A framework I’ve previously used which is a fantastic way to evaluate thematic investment vehicles’ suitability for inclusion as a part of one’s portfolio is the so-called “trinity” approach of thematic investing. This involves asking three questions of a thematic product – the answers of which should make it apparent whether or not that product is a good fit for you and your portfolio.

Here, I use the framework to analyse the Global X Cloud Computing ETF (CLOU), which is an extremely interesting product in a red-hot thematic space. Up 48.79% YTD, CLOU has been a strong performer since lockdown measures were introduced.

We have probably only seen the tip of the iceberg in terms of what is to come for cloud computing. However, has this inevitable future growth been priced into cloud computing-related companies – have we already seen the best of CLOU? Or has this phenomenal performance for such a large ETP ($1.42bn AUM) just been an indication of better things to come? Let’s take a look under the hood so we can get a better idea of what CLOU is all about and what the future might hold for it.

Is The Theme A Winner?

For those unfamiliar with cloud computing and what it entails, it is basically the provision of computing services (for any number of functions – anything from website hosting to transaction systems, data storage and analysis, real-time sensor analysis, creating and delivering software applications, provision of infrastructure – and everything in between). This is provisioned from a remote location to companies (or, indeed, individuals) who typically pay only for what they use.

Traditionally, companies that needed computing capacity would have had to buy expensive computer servers, software, and other infrastructure.

This was fraught with inconvenience.

The most obvious problem was the high capital expenditure associated with obtaining all of this hardware, software, and infrastructure. You had to store it somewhere and make sure you had exactly the right capacity for your needs. This would make it time-consuming and costly if you subsequently needed to scale up. You also had to maintain it and make sure it all aligned with compliance procedures and regulations. With Moore’s Law, the equipment’s shelf life could also be extremely short. It was a major headache in terms of logistics and cost.

Then came cloud computing.

Cloud computing enables companies to access an absolute myriad of cutting-edge computing capacity and infrastructure – all scalable and reachable at a moment’s notice.

The Amazon Web Services (AWS) platform (NASDAQ:AMZN), which is by a distance the leader in terms of market share for cloud computing (Amazon held 47.8% of market share in 2018, three times more than their nearest competitor Microsoft (NASDAQ:MSFT)), can be used as an example to show some of the benefits the cloud can provide for enterprises. As AWS themselves put it:

AWS has the services to help you build sophisticated applications with increased flexibility, scalability and reliability. Whether you’re looking for compute power, database storage, content delivery, or other functionality, with AWS you pay only for the individual services you need, for as long as you use them, without complex licensing… The cloud allows you to trade fixed expenses (such as data centers and physical servers) for variable expenses, and only pay for IT as you consume it. And, because of the economies of scale, the variable expenses are much lower than what you would pay to do it yourself… By paying for services on an as-needed basis, you can redirect your focus to innovation and invention.

Customers gain from the enormous economies of scale that cloud computing providers offer, which they could typically never hope to achieve if they bought their own infrastructure. Most of the biggest names in business see these benefits and leverage its use, and SMEs are quickly following suit. For examples of some of the behemoths using cloud computing capacity, Netflix (NASDAQ:NFLX), Reddit, AOL, and Pinterest (NYSE:PINS) all use AWS as their host server.

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Cloud computing is set to grow exponentially as more and more businesses realize the benefits on offer, and also as more sophisticated computing methods (think quantum computing) which would have prohibitive infrastructural costs for most firms but incredible benefits to those who can harness their use, become available.

The global cloud computing market was estimated to grow at an 18% CAGR up to 2023. Yet, this estimate was made before COVID-19 restrictions were put in place, and more companies than ever came to realise the value of a virtual presence over a physical one. This CAGR will, therefore, undoubtedly increase as companies’ budgets begin to normalise, and they invest further in their technological capacity.

Therefore, is the cloud computing theme a winner? I view it as one of the most obvious investable growth areas available to investors today. I can answer this with a resounding yes.

Does This Product Capture The Theme Effectively?

The ETF ecosphere and, indeed, the asset management world at large have been guilty on numerous occasions of offering products that don’t really do what they say on the tin. There is no point investing in a thematic ETF even if you have identified a winning theme with clear growth prospects if the constituent companies of your product are only tangentially related to that theme – i.e., only garner a small bit of their profits from the business activity in question. Or, worse again, you could buy into a fund thinking it is a thematic or factor-oriented fund when it turns out to be a closet index tracker.

Such has been the prevalence of this issue that there are now even tools designed to help you identify closet trackers.

It would be sickening to buy a product whose name aligns well with your investment thesis, only for you to be correct in your thesis, and the product not to follow suit price-wise as it is not directly invested in companies which derive the majority of their profits from that theme. This is why it is imperative that you look beneath the hood when investing in a thematic vehicle.

