One of the groups of stocks that have outperformed over the last year, and over the last decade, are cloud stocks. Most companies in the world are in the process of migrating some or all of their computing needs to the cloud. Cloud technology is also enabling an entirely new generation of industries.
It’s inevitable that many of the multibagger stocks of the next decade will be connected to cloud technology in one way or another. In this article we explore the different types of cloud companies and highlight some of the stocks to keep an eye on.
- What is cloud computing
- Advantages of cloud technology
- Disadvantages of cloud technology
- Why invest in cloud technology?
- Types of cloud technology companies
- How to analyze cloud computing stocks
What is cloud computing
Cloud computing refers to the delivery of computing services via the internet. Services that can be provided using cloud technology include processing power, data storage, networking, and software applications. Cloud technology allows these services to be made available on an on-demand or subscription basis. Most cloud applications and services can be accessed via a web browser, or via an application. If services are accessed via an application, most data and processing is still located in a data center.
When we refer to the cloud, we are talking about a network of data centers that house servers and networking equipment that are accessed via the internet or via private networks. Companies can use cloud computing services for their own computing needs or to offer services to other users. Public cloud services are those services made available to a wide audience. In a public cloud, hardware is shared by different users. All that is required to access a public cloud is a reliable internet connection.
Companies can also set up a private cloud for sensitive data and applications. In this case servers are located on site, or in a dedicated data center. A private cloud can be accessed via a private network or a VPN (virtual private network) on the internet. Most large organizations use hybrid clouds, combining public and private clouds. This gives them greater control over security where necessary, while also offering the flexibility of a public cloud.
Advantages of cloud technology
Cloud technology offers users several significant advantages. Most important among the benefits of the cloud are flexibility and cost saving. Rather than buying and managing hardware and software, companies and individual users can access a service when they need it and only pay for what they use. Not only is this cheaper, but companies can scale without needing to plan for the future.
Serverless computing allows large companies to outsource certain functions like backing up data and disaster recovery, security, and network management. It also allows companies to periodically access exceptionally large amounts of processing power to run machine learning applications. These benefits in turn allow small companies to access a wide range of computing services without having to invest large amounts of capital upfront. It also gives companies access to a wider range of services than they would otherwise be able to afford.
For service and software providers, cloud technology makes new business models possible. Rather than selling software, they can offer services on a pay-per-use or subscription model. This in turn increases the size of their total addressable market. Cloud technology is also essential to many of the current business trends including streaming media, remote working and distance learning.
Disadvantages of cloud technology
While there are many benefits to cloud computing, there are some minor disadvantages. Firstly, cloud applications rely on fast and reliable internet connections. While broadband penetration is relatively high in most cities, there are areas of the world that cannot access cloud services. Furthermore, cloud services are not available if a user’s connection is disrupted. The second disadvantage is that while cloud computing offers a lot of flexibility, it can be difficult to move to a new cloud platform. If service levels fall, or pricing is too high, changing cloud providers can be a time consuming and costly exercise.
In some instances, increasing the distance between a user or device and the server on which data is processed can increase latency. This is especially relevant to IoT devices that gather and process data in real time. The solution to this is edge computing which brings certain applications to the edge of a network and closer to where data is gathered. Although edge computing does the opposite of cloud computing, the two technologies are viewed as complimentary.
Why invest in cloud technology?
The cloud industry is one of the fastest growing areas of the technology sector. Many cloud technology companies and their stocks have performed very well during 2020, despite the covid-19 pandemic. While historical growth has been strong, there is a long way to go as businesses migrate more activities to the cloud. In 2019, global cloud revenue topped $233 billion, but the industry is expected to generate $1 trillion in revenue within the next five to seven years.
In addition, the flexibility that cloud computing offers makes a large number of new services and business models possible. Investors can now participate in brand new industries with massive potential markets. Cloud technology is also the backbone for many of the companies riding the megatrends that are shaping the investment landscape. Investors can invest in the companies that provide cloud infrastructure and the hardware that goes with it, as well as the companies leveraging the benefits of cloud technology.
