. The founder is a guy named Dave Duffield. He's still pretty much the biggest owner. One of his lieutenants at PeopleSoft also joined him, he's now the co-CEO, that's Aneel Bhusri. Together, Dan and other employees own about 24% of the company. They still have a lot of skin in the game. Duffield is the chairman, but still on the board, still the biggest owner. Bhusri has recently taken on a co-CEO, but he's still co-CEO on the board. They've got a really good professional management team, people that have been at Workday for a long time at other big companies. They're also one of those great companies to work, so they pride themselves a lot on keeping employees happy. They're perennially on the Fortune's best places to work less. I think in the past couple of years they've switched between four or five or six, so they're considered among the best big companies to work for. Which is important, because they need to attract good talent. Software engineers are in demand, and so by having happy employees, they can retain them and get great people, make great products, keep the customers happy, and then keep the shareholders happy.

Moser: Yeah, that makes a lot of sense. It seems like such a strong business from so many different angles. Of course nothing comes risk-free, though it does feel like the bigger this company gets, the more investors are able to mitigate that risk, I guess. What are some of the risks or concerns, things that you'd need to keep an eye on with a business like this, separate from the current environment? Understanding that COVID's got everybody running around trying to figure out how to change things up. Actually, honestly it feels to me like COVID might be an opportunity for a business like this to even really prove its medal even more so. But what would you say are some of the risks or concerns investors should at least keep top of mind?

Mathews: There's two things that concern me. One is just that growth is slowing down. So, as the company has gotten bigger, its rate of growth has come down. I first started looking at this stock in 2015, 2016, and had about $1 billion in revenue. This past year it had about $4 billion, they'll have about $5 billion next year. But what has happened is, this is a company from 2016-2019, was growing 30%-40% a year. We're looking at the past year, they grew 21%, the next two or three years, analysts are saying, we'll probably grow 17%-18%. It's still a healthy growth rate, but not the astronomical levels that we're used to seeing with some of the other cloud-based companies. This year I think they're going to go from $4 billion to $5 billion in sales. They'll add $1 billion in sales, that's only 20%, 25% growth.

When you start getting big, it's hard to maintain that compound level of growth. They're still growing healthily, but just not the same growth path that they're on historically. That's one concern, something to keep an eye on. A good way to keep an eye on that is to look at growth in their backlog. One of the things that they do is they track all the money they essentially have under contract for the future. Right now that's about $9 billion. Revenue in the past year was $4 billion to $4.5 billion. If you think about that, they've got under contract. If they did not sign a single new contract or get a single renewal, they've got two years of revenue on the books. That's probably one of the things I really like about them.

Coming back to another big risk, and this is one of those "it is what it is" type of situations, but it's a Silicon Valley growth stock that uses a lot of stock options. As an investor, when you're modeling this out, you should plan on having some dilution. In the past four or five years, shares have gone from 190 million to 234 million. So, a 23% jump there, and a lot of it is stock options. You're going to have a 2%, 3%, 4%, 5% leak out to employees every year. It is what it is.

Moser: That's the cost of doing business in many cases of these types of companies, particularly when they're younger and really trying to establish their positioning. I saw that when we talk about the business and how it's growing that top line, clearly not yet profitable. I think that is just a matter of time. You can look at the cash flow statement and say, "Well, let me gather, bringing in a ton of free cash flow." Operating cash flow is better than $1 billion, [laughs] but then you look at the stock-based compensation, let's reassess here because yeah, that stock based compensation is up there. But again, that's something that will come down over time at least a little bit and as the business matures. It seems like, based on that margin picture, it's poised for some very healthy economics down the line as it continues to mature.

Mathews: I don't love the current Silicon Valley norms of huge levels of stock-based comp. But the truth is, it's most annoying when the company is most successful. [laughs] If the company is doing poorly, some people might get their options repriced, but a lot of them will expire worthless.

Moser: Yeah.

Mathews: I'm hoping that what I'll see is that while this company did great, there was a little bit of nagging friction that slowed it down with these stock options but still the end result to you as a shareholder is a great success.

