It has been a tough beginning of the year for SaaS stocks and tech stocks in general. Our On-Demand Index is down 14.48% YTD. In comparison, the Dow is down 5.76% YTD, Nasdaq Composite index is down 8.85% and the iShares S&P GSTI Software Index Fund (IGV) is down 8.99%.

As the on-demand software market expands and matures (yes it will happen!), there will be a closer correlation to company performance and stock performance. Momentum and hype are key factors in stock performance in the early stages of many an emerging software category.

The hyper growth of web companies as the Nasdaq peaked over 5000* in March 2000 is a classic example of what happens after the mania subsides (or goes bust in that case.) During the hyper-growth and hype stage people are betting (I do mean betting rather than investing) that every company offering the emerging software is going to succeed and become the next Google. But for every Google, dozens (or hundreds?) of companies fade away, never becoming a profitable, sustained business, while only a handful at best become successful. And most of those successful firms get acquired.

Why do some companies succeed while others fade away? My undergraduate degree is engineering, so you’d probably expect me to say those with the best technology succeed. But that’s actually way down the list.

The ingredients for success are:

• a product that does something of value for the customer,
• marketing and sales activities that create buzz and awareness,
• consultants who can help early adopters effectively implement the product, and, 
• a business model that generates profits.

The last ingredient seemed to be forgotten during the Internet boom (and bust) cycle earlier this decade. The key phrase from those times was “number of eyeballs.” People were investing in companies based on those eyeballs rather than on sales or even profit.

You can give stuff away for free for a while, but at some point you’ve got to charge for something. And at some point your business model has to generate profit from sales. It is a simple principle that applies to the local store or a high tech company. To stay in business you have to generate sales and make a profit.

During the hype or mania phase of an emerging technology market, software firms can spend (sometimes lavishly) venture capitalists’ (VC) money without making a profit. I am not concerned about VC’s money (they can take care of themselves quite well), but at some point the VC money stops and a company has to make a profit.

Maybe the founders and the VCs cash out after an IPO or after being acquired, but eventually the business has to stand on its own if it is going to continue to exist. The laws of business are not curtailed because some cool software has arrived.

While we watch the on-demand (or SaaS) index and the underlying companies you will, eventually, see the stock and company performance diverge. After the mania and hype subside, the companies that offer applications that provide business value and have a sustainable business model (can make a profit) will rise to the top. That’s why companies like Oracle, Microsoft and Google rose out of the pack during their emerging market phases. That is why some of the companies in the index will emerge and others will fade away.

Index adjustments

We are expanding the index, as planned, based on feedback from readers and colleagues. The expanded index includes the following companies:

• athenahealth, Inc. (ATHN)
• Blackboard Inc. (BBBB)
• Concur Technologies, Inc (CNQR)
• salesforce.com, inc. (CRM)
• Constant Contact, Inc. (CTCT)
• DemandTec, Inc. (DMAN)
• Kenexa Corporation (KNXA)
• LoopNet, Inc. (LOOP)
• NetSuite, Inc. (N )
• Omniture, Inc. (OMTR)
• RightNow Technologies, Inc. (RNOW)
• SuccessFactors, Inc. (SFSF)
• Taleo Corporation (TLEO)
• DealerTrack Holdings, Inc. (TRAK)
• The TriZetto Group, Inc. (TZIX)
• Ultimate Software Group Inc. (ULTI)
• Vocus, Inc. (VOCS)
• Visual Sciences, Inc. (VSCN)

The index is calculated on an equal-weight representation based on closing prices as of 12/31/07.

Disclosure: I have no current stock positions in any of the companies listed in this index and no current business relationships.

*That’s right. On March 10, 2000 the Nasdaq closed at 5,048.62. Remember those days?