SKYY - CLOU: A Solid Cloud Computing Recovery ETF

Summary

• With the Fed looking to slow and eventually pause rate hikes in 2023, beaten-down tech stocks are positioned for a recovery.
• Global X Cloud Computing ETF is a solid choice for diversified exposure to SaaS and cloud infrastructure stocks.
• Despite its short history and relatively concentrated portfolio, CLOU has outperformed its peers since inception with a slightly lower risk profile.
• I examine CLOU's index methodology and sector outlook to determine if it is a buy at current levels.

Valuations of most high-growth, low-profitability SaaS (Software as a Service) and cloud computing companies plummeted as the market cycle turned and investors sought stable cash flows, higher yields, and greater safety during the rapid rise of inflation and interest rates.

However, the latest polling data reveals that a majority of economists are predicting that the Fed will indefinitely pause its rate hike campaign after two additional 25-basis-point hikes, leaving the Fed Funds Rate slightly below its previously announced target of at least 5.25%. This news, along with conflicting economic data suggesting that any recession will likely be mild, seems to be quite bullish for equities, particularly those that are highly sensitive to interest rate movements.

So today I wanted be take a look at a couple of beaten-down tech exchange-traded funds ("ETFs"). These are the First Trust Dow Jones Internet Fund ( FDN ) and the Global X Cloud Computing ETF ( CLOU ), to see whether it might be the right time to initiate a position in either or both as a possible SaaS recovery play. This first article will focus on the much smaller and newer ETF of the two, CLOU.

CLOU: A Surprisingly Broad Subsector ETF

Although it is one of the smaller major asset managers with around $40B in assets under management ("AUM"), CLOU's parent Global X is well-known for its large assortment of niche subsector and special-case ETFs, remaining true to its slogan "Beyond Ordinary ETFs." The firm was acquired in 2018 by Mirae Asset Financial Group, South Korea's leading asset management company with over $500B in AUM, so investors can be assured that Global X has solid management and backing.

Launched in 2019, CLOU is a relatively new ETF focused, as its ticker suggests, on companies involved in the cloud computing sector. Its annual expense ratio is fairly high at 0.68% with an occasional semiannual dividend (no dividends were paid in 2020 or 2022). Global X posits that the cloud computing market is forecast to triple between 2022 and 2030 and enjoys a number of structural tailwinds.

Stock Selection

As my followers know, my first step when evaluating an ETF is to look at its stock selection process, which typically follows its underlying index's methodology. CLOU's benchmark is the INDXX Global Cloud Computing Index, which takes a broad view of the cloud computing space, ranging from SaaS providers to data center real estate investment trusts ("REITs") to cloud and edge computing infrastructure companies. I like this approach, as the index is not limited geographically (except for companies whose primary shares are listed in India) and can include up to five REITs.

For a company to be considered for inclusion in the index, it must have a market cap larger than $200M and must derive either 50% of its revenue or at least $500M annually from cloud-based services or infrastructure. From this stock universe, the index selects the top 36 companies ranked by percentage of sales derived from cloud computing activities. These criteria help to create a portfolio that covers a nice spectrum of the technology sector, ranging from large-cap blue chips like Microsoft (MSFT), Alphabet (GOOGL), Salesforce (CRM), International Business Machines (IBM), and Digital Realty Trust (DLR) to smaller pure plays like PAYC, FIVN, and ZS.

Application software comprises over half of CLOU's holdings, with internet services and infrastructure coming in second at 20.5%. It also offers decent international exposure, with 15% of its holdings based in Sweden, Canada, Israel, or China.

Position Weighting

CLOU has several weighting constraints that are imposed upon inclusion and rebalancing each year, although investors will notice that position weightings can change significantly from their initial levels over the course of the year given the high volatility of the SaaS and cloud computing sectors. This is currently the case with CLOU's largest holding, Coupa Software Inc ( COUP ), which recently announced in December that it is being acquired by investment firm Thoma Bravo.

Upon annual rebalancing, the fund's holdings are weighted by market cap with a maximum weighting of 4% and a minimum weighting of 0.3%. Companies that derive less than 50% of their revenue from cloud computing are limited to a max weighting of 2% each, and REITs are allowed to comprise a maximum combined weighting of 10%.

As we can see above, CLOU's top ten holdings comprise 45.5% of its portfolio, so it is much more concentrated and less diversified at 36 total holdings than similarly focused cloud ETFs from WisdomTree ( WCLD ) and First Trust ( SKYY ). In comparison, WCLD's top ten holdings (out of 75) make up only 19% of its portfolio, while SKYY's top ten (out of 67) come closer at 36%.

Performance

Over the last year, CLOU has significantly outperformed its larger peers while slightly underperforming the Nasdaq-100 ( QQQ ). Here, we see the benefits of CLOU's large-cap blue chip exposure and slightly lower risk profile.

With an inception date in mid-2019 and the ensuing COVID crash, CLOU's "long-term" performance does not give us much more insight other than confirming its recent outperformance relative to its peers along with its underperformance relative to QQQ since inception. Students of risk-adjusted performance know that QQQ is difficult to beat over the long term for any tech fund, so time will tell whether CLOU and its peers can outperform QQQ when the tech sector finally rebounds.

Whether SaaS and cloud infrastructure stocks can again outperform the broader tech sector will largely depend on the extent to which their growth can return to pre-2022 levels in the next few years, as current valuations for many pure-play cloud-focused stocks are a fraction of their historical averages and therefore offer significant upside if valuations were to revert to their means. Of course, in many cases those valuations were stretched to begin with, so a reversion to lower levels might be a more realistic expectation.

Worsening economic data could also send these stocks lower along with the overall market, but low-to-negative growth outlooks are already priced into multiple tech sectors from SaaS to semiconductors to data centers, so I personally think the "bad economic news is good interest rate news" logic could very likely send cloud computing shares higher even in the event that a more prolonged recession becomes likely.

Conclusion

Software and particularly SaaS and cybersecurity stocks have taken a particularly hard beating since late 2021 and were the first sector to experience mass layoffs and other cost-cutting initiatives in 2022, which have since rippled through several other sectors to a lesser extent. However, the market's extreme bearishness on software and cloud stocks finally seems to be abating, as poor earnings and growth expectations have been baked into share prices since at least October and may have bottomed with a hard bounce in early November.

While economic risks still abound, emerging data suggests that a deep recession is unlikely to take shape as long as the Fed pauses its interest rate hikes soon. It appears that this may indeed be the case, which should be a boon for rate-sensitive equities like cloud computing stocks. Therefore, I rate Global X Cloud Computing ETF a long-term buy at current levels based on potential macro environment catalysts, already priced-in low growth expectations, and historically low valuations of its holdings.

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