Moser: Well, it certainly seems like it's been a great success thus far. The five-year chart there looks like this thing is close to a five bagger status or something like that. Any time you get the business is really trying to reshape a space that is so important, so crucial as this, I totally agree with you. It's a difficult thing to do, particularly when you talk about these big companies, these customers that they serve. I love the idea, I love the pic, it's not a business I was as familiar with, but I feel a lot more familiar with it now. The comp to Salesforce has me even more intrigued because I've always been a big fan of Salesforce and what they've done today. Brendan, now, given that it's Wildcard Wednesday, this was going to be a show I was going to give you a chance to just throw out your top idea for 2021, and we were just going to end the show, that would be it. But it's Wildcard Wednesday, Brendan. We're going to wildcard this thing.

Mathews: Wildcard.

Moser: Let's wildcard it, baby. I'm going to throw you an idea, how about that? Two ideas.

Mathews: I'm ready.

Moser: Well, Wednesday used to actually be a healthcare show. Back in the day, Wednesday, the industry that we covered on Industry Focus was healthcare. As things in life do, they changed and so did our schedule. So Wildcard Wednesday was born, and we do try to bring in healthcare as much as we can. We're going to continue to focus on doing that more here in 2021, but we definitely have a lot of listeners out there that really are clamoring for more healthcare. Just like Cowbell, we need more healthcare. I'm going to give you a healthcare pick today, a stock that I like in the healthcare space and hopefully our listeners will like it as well. But it's a stock that I followed for a really long time. It still seems to me it's under many radars, and it's a company called Masimo (MASI -0.33%), and the ticker is MAS.

Just for a little context, this is a business that I've actually first bought for our Real Money Portfolio initiative here at The Motley Fool back in 2011. We had a Real Money Portfolio initiative we ran called Rising Stars. A little bit different than the services we provide now, but this something where we individually had an opportunity to run a Real Money Portfolio that was public-facing. Masimo was a company that I found, had researched, I liked, and added to that portfolio. The stock is up around 800% since then. We like to add to our winners. This is a stock I own myself, and I think this is going to be one that is poised to continue to win for a lot of reasons.

But Masimo, first and foremost, what this company does, it's a medical device company. For those who don't know, their expertise is in pulse oximetry. That's a fancy way of saying that they came up with technology to measure the arterial oxygen in the blood and the pulse rate of patients. So ultimately, when you go into the hospital, they need to keep track of your arterial oxygen in the blood and your pulse rate. Well, low oxygen levels in the blood, obviously, that's not good. That can result in brain damage, death, so they really needed technology to be able to do that effectively, and most technology, up to the point of Masimo, was more invasive and not very accurate. But they came up with this signal extraction technology, SET technology, that has really changed the game in pulse oximetry over the last several years.

Much like Workday, this is a business that has a founder still at the helm there. Joe Kiani is the CEO of the company, the founder of the company. He still owns about 7% of the shares today, but he is a very innovative founder. He basically built this business and this whole idea in his garage and was able to grow it from there. So certainly, leadership is one reason why I love it. But I also like their business model. We talk sometimes about those razor and blade business models, and Masimo is one such business, where they get that equipment into the hospitals and then they sell the consumables, the disposables that are required to help that equipment ultimately function and be useful. They make their money from the equipment and the consumables. Those consumables are pretty high margin. Then finally, I think the reason why this is poised to do well for 2021 and beyond, is we hear a lot of talk about the Internet of Things. You've heard that term before, I assume, the Internet of Things?

Mathews: IoT?

Moser: Yeah, IoT. Well, have you ever heard of IoMT?

Mathews: The Internet of Medical Things.