CLOU has an extremely interesting basket of companies. It contains all of the major cloud providers (Such as Amazon, Microsoft, Google (GOOGL), Alibaba (BABA), and IBM (IBM)) – however, these don’t dominate the basket. They make up just 7.089% collectively. This is interesting as these are the big names you would expect to dominate a cloud computing index, but, in reality, they derive a large amount of their profits from other business activities. Although you would expect them to show a decent correlation with growth of the cloud, it is hardly the benefit you would get from companies directly invested in it. Their share prices could also fall for reasons that have nothing to do with the cloud computing arms of their businesses. I think these low, but not insignificant, weightings were an excellent call by the index constructors.

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The biggest constituents of CLOU are companies such as Fastly, Inc. (FSLY), which is an edge-cloud provider; Xero (OTCPK:XROLF), a cloud-based accounting provider for SMEs; and Anaplan (PLAN), a cloud-based planning software company. These come in at 4.382%, 4.285%, and 4.265%, respectively. In fact, the basket is littered with such names – 36 in total – and although the fund stipulates that they cannot invest in companies with market caps lower than $200m, CLOU provides a fantastic mix of global, cloud-related companies that should profit if and when the cloud movement grows and continues to take off. It is certainly not a closet MSCI world tracker.

I think CLOU has invested in a fantastic mix of cloud-related companies, which look to profit from many different angles as and when the cloud industry itself grows. They’ve successfully avoided the temptation to overinvest in the household-name providers who don’t necessarily obtain most of their profits from cloud computing and have instead invested in a diversified basket of stocks concentrated on the cloud computing theme.

Does this product, therefore, capture the theme effectively? I would say without a doubt.

Has The Theme’s Potential Already Been Priced In?

All too often, a secular or structural trend’s impending growth becomes apparent to investors, who then attempt to front-run the theme by investing in it, creating a bubble, and sending prices over-and-above what the companies’ intrinsic values will ever plausibly reach.

For a lucid example of this, look at the internet bubble that formed in the late 1990s and early 2000s. Any company whose business activities or name bore any relation to the internet saw their stock valuations soar at that time, above and beyond what their cash flows were ever likely to justify.

Was this to say that investors at the time were wrong about the impending internet revolution? No. In fact, they were absolutely correct – the internet has shaped the world more than most people could ever imagine. It has become an integral part of the vast majority of people’s lives and dominates business. Yet, most people who invested in the bubble back then lost their shirts when valuations came back down to earth.

I do not believe that this situation applies to cloud computing. Although the valuations of some of CLOU’s constituent companies may at first glance appear high, I believe that the impending growth in the cloud computing space more than justifies these valuations. There is also nowhere near the hype surrounding this theme as there was for the internet bubble. I think it has been underestimated. Many companies still buy their own physical computer infrastructure, but with the safety of the cloud, as well as the performance it can offer and the incredible cost savings, I believe the future of business is going to be cloud-based. This theme has so far to go before the public realizes how much it is going to shape our future. I believe the cloud computing wave is going to be one of the biggest changes to affect business since the introduction of the internet itself.

This is not to say investing in CLOU is without risk – indeed, given the growth of the industry, new players could come and go almost instantaneously. Also, future growth above and beyond what profits could ever justify may have been priced in to some of the constituents of CLOU’s basket.

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However, the size of the basket means that the growth of the companies who stand to benefit from the cloud’s growth will more than compensate for any overvalued companies who have slipped through the net. As things stand, I think it is an excellent price to get into CLOU and invested in the cloud computing space. Despite impressive growth this year, it is still very early days for the cloud computing structural trend.

Traditional metrics (such as the PE ratio) are not going to be of much use here. CLOU is chock-full of growth companies who will be reinvesting their earnings directly back into operations to avoid declaring them as earnings. It is better to look at the growth prospects of the companies, and see if they are likely to grow their business in order to further increase their enterprise value, and so share price.

We have seen that CLOU’s basket is comprised principally of companies that are fully invested in the cloud space, and look to profit as and when the cloud industry grows. According to PWC, cloud spending is poised to increase 19% this year – and this despite an overall decrease in IT spending of 8%! As IT spending normalises, it would be reasonable to assume that this spending will increase substantially.

CLOU has what appears a somewhat high TER of 0.68%. However, for the basket of companies you receive, and the exposure you get, I think this is a very reasonable figure. You’re also getting an extremely high AUM of $1.42bn, which means its median spread is just 0.04% (many ETP’s have a deceptively low TER, but low volume can mean you get hit on the way in or out by a large spread).

In all, given the inevitable growing CAGR of cloud computing, and the way you can leverage the theme through this ETF, I think there is plenty of capital compounding potential of the constituent companies of this ETF to go before we could call CLOU overpriced. It is rare that you can see a theme with such clarity, and such obvious growth ahead of it. I believe cloud computing is such a theme, and CLOU an excellent vehicle through which to track it.

So, has this theme been priced in already? Given the strength of this impending cloud revolution, I would say it is far from being overpriced.

In conclusion, upon answering the three questions asked of CLOU, I think it looks to be an extremely attractive product to allocate a small bit of the speculative side of an investor’s portfolio to. Given its constituent companies, I see it as a fantastic way to track a trend that is in inevitable ascent, and one which has a long way to go before it reaches anything that resembles maturity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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