Types of cloud technology companies
Companies in the cloud space can be divided between three levels according to the services they provide. The largest cloud providers typically operate on multiple levels, while smaller players operate on just one level.
- Infrastructure as a Service (IaaS)
- Platform as a Service (PaaS)
- Software as a Service (SaaS)
- Other related companies
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Infrastructure as a Service (IaaS)
IaaS platforms provide the basic data center infrastructure including servers and networking to their customers. Essentially, IaaS platforms provide their customers with scalable, virtual machines that they can use for any computing function. This gives customers the greatest flexibility, but customers are still required to provide and manage the operating system, middleware, data, and applications.
This segment is dominated by the big three of cloud computing; Amazon, Microsoft, and Google. But there are other IaaS providers including the largest of china’s tech giants, IBM, and Oracle.
- Amazon (AMZN) – Amazon Web services (AWS) is currently the largest cloud company in the world. In fact, the Amazon cloud business is responsible for most of the company’s earnings growth. The Amazon cloud IaaS platform is EC2 (Elastic Compute Cloud). Customers can rent virtual machines on which to run any applications with full scalability. Customers can run and terminate applications as needed, and only pay when a server is being used.
- Microsoft (MSFT) – Microsoft Azure offers a wide range of cloud solutions across all three levels of cloud computing. The Microsoft cloud IaaS offering provides virtual servers to large corporations. Companies can develop their own software or run third party applications and databases on these servers.
- Alphabet (GOOG/GOOGL) – The Google cloud platform is also available on all three levels. The IaaS platform is Google Compute Engine (GCE). Customers run their virtual machines on the same infrastructure that Google uses to run its search engine, YouTube and other applications.
- Alibaba (BABA) – Alibaba runs its e-commerce businesses on the same infrastructure that it rents out to clients. Alibaba Cloud dominates the cloud industry in China, with a range of products and applications dedicated to data analytics and storage.
- IBM (IBM) and Oracle (ORCL) joined the cloud revolution later than their competitors but are working hard to catch up. Their IaaS platforms are more complex and give clients access to a wide range of services suited to the corporate market. IBM and Oracle have the benefit of strong corporate relationships and may be able to gain market share amongst the corporates that migrate to the cloud later.
Platform as a Service (PaaS)
PaaS platforms provide the same infrastructure as IaaS platforms, and in addition an operating system, middleware, and runtime. Customers can then develop and distribute their own applications using on the platform. PaaS platforms allow companies to develop, use and distribute applications and databases without having to invest in hardware.
Most of the IaaS companies mentioned above also offer PaaS solutions. Smaller niche operators offer platforms with tools for specific functions. Microsoft, Amazon, Alphabet, and IBM as the giants of the cloud industry all provide PaaS services as well as their IaaS platforms.
- Microsoft Azure can also be used as an environment for programmers to develop and run applications using Microsoft’s own development tools.
- Amazon’s Elastic Beanstalk is a platform for developers to build and run web applications. Apps can be written in several programming languages. The platform handles deployment, load balancing and autoscaling.
- Google App Engine is the Google cloud offering for developers to build and run applications.
- IBM acquired Red Hat in 2019 to enter the PaaS space. Red Hat OpenShift is a popular opensource platform amongst the development community.
- Twilio (TWLO) – Twilio is a platform dedicated to developing communication tools within other applications. Programmers can use the cloud-based development tools to add voice and text communication functions to the apps they are developing.
- Salesforce (CRM) – The Salesforce PaaS platform allows developers to build applications that interface with the rest of the Salesforce solutions and databases. Salesforce also owns Heroku, a cloud platform that allows developers to build applications using several languages.
- SAP (SAP) – Europe’s biggest tech company, SAP, launched the SAP Cloud Platform in 2012. This PaaS service allows users to build and extend applications in the cloud and quickly build and deploy web applications.
