As a young investor, the draw of SaaS stocks is very appealing. However, I continue to hear analysts rave about how SaaS is just like the dotcom bubble, and SaaS stocks are bound to come crashing down. So I did some research. Here is why SaaS stocks are different (thread):

First, let’s talk about what led to the dotcom bubble. In the late 1990s, investors become enthralled with just about any company with a .com at the end of its name. Investors poured billions of dollars into a variety of .com stocks without actually doing proper research.

Many investors bought into speculative businesses with questionable business plans, ugly cash flow statements, and extreme valuations. This caused a massive spike in the market, particularly for these .com businesses. Then, on March 11, 2000, a sell off of these businesses began.

The sell off didn’t stop. Businesses with promising ideas quickly went under, erasing all of their gains in a matter of weeks. Let’s take a look at a couple of these businesses.

http://Pets.com  was a pet food supply company with a business model fairly similar to that of $CHWY. Investors were right that pet food delivery would become an enormously profitable business over the next few decades, but the business still went under.

http://Webvan.com  was a grocery delivery service similar to Instacart. Again, investors were correct that this would be a huge market opportunity, yet the business still went bankrupt.

Finally, http://theGlobe.com  was a social media site allowing users to create their own webpages, somewhat similar to $FB. Investors were so euphoric about this opportunity that the stock shot up 997% on the day of its IPO. But even this company crashed.

Great ideas, business failures. Scary, right? Investors were right about the ideas, but they failed to look beyond the ideas and into the actual business. This was a serious issue because each of these businesses had fundamental problem.

For example, http://pets.com  had a business model that was illogical and bound to fail. Marketing is important and a high cost for many young companies, but http://pets.com  spent $17M on marketing in Q2 of 2000, despite making only $8.8M in revenue!

http://Webvan.com  spread themselves too thin, expanding to eight cities before even verifying their business model, while http://theGlobe.com  simply could not sustain the expectations created by a 997% rise in one day.

Some of these stories have eerie similarities to some SaaS stocks today: massive gains following an IPO, rapid expansion, and unprofitable businesses. Yet, the best SaaS stocks are fundamentally different.

Unlike .com companies, many SaaS companies exhibit high gross margins and proven business models. These companies have carefully, yet rapidly, expanded, and many are on the path to profitability or are already profitable. Plus, they have demonstrated their resiliency.

Take $AYX, for example. Since IPOing in 2017, the stock has risen rapidly from $15.50 to a current price of $168.10. In doing so, however, the company has stuck to its business model and maintained financial stability. $AYX has gross margins of ~90%, no debt, and is FCF positive.

$DDOG is another example. One of the fastest growing stocks on the market today, analysts have been warning of a $DDOG crash. Yet, the company has not only shown resiliency to survive crashes, but it has maintained solid financials: 80% gross margins, lots of cash & FCF positive.

It is worth noting, however, that the best companies still survived the .com crash. $AMZN & $EBAY are still around today. Thus, just as there were good and bad .com companies back then, there are good and bad SaaS companies now.

In fact, even though SaaS stocks overall look better off today, fundamentally, than .com stocks looked back then, investors can still learn a few key lessons from the dotcom bubble:

(1) Do your research! Do not invest in a SaaS stock just because it claims to provide a valuable service or people on Twitter tell you that it is good. Opportunistic companies will use high TAMs and hazy software promises to obscure otherwise questionable fundamentals.

(2) Pay attention to red flags! If a company is spending twice its revenue on marketing, that should be a red flag. Similarly, if a company is expanding too quickly, be wary. If a company really is that great, you can buy in a little later once it has proven its business model.

(3) Valuation is important, but don’t let it scare you away! For years, bears have claimed $AMZN is overvalued, yet it continues to outperform. Don’t be afraid of a company just because it’s “overvalued,” but understand why it is overvalued and make sure you’re ok with that.

(4a) Be Wary of IPOs! Some companies like http://pets.com  or http://theGlobe.com  may have rushed to IPO, despite being unprepared, because they saw the potential for huge gains. Recent SaaS IPOs, no matter the business, have rocketed up on the first day of trading.

(4b) Buying an IPO isn’t always bad, but if you are concerned about a SaaS crash, it may be wise to wait a few quarters and see how the company performs first. Thus, you don’t unwittingly buy into an overhyped & bad business model.

(5) Pay attention to basic business fundamentals! Companies you invest in should have a path to profitability, be spending their money in a wise way, and have a business model that actually works. Just because a business has a good idea doesn’t mean it will succeed.

(6a) Don’t panic! SaaS stocks have already had a couple significant pullbacks over the last few years, yet every time, they have rebounded. If your stock falls 30%, it is certainly worth re-examining the business model.

(6b) But do not panic and sell just because your portfolio was red for a few days. Widespread panic is what led to the .com crash, and people today are still unsure how it really started. If the company is truly great, a 30% drop is an opportunity to buy, not a reason to sell!

This, of course, is all my opinion. I have done significant research, but I should note that I was not investing during the dotcom bubble. As always, comments, thoughts, and questions are appreciated.

Thank you for reading and feel free to share!

Long (good) SaaS stocks!

Would love to hear what @saxena_puru @cperruna @BrianFeroldi @dannyvena @hhhypergrowth @adventuresinfi @richard_chu97 or other great investors who invest in SaaS stocks think of this! Thank you!