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How to Apply the Rule of 40

In the previous article, we covered why the Rule of 40 is a useful benchmark for evaluating cloud computing growth companies. The next thing to discuss is how to use the Rule of 40 for creating a portfolio.

Portfolio Options

There are several common ways to build a portfolio using the Rule of 40:

The option you chose will depend on how much "hands on" work you are willing to do. Each of these has its trade-offs. Of course, there are many more options than just these 3. But the intention is to cover a few broad ideas that can be tweaked when creating or adding to a portfolio.

Picking Individual Stocks

First, picking individual stocks requires an extensive amount of research. Not only are you looking at financial metrics (including the Rule of 40), you're also evaluating qualitative measures. Things like evaluating management quality and competitive advantage may involve reading annual reports, listening to earnings calls, and experience using the product. This requires a lot of work and patience.

Most of the great individual stock pickers have concentrated portfolios. This often runs contrary to conventional financial advice. Most financial advisors recommend diversification to reduce risk. Since diversification almost guarantees mediocre to average results, Peter Lynch coined the term "diworsification".

Great investors like Charlie Munger believe great opportunities are very limited. And Warren Buffet uses a punch card analogy where you're given a limit of 20 slots. That is, you are limited to choosing only 20 investments for a lifetime. Once an investment decision gets made, you cannot get that slot back. The hard limit causes you to be extra stringent when making a decision. When done properly, it will feel like going through many companies and saying "no" almost all the time.

When using a stock-picking, concentrated approach effectively, you must bet big on "fat pitches". Making a small bet on a great opportunity will have limited upside. Having the conviction to bet big and then having the patience to wait for the results is simple but not easy. It requires managing emotions, especially during bear markets and other periods of volatility.

The next method we'll discuss involves a very different philosophy.

Buying a Basket of Stocks

Simply buying a basket of stocks is a more mechanical approach than picking individual stocks. This is generally done using a financial model like the Rule of 40 and rebalancing regularly. Generally, once per year. The basket should contain roughly 20 to 30 stocks that meet the revenue growth, Free Cash Flow (FCF) margin, and valuation requirements.

This approach is usually much less concentrated than picking individual stocks. But more concentrated than buying an entire index. The aim is to beat the overall index.

One of the core principles of applying a model is that you don't know which of the stocks will outperform, which stocks will do just okay, and which ones will be duds. However, by buying up to 30 stocks, the bulk of the returns will come from the top performers. In fact, when you buy an index fund (including the S&P 500), most of the returns over any extended period of time come from the top 4 or 5% of companies. The same idea applies here. The main difference, in theory, is that the subset of stocks selected by the model should beat the index over the long run. That being said, almost all models have temporary periods where they underperform, however. It will take some conviction and patience to stick with a model through these periods. Given a long time span, even a small return advantage will have a big impact on how much you end up with in the end.

Rebalancing is a critical component of this approach. This is important for dropping stocks that no longer meet the original criteria and replacing them with stocks that do. In the Rule of 40 case, it is very difficult to maintain both high profit margins and high revenue growth over extended periods of time. Our ranking system also takes the stock's valuation into account (measured by Enterprise Value to Reveue). (See Rule of 40 page) This helps avoid overpaying for companies that otherwise would meet the criteria.

Rebalancing will also require dropping a company that becomes overvalued even if the company performs well. For example, let's say Company A has a Rule of 40 score of 45. When the rebalancing point is reached the following year, it still has a score of 45. However, EV to Revenue expanded from 4 to 8. In this case, it went from being undervalued or fairly valued to being overvalued. While an investor using the stock picking approach may continue to hold this stock, the rebalancing approach would require selling it. And perhaps buy it again later if the valuation became favorable.

Advocates of the buy and hold stock pickers do have a couple valid arguments in this situation. First, selling at a gain creates a taxable event. For obvious reasons, taxes eat away at your long-term gains. Second, if the company continues to perform well for the foreseeable future, benefits from long-term compounding will be enough to keep the stock though periods where it's overvalued.

Buying the EMCLOUD Index

The final investing option we'll discuss here is the idea of buying the EMCLOUD index. Thanks to ETFs, this not only possible but very easy. The WisdomTree Cloud Computing Fund (WCLD) tracks the EMCLOUD index. It will match the price and performance of the index before management fees. ETFs are attractive for their efficiency. Management fees are much lower for ETFs than traditional mutual funds.

Over time, the index has done very well. Since the beginning, it has performed 3 times better than the S&P 500 and nearly twice that of the NASDAQ (see the chart from BVP at the bottom of our Introducing Valuations.cloud article). This is remarkable considering the correction that took place after the bubble peaked in late 2021.

In the other 2 investment options mentioned above, vetting companies was the responsibility of the investor. When picking individual stocks, a lot of research is required to determine if a stock is a good fit for your portfolio. In the second approach, a periodic rebalance was necessary to replace companies that no longer fit the original criteria, usually on an annual basis. However, with this approach, the vetting is automatically done for you.

Twice per year, the index gets rebalanced and "reconstituted". That is, every security must continue to meet the eligibility criteria. For example, if annual revenue growth falls below 7% for both of the last two fiscal years, it will be dropped from the index. The company must also maintain its cloud computing industry focus. You also don't have to be concerned with the weighting of each security as the index handles the rebalancing for you. In the case of WCLD, each rebalance will reset all the securities to be equal weight.

We currently cover 3 cloud computing ETF's. For each of these, we provide a list of holdings along with financial metrics. Using this data, you can decide which ETF is best for you. This can even be used to discover new stock picks. Each is fundamentally different. WCLD focuses on cloud growth companies while the other 2 have a broader scope.

To sum it all up, the best strategy will depend specifically on your needs. It will depend on how much research you want to put in and how comfortable you are with a concentrated portfolio. Each of these will require patience to allow compounding to do its magic over time.