Software as a Service (SaaS)
SaaS companies are the most prolific of the cloud providers. These are companies that allow customers to access software via the cloud on a pay-per-use or subscription basis. A good example of a SaaS product is Microsoft’s Office365. In the past, customers had to buy the Office software suite and install it on their PC.
Office365 now makes the full range of applications, including Outlook, Excel, and Word, available on connected devices including PCs, notebooks, tablets, and smartphones. Our next article will provide a more detailed analysis of SaaS companies, so here we will list just a few examples to illustrate the variety of SaaS applications.
- Netflix (NFLX) the world’s most successful streaming company has revolutionized content distribution by making on-demand video available from the cloud.
- Zoom (ZM) has enabled much of the world’s transition to working from home by making cloud-based video communications widely available.
- Adobe (ADBE) has used the cloud to make its creative software applications available on a subscription basis, thereby increasing its potential market size.
- Slack (WORK) allows teams to collaborate remotely on projects and manage their workflow.
- Cloudflare (NET) provides CDNs (content delivery network) and cloud security to clients via cloud-based applications.
- Shopify (SHOP), which is based in Canada, provides e-commerce and point of sale infrastructure to online stores.
Other related companies
Besides investing in cloud computing services, investors can also invest in the companies that supply the industry. In particular are the many hardware companies that supply the servers and networking equipment for data centers, as well as companies that own and lease data centers.
- Intel (INTC), Nvidia (NVDA) and Micron Technology (MU) all manufacture the chips used in data center servers.
- Arista Networks (ANET) and Cisco Systems (CSCO) make network switches and routers used to build efficient networks.
- CoreSite Realty Corp (COR) and Digital Realty (DLR) are data center REITs. These companies invest in data centers that give their customers access to the cloud.
How to analyze cloud computing stocks
Cloud stocks typically fall into the growth stocks category. This means valuation metrics are of limited use when finding stocks to buy. More important are revenue growth, margin growth and the potential market size. The following are a few of the factors to consider when stock picking in the cloud space:
Price to sales ratio
A lot of cloud stocks are not yet profitable. This means price to earnings ratios are of little use. Instead, you can use the price to sales ratio to compare one stock with another. While the price-to-sales ratio for the broader stock market is around 1.5, for cloud stocks it is typically higher than 5, and can be as high as 50. The higher the ratio the more certain you need to be that revenue growth will continue. Alternatively, if margins are expanding rapidly, a high price to sales ratio may be sustainable.
The rule of 40
A company’s long-term earnings potential depends on revenue growth and margin expansion. The rule of 40 has emerged as a popular way to identify cloud stocks with good prospects. To test a stock, you simply add the annual revenue growth rate to the net profit margin. So, a company with revenue growth of 35% and a net profit margin of 10% will have a score of 45. If the result is above 40, the stock is worth considering. This addresses the tradeoff between growth and margins for growth stocks and ensures that a company scores well on at least one of the two metrics.
Total addressable market and market share
Historical data can only tell you part of the story. Ultimately, long term price targets depend on the potential size of a market, and a company’s share of that market. This part of the analysis is easier said than done, and it’s not easy to assess the potential size of a new market. Generally, you will want to identify the market leaders in each market segment, and make sure that market segment is growing consistently.
Trend and momentum
Investing in growth stocks involves a lot of uncertainty. You can however tilt the odds in your favor by also considering the trend and momentum of a stock’s price. When growth stocks trade on high valuations, the potential for large declines is high. To reduce risk, most investors try to stick with stocks in a clear uptrend and avoid stocks that fall below their 200-day moving average.
Another approach is to invest in a cloud computing ETF (exchange traded fund). The following three ETFs invest in cloud stocks and are listed on US exchanges. Similar ETFs are listed in other markets.
- First Trust Cloud Computing ETF (SKYY)
- Global X Cloud Computing ETF (CLOU)
- WisdomTree Cloud Computing Fund (WCLD)
These funds have all outperformed the S&P 500 convincingly – however, the excess returns do come with increased volatility.