Moser: Precisely. The Internet of Medical Things, it's really a thing, people. I'm actually not making this up. It's really a thing, if you've not heard of it. But the IoMT, the Internet of Medical Things, it's essentially connected infrastructure of medical devices and software applications, health systems and services. So Masimo, as I said, this is a very innovative company, something that they've been working on here, that they have now brought to market and COVID, one of the nice things that's come from this, is that it's really proven the utility, the SafetyNet product that they've offered. It's this product that basically helps them provide remote care for patients. Ultimately, it's really served them well for COVID-19 patients. But ultimately, it is for patients with chronic conditions. I mean, anything from COPD or heart disease like CHF there, congestive heart failure, I mean, all sorts of different chronic problems. This is what this SafetyNet system was built for. As we continue on here through 2021 and beyond, as 5G rolls and that connectivity proliferates, I think we're going to see them really realize a lot of value from the SafetyNet. It's definitely been a very big point of focus for them over the last several quarters, they've been talking a lot about it in the calls. I think that you've got a very innovative company here with a leader who has been there from the start, and they are continuing to play into, I think, what is a very big trend in telemedicine and the Internet of Medical Things and whatnot.

So, all things put together there, Masimo just seems like a business that continues to win. It's profitable, they make healthy cash. They continue to innovate and it's still kind of a small company in the context of things right now. I think somewhere around a $16 billion market cap. Again, it was much smaller not all that long ago, but the reason why it continues to grow is because the business just continues to do really well. So, I think that this is one that investors should certainly have at the top of their list for 2021.

Mathews: So, Jason, I'm looking at this one. They've got a very healthy cash position on the balance sheet.

Moser: Yeah.

Mathews: They've got high margins in excess of 20% on the operating side. They're growing nicely. What should we be worried about here?

Moser: I think two things that really come to mind for me whenever I see a business like this, these medical device companies, basically, one is on the compensation side. Like, the hospitals are buying their equipment, and ultimately, they're going to be subject to that payer risk, whether it's Medicare, or Medicaid, or the big private insurers like UnitedHealth Group. I mean, ultimately, insurers, public or private, hold some of the cards here and so reimbursements can be a question mark now. I don't worry as much about that based on the track record thus far, the technology, the need for this actual service that they offer. I think pulse oximetry is not really optional, so reimbursement has not been too much of an issue, but it's still something we're keeping an eye on because our healthcare system is seemingly always in flux.

Then the other one, this is a company that really its biggest strength beyond just its culture of innovation is really its IP, its intellectual property. Everything that they've built to this point, that signal extraction technology, they've protected it. But as I mentioned with that razor and blade model, they are subject to knock-offs on the consumable side. The sensors that they offer for their equipment, that's proprietary technology, but they have been victim to knock-offs in the past. So that's always just something to keep in mind and that is one of those things that probably will never go away. But I think they've done a pretty good job at this point of protecting their technology. I think as long as healthcare is a thing and I think that is always going to be the case, and as long as this company continues to innovate, and I think they've shown that they are more than willing to continue doing that, I feel like those risks are relatively minimal, but they're always going to be there.

Mathews: That's the thing about us, Jason, is we're like the human fund. We're betting on people. [laughs] As long as there are people, there will be healthcare. As long as there are employees, you'll need to keep track. As always, big companies have people that are employed, you'll need some software form, so it's like a human fund.

Moser: You've given me a great idea for my Christmas gifts for 2021. I'm going to put that in the old memory bank up there, Brendan. I appreciate that.

Mathews: Sounds good. [laughs] I was looking forward to that.

Moser: [laughs] Yeah. You'll get a card in the mail. [laughs] Man, this is really great. It's been a while. I'm really glad we're able to get back together on the show here and talk. Thanks so much for doing this. I mean, taking the time to dive into a stock and present it to our listeners, I know they're going to love it. Really, it sounds like you're just doing a lot of great stuff there with Motley Fool Ventures as well. So, we're going to need to make this a little bit more of a common meeting here this year in 2021, beyond just our top stocks. We need to get you on the show here a little bit more often, so we'll make sure and do that.

Mathews: Thanks, Jason. Fool on!

Moser: All right, folks. Remember, you can always reach out to us on Twitter at @MFIndustryFocus, or feel free to drop us an email, [email protected], let us know your top stock of 2021.

As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

Thanks, as always, to Tim Sparks for putting the show together for us, for Brendan Mathews, I'm Jason Moser. Thanks for listening and we'll see you next week.