2023-05-12 01:10:15 ET
Summary
- First Trust Cloud Computing ETF invests in cloud computing companies.
- The fund is not overvalued on the basis of its underlying earnings capacity.
- However, the earnings multiple is rich, which I doubt will hold for too long. Further, the fund is volatile.
- While SKYY may perform reasonably well in the long run, on a volatility-adjusted basis, I would argue it is a sub-par fund and worth avoiding on this basis.
Introduction
First Trust Cloud Computing ETF ( SKYY ) is an exchange-traded fund that invests in mostly U.S. cloud computing companies. Total assets under management came to $2.46 billion as of May 10, 2023, with an expense ratio of 0.60% at present, and a bid/ask spread of 0.03%.
In an increasingly technological world, SKYY's investment proposition seems fundamentally strong from a business standpoint. However, it is worth reviewing SKYY from a fundamental valuation standpoint; a collection of strong businesses does not necessarily result in a collectively good investment if the price is too high. SKYY has performed well year-to-date (+12.37% at the time of writing), but over the past year the fund has risen by only +1.17% (as compared to the S&P 500's moves of +7.72 and +4.68%, respectively). SKYY has in fact managed to maintain this performance in spite of net fund outflows which have summed to a massive $1.2 billion over the past twelve months.
It seems as though SKYY's investor community is tepid; 2022 was bad for stocks, and SKYY's investors may have been over-levered or sensitive to risk. SKYY was however admittedly quite volatile in 2022, more so that the broader U.S. market indices. I calculate the fund's three-year beta relative to the S&P 500 as 1.44x, which does indeed make the fund considerably volatile on a relative basis. The annualised standard deviation is 26% vs. the S&P 500's 18% over the same period. The correlation is also high, at 0.82x overall. So, SKYY is clearly a high-beta bet on technology.
Methodology
Per First Trust's website , the ETF invests pursuant to its index which tracks the performance of cloud computing companies as classified by the Consumer Technology Association. To be included in the portfolio, companies must meet criteria involving market capitalization (more than $500 million), free float (at least 20%), and trading volume. Companies are classified into Infrastructure-as-a-Service (or "IaaS"), Platform-as-a-Service (or "PaaS"), and Software-as-a-Service (or "SaaS") categories. A "modified theme strength-weighted" methodology is used, calculating a cloud score for each security based on its business categories. Security weights are determined by dividing each company's score by the total sum of scores, with individual weights capped at 4.5% and no lower than 0.25%. The index is limited to 80 securities and is reconstituted and rebalanced quarterly.
As of May 10, 2023, SKYY had 65 holdings, safely under the 80-cap limit. The top holdings at that time are presented in the table below.
While the fund is relatively concentrated, the top 10 holdings together represent less than 40% of the overall portfolio, while the top 10's composition is fairly even. The largest holdings are household names: Microsoft Corporation ( MSFT ), Alphabet Inc. ( GOOGL ) which is the owner of Google, and Amazon.com, Inc. ( AMZN ).
Geographical Exposures
While SKYY invests mostly in U.S. companies, the fund also has holdings in Canada (2.9%), Germany (1.46%), and Israel (1.25%) (see chart below).
It is important to account for the geographical exposures when calculating the fund's weighted risk-free rate and country risk premium, however in this case we are clearly looking at a mostly U.S. equity fund.
Return Profile
Financial data for this portfolio are limited on a trailing basis. I will focus on Morningstar 's current estimate for forward price/earnings: 24.90x as of April 23, 2023. The price/book is reported as 3.79x. This implies a forward return on equity of 15.22%, which is surprisingly low for a relatively expensive fund with an implied forward earnings yield of just 4.02%. Also, the indicative dividend yield was reported as 0.97%, which suggests a roughly 30% distribution rate of earnings which I will account for. Morningstar also offer a three- to five-year earnings growth rate of 11.86% by their consensus.
Holding most factors constant, but assuming no IRR-enhancing share buybacks for the moment, and also assuming that the forward earnings multiple matures to a lower 22x (to err on the side of conservativeness), my model indicates that SKYY offers a five-year IRR potential of about 8.24%. Bear in mind I have assumed that the fund's portfolio's return on equity softens from an average of 15% to a lower 13% over this six-year period (i.e., through to the terminal year six).
This is a fine return in nominal terms, however I must remind you of the volatility of this fund; with a three-year beta of 1.44x, investors are paying up for the privilege of owning SKYY. On a volatility-adjusted basis, the ETF is below average by my experience. For the same level of risk, I think that owning the S&P 500 would be a safer choice; you have exposure to more companies, more sectors, broadly less volatility. Sure, SKYY has the chance to out-perform, but its volatile nature can work against you too. On valuation, the IRR in my base case is not even nominally high, either.
I don't think you would want to give the fund too much benefit of the doubt regarding earnings growth; my assumptions are in line with return on equity potential (although I suppose you could hold the ROE higher for longer). You could question my softer earnings multiple assumption, but I just think a 25x multiple would be far too rich in five years' time for a more mature portfolio. I would place a multiple of roughly 18x on a mature U.S. portfolio with low real earnings growth. For example, an equity risk premium 5.5% with zero real earnings growth (e.g., inflation of 2%, and nominal earnings growth to perpetuity of 2%) is 18.18x if you divide 1 by the net 5.5%. A multiple of 25x is rich, and with a return on equity of circa 15%, SKYY's forward earnings capacity is just not demonstrably high enough to justify this forever.
In summary, SKYY's investment theme is relevant and appealing, but the valuation of the fund is not particularly interesting, with an IRR of maybe 8-10% if you are lucky. Meanwhile, SKYY is volatile; on an adjusted basis, I would stay away.
For further details see:
SKYY: Cloud Computing Stocks Are Too Volatile To Own