Paycom (PAYC 0.67%), a human capital management and payroll company, rode the tailwinds of a strong labor market to become one of the best-performing cloud stocks during this terrible economic environment. However, investors should be wary about Paycom's outperformance continuing.

Here are two reasons investors should be cautious about investing in Paycom.

1. Risk of a worsening economy

Paycom charges its clients monthly on a per-employee basis for services like payroll, which generates most of its recurring revenue. As a result, Paycom's fundamentals are typically at their best during times of a strong economy with a healthy labor market. Alternatively, Paycom's fundamentals will diminish in periods of declining economic activity, marked by high unemployment.

For example, in 2020, when COVID-19 hit American shores, unemployment spiked into double digits during the second quarter of 2020. As a result, Paycom's recurring revenue growth rate dropped significantly due to headcount reductions among its client base.

The following chart illustrates the effect of unemployment on the company's recurring revenue growth.

Metric Q2 2021 Q2 2020 Q2 2019
Unemployment rate 5.9% 13% 3.6%
Recurring revenue growth rate 33.5% 7% 31%
Recurring revenues $237.6 million $178 million $166 million

Data source: Paycom and U.S. Bureau of Labor Statistics.

Paycom is outperforming many other cloud and software stocks today because the unemployment rate is still low at 3.5% as of September 2022, despite high inflation and rising interest rates.

Of course, as the Federal Reserve raises interest rates further, the unemployment rate will eventually rise. And should the Federal Reserve push the economy into a recession, the recent fantastic quarterly results from Paycom will likely end.

2. Competition

Two competitive factors are turning against Paycom.

First, the total addressable market for human capital management ranges from $18.5 billion to a little over $22 billion, depending on which third-party researcher you believe. While Paycom's market share today still looks early in the opportunity at around 6% of the total addressable market, grabbing further market share is becoming much more challenging as the space grows increasingly crowded with aggressive new competitors. And if you believe a short seller's report released by Kerrisdale Capital in July 2022, the payroll and human capital management sector are much closer to saturation than Paycom's management implies.

Second, one of the company's original competitive advantages since its start in 1998 was that it was one of the first cloud-based payroll service providers. And it could use the advantages of being in the cloud to take market share from legacy enterprise software providers.

However, almost all payroll and human capital management providers have savvy cloud operations today, including older traditional enterprise software companies like ADP and Paychex. As a result, Paycom has become increasingly more challenged to differentiate itself technologically or in other ways from its competitors. 

Outstanding results, but consider the risks

The company's second-quarter results showed strong revenue growth, expanding margins, profitability, and positive free cash flow -- great results in this terrible market.

Charts showing Paycom's operating margin, net income, and free cash flow rising in 2022.

PAYC Operating Margin (TTM) data by YCharts

However, while this company produced outstanding results in the second quarter and remains a popular choice with investors, there is no guarantee that it can continue to execute well enough to maintain its rapid growth, particularly as the odds of a recession grow.

The market values Paycom at a sky-high price/earnings-to-growth (PEG) ratio of 3.8. Most investors consider a PEG ratio far higher than 1.0 a sign of an overvalued stock. Consequently, should Paycom's predictable revenue growth become unpredictable and fall off a cliff, its stock price would likely collapse.

So, while Paycom is an enticing investment because of relatively recent fantastic results, you should consider its risks before investing.