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Small Cap Low-Risk Pick No. 3: Ellie Mae Inc.

By Motley Fool Staff - Apr 8, 2016 at 6:43AM

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David Gardner explains why this relatively anonymous company which makes mortgage software deserves your attention.

You may not know the name, but Ellie Mae (ELLI) processes about 25% of the mortgage applications in the United States.

In this clip from the Rule Breaker Investing podcast, David Gardner explains why the stock is a fantastic pick, what makes investing in Ellie Mae different from investing in real estate and shares a word of caution for investors looking to stay in-the-know about the stock.

Check out David Gardner's other favorite companies:

A transcript follows the video.

This podcast was recorded on Feb. 10, 2016. 

Stock No. 3 this week is Ellie Mae. Ellie Mae, the ticker symbol is ELLI, it's on the NASDAQ. By the way, I haven't been giving ticker symbols, but you can look it up online. Use to find your ticker symbols if you need these.

The stock was recently at $60 per share. This company's smaller than the first two I covered. It's about $1.8 billion, its market cap. Its risk rating, right in there at 6. Again, each of these, 5 or 6, these are very low-risk investments. We define risk, by the way, as the chance that you will permanently lose a fair amount of your capital if you own the stock for the long term.

That's what risk is for me. That's what we're trying to avoid. So we think that's much less likely to happen in these companies that I'm mentioning this week than some of the others, some of our biotechs or others that are certainly higher risk, sometimes higher reward too.

Ellie Mae is a software company. It processes mortgage applications. In fact, the company has about 25% of the market share of the U.S. So this is a company that is using the software-as-a-service model, connecting mortgage professionals with lenders and service providers, and this is a good example of a growth market that's very quiet. Very few people have heard of Ellie Mae. However, if you're in the mortgage indu stry, I'm pretty sure you have. You may well be using the company's platform.

We first brought this stock to Rule Breakers in October of 2012. It's done quite well, up 137% since then. The S&P 500 up 41%. So, this has been a quiet double and a strong performer, a company that has good growth and took a real hit recently when -- it was, in fact, Feb 5, just days ago. It dropped 11% or so in one day -- not on its news, but simply on the enterprise software industry selling off.

You may have seen Tableau, which is certainly a leader in that industry, gave some pretty bearish projections about its business in the next few years. So, Tableau watched its market cap get shaved in half that day. So a company like Ellie Mae sold off 11%, not on its news, but in sympathy with the rest of its so-called "industry."

But, what I want to point out here, and here's our general investing principle: I really like the so-called "picks and shovels" companies when they're working in industries that I think are going to be around a long time. So, you know the whole thing about picks and shovels? You probably do.

The idea was, the only people who made money during the Gold Rush back in 1849 weren't those that went out to California hoping to strike it rich finding gold, but rather the companies that were selling the picks and the shovels to go ahead and search for gold. So that's the way I think of a company like Ellie Mae.

This is not a play on the housing market, per se. I'm not making any comments about the strength or not of mortgages right now, or, specifically, mortgage lending. This is not something that I spend a lot of time at personally. I'm not an expert on housing or real estate. I like software companies. That's what Ellie Mae is. It's a software company, a picks and shovels company, and usually, the ones off the beaten path are good for long-term returns.

Now, a note of caution: This company is pretty opaque. Part of being a picks and shovels company is that you and I have a harder time figuring out how that business is doing. So when you own a stock like this -- and I have it in my portfolio -- I'll usually be surprised if there's bad news. I feel like you and I can see when bad news is hitting Chipotle, because it hits national headlines. But we have less of a shot of doing that at these more opaque business-to-business companies. So that's something you have to bare in mind as a point of caution around Ellie Mae.

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