Why SaaS businesses are still proving the world's best growth stocks

Back in 2018 and 2019 I repeatedly wrote about fast-rising software-as-service (SaaS) businesses on the ASX and why they looked good growth bets for investors. 

The businesses I wrote about as likely winners included Xero (ASX: XRO), Wisetech (ASX: WTC), Pro Medicus (ASX: PME) and the now delisted Altium. 

Australia's most successful growth businesses ever, in Atlassian and Canva are also largely SaaS-based business. So, this is a space you must understand if you like growth stocks. 

Unfortunately, I'm not quite so plugged into the small-cap end of the share market these days, so I cannot reveal the next set of huge winners, but I will name a few smaller ones below for investors to kick the tyres on. 

Why these businesses are often growth stars for investors

It's called software-as-a-service as it delivers a service (such as an online accounting platform in Xero's case or medical imaging for Pro Medicus), which users can subscribe to in return for a fee that is typically paid monthly. 

Most of the big share market winners are enterprise SaaS, which means they sell subscriptions business-to-business rather than to individuals. 

The SaaS business model has several big advantages over the business models of traditional blue-chip companies, and I'll outline some below. 

Recurring revenue and high gross margins

Probably the biggest advantage is the recurring revenue model. This means once a customer is signed up, they'll pay the SaaS provider indefinitely to use the service, without the provider incurring much in the way of additional costs down the line.

Compare this recurring revenue model to a miner like BHP (ASX: BHP). The miner must invest billions of dollars in capex every time it wants to dig a new mine to generate additional sales revenue.

Or compare the model to a business like blood products giant CSL (ASX: CSL), which many consider to be one of the best companies on the local market.

If CSL sells 100,000 blood product treatments in FY 2025, it will have to sell another 100,000  to new customers in FY 2026 just to reach breakeven, assuming an equal selling price.

This is hard going versus a recurring revenue SaaS model where every new customer added goes on top of the prior year's total subscribers.

SaaS businesses that deliver software platforms online also don't incur the cost of goods sold like CSL, absorbing manufacturing costs before trying to sell another product.

This means they tend to boast the highest gross margins in business, often between 70% and 90%, with a rule of thumb being the higher the better. 

On the other hand, an automaker like Toyota or Tesla will only have gross margins of 15% to 20%. Supermarket giant Coles (ASX: COL) had a gross margin of 26.9% in financial year 2024.

If a business has a high gross margin, it leaves a lot of cash left over from the products sold as either profit, or to reinvest in marketing (to grow more) or new product development to retain and add customers. 

Product development, pricing power, watch churn

The beauty of SaaS is that updates to platforms (services) can be delivered online to millions of subscribers via not much more than the click of a button.

Whereas if a company like Cochlear (ASX: COH) has a new product in the pipeline, buyers may potentially delay purchases in anticipation of a new product in the future. 

The SaaS model of online updates is also important as it fuels innovation and product development. 

SaaS providers and their software engineers can constantly work to improve product features or functionality that help clients save time and money via increased efficiencies, data, AI, or customer management, for example.

Another key metric I always look for in a SaaS business is churn, which is a measure of a provider's product strength and pricing power. 

Churn expressed as a percentage shows how often a company's customer base cancels subscriptions over a given year. 

What impressed me about WiseTech in 2018 and 2019 was its exceptionally low churn, which was industry-leading at below 5%. 

What this shows you is that its customer base is sticky, so its customers must love its product and be unlikely to cancel it. It also suggests WiseTech has a competitive advantage, which is a slightly intangible quality that the likes of Warren Buffett urge investors to look for if you want to own a growth stock. 

A low churn rate also suggests a SaaS provider can push through price increases, without losing customers. 

Recently, cloud accounting giant Xero has pushed through price rises to customers with minimal churn to suggest its customers love its product. So, in general, we can assume an enterprise SaaS user is unlikely to uproot such a critical system unless it believes there's a far cheaper or superior alternative.

This ability or pricing power boosts margins and profits, with Xero shares up way more than 1000% since I first started regularly writing about its potential back in 2014 or so. 

Xero does have some competition from SaaS rival and QuickBooks giant Intuit NASDAQ: INTU), however, which is another epic growth stock for the same reasons. 

Other metrics, such as lifetime value and return on invested capital, are also relatively easy for an investor to look at to get an idea of good SaaS businesses. 

Founders, management

Also, pay attention to founders and chief executives. Over the years, I have spoken to a lot of the Australian ones and listened to pretty much all of them. 

The best for me was Rod Drury at Xero, whose erudition, vision and clarity of thought on software and rewiring the small business economy were amazing. 

Drury is no longer at Xero, but if anyone knows of a SaaS small-cap with a founder as impressive as Rod, please do let me know in the comments below! 

In summary, as an investor, I'd say always listen to the founders and management first for an idea on how the company is likely to travel, rather than the opinions of analysts or commentators such as myself. 

Believe it or not, a lot of professional investors rubbished Xero as a loss maker between 2015 and 2020! But they could not have been more wrong about the share price direction. 

So, what's not to like about SaaS businesses?

SaaS businesses are not going to impress value investors as they typically trade on high multiples of profits and sales. If you pay too much for one and it runs into problems, you're at risk of major capital losses. 

You could also argue that some are wildly overvalued today, such as Pro Medicus. 

However, the likes of Xero and WiseTech are on more sensible valuations. WiseTech has impressed and ticks the boxes on many classic SaaS metrics, although I'm not a big fan of its acquisitive model and the fact that it heavily capitalises expenses to boost profits. 

So, I personally prefer the cleaner accounts of Xero. 

Agentic artificial intelligence (AI) is also being touted as a risk to SaaS business models and this is definitely something I'd keep an eye on. 

AI agents may soon be able to perform some of the services SaaS providers offer, so there may be cheaper competition. 

However, AI is a double-edged sword, as many SaaS providers may be able to use it to reduce costs and offer better products. For example, Pro Medicus suggests AI could help its customers make better medical decisions, so you don't want to get shaken out of these businesses unnecessarily. 

More generally, in terms of AI, if you want to look for growth winners, I'd suggest considering who will win in the chatbot assistant and wearables space. Moreover, I'd consider whether these markets will be winner-takes-all like search turned out to be for Google, or split between multiple big tech players. 

What are the next hot SaaS businesses?

As I said, I am not so plugged into the small-cap end of the share market as I was in say 2018 or 2019, although I am aware of a few smaller ones that still have potential to grow. 

Stock picker and the founder of A Rich Life, Claude Walker, put me onto Objective Corporation (ASX: OCL) around 12 to 18 months ago. It's an enterprise SaaS business I did kick the tyres on, and shares are up about 70% since this time last year. The founder, Tony Walls, still owns about 65% of the business, which I absolutely love, although the valuation has increased a lot recently, so it's not so cheap anymore. 

Another one being touted is Energy One (ASX: EOL), although I must admit to knowing next to nothing about this business.

While Catapult Sports (ASX: CAT) is now soaring, I do personally know its chairman, Adir Shiffman, who kindly taught me a lot about e-commerce businesses and software over the years.  

I've also spoken to Catapult's chief executive, Will Lopes, many times, and Catapult is still arguably cheap versus its peers in terms of sales multiples, for example, although I've not looked at it in detail recently. 

Technology One (ASX: TNE) is another classic enterprise SaaS business, with financial software group Bravura (ASX: BVS) and Gentrack (ASX: GTK) also catching the attention of small-cap professionals. 

Some of the big enterprise SaaS winners in the US I like include Okta (NASDAQ: OKTA), Salesforce (NASDAQ: CRM), Shopify (NASDAQ: SHOP) and MongoDB (NASDAQ: MDB).

While most of the super hot cybersecurity winners like Crowdstrike (NYSE: CRWD), Palo Alto Networks (NASDAQ: PNW), Zscaler (NASDAQ: ZS) are also SaaS businesses. Moreover, the world's hottest tech and growth stock, Palantir (NASDAQ: PLTR), also offers enterprise SaaS products. 

We can see that when it comes to growth, SaaS is still a winner for many reasons. And if you find a good business that's preferably founder-led, you might be onto a big generational winner. 

Remember to look for gross margins, churn, return on invested capital, management, market size, and product quality/stickiness. Good luck!