The Best Stocks to Buy in 3D Printing

When The Economist referred to 3D printing as the "Third Industrial Revolution" in April 2012, it didn't take long for investors and the media to become enamored with the technology, which holds the potential to revolutionize the way things are made and how inventory is managed and to usher in a new world of mass customization.

At the time, the investing implications seemed staggering: Worldwide manufacturing produces about $12.8 trillion in economic output each year, and a small chunk of that could add up to big profits for the handful of 3D printing stocks that existed then.

As continued media coverage and investor excitement crept into the sector, it sent 3D printing stocks on a parabolic rise, reflecting extreme optimism about technology's promising future. However, once investors realized that the Third Industrial Revolution wasn't going to happen overnight, and companies failed to live up to their lofty expectations, the majority of 3D printing stocks no longer appeared to be worth their weight in 3D-printed selfies.

SSYS data by YCharts.

From a long-term investor's point of view, the sell-off in 3D printing stocks that got us here today could be viewed as a positive development, because many companies are now trading at more reasonable valuations relative to their still-promising long-term growth prospects.

According to Wohlers Report 2014, a leading 3D printing insights report, worldwide 3D printing revenues are expected to grow by more than 31% per year between 2013 and 2020, translating to a nearly sixfold increase in size over seven years. What was a $3.07 billion industry in 2013 is forecast to generate over $21 billion in revenue by 2020.

If I had to pick just the best 3D printing stocks to buy and hold through 2020, my money would be on Stratasys and Proto Labs .

The Gillette razor of 3D printing Through the end of the first quarter, Stratasys has sold more than 129,000 3D printers since creating its MakerBot, Objet, and Stratasys brands. This market-leading installed base "feeds" the company's razor-and-blade business model, where the 3D printers it sells act as the razors and the materials they consume over their life cycles act as the blades.

Ultimately, a large installed base of 3D printers lays the foundation for creating a healthy long-term recurring revenue stream for materials, which tend to carry higher profit margins than 3D printing hardware. These favorable margins suggest that a growing installed base could positively impact earnings in the long run by driving increased consumables revenues. During the first quarter, Stratasys' consumables revenue increased by 18% year over year, or 25% after accounting for currency fluctuations.

Despite this core strength, Stratasys has experienced several challenges in recent quarters, which have negatively weighed on shares. Most notably, a softening capital spending environment, currency headwinds brought on by the strong U.S. dollar, and several missteps with MakerBot have raised questions about Stratasys' nearer term prospects. Potential investors should consider whether management can successfully navigate these challenges in ways that keep the underlying strength of its business and brand intact over the long haul.

Bending the rules a bitOK, OK, technically, Proto Labs isn't close to being a pure-play 3D printing stock. Last quarter, a mere 7.8% of Proto Labs' revenue was generated by 3D printing activities. However, this doesn't change the fact that its quick-turn manufacturing services can rapidly take a customer from early-stage 3D-printed prototypes to mid-volume manufacturing runs in the tens of thousands of units using real manufacturing processes like CNC machining and injection molding.

At its core, Proto Labs utilizes cutting-edge automation technology that the company claims makes it the world's fastest manufacturer for machined and molded parts. This competitive advantage, coupled with its emphasis on customer experience, has allowed the company to grow sales like gangbusters in recent years.

PRLB Revenue (Quarterly) data by YCharts.

Beyond speed, no other company matches the breadth of manufacturing services that Proto Labs offers under one roof, likely because the level of capital and resources required to replicate Proto Labs' business model in its entirety would be prohibitively high.

Looking ahead, Proto Labs' continued path to growth is clear, and involves bringing new manufacturing services and materials online that expand its addressable market, which would in turn give it an opportunity to compete for more product developers' business across the globe.

As exciting as Proto Labs' business prospects are, the company's growth trajectory isn't free from risk. The nature of Proto Labs' quick-turn manufacturing operating model means that it rarely maintains an order backlog to buffer itself during periods of economic uncertainty should customers decide to postpone or cancel orders.

To be brutally honest, a period of economic uncertainty is inevitable at some point, and would likely cause Proto Labs' shareholders to experience high volatility if customer orders suddenly dried up.

Investors who can endure this potential volatility may find comfort in knowing that Proto Labs' technology-agnostic approach is built to last, because it allows the company's business model to be highly adaptable. Should a promising manufacturing or 3D printing technology enter the market, Proto Labs could merely acquire said technology, offer it as a service, and continue serving its product developers without skipping much of a beat.

Buying is just the beginningBecause the 3D printing industry is expected to grow dramatically in the coming years, it's inviting new forms of competition seeking to cash in on the potential spoils. Well-funded start-ups, academic institutions, and technology giants all have plans to enter the 3D printing space in the coming years. With increased competition on the horizon, the industry is sure to become more cutthroat, and R&D budgets could balloon to help existing 3D printing stocks cultivate new levels of innovation.

For investors considering taking the plunge into 3D printing stocks, the industry dynamics at play will require regular monitoring for material developments that could undermine an investment thesis. As long as the underlying business fundamentals of a 3D printing stock remain intact, enjoy what's sure to be a wild ride.

The article The Best Stocks to Buy in 3D Printing originally appeared on Fool.com.

Steve Heller owns shares of 3D Systems, Arcam, ExOne, and Proto Labs. He may consider putting his money where his mouth is and buying shares of Stratasys in the future. The Motley Fool recommends and owns shares of 3D Systems, ExOne, Proto Labs, and Stratasys. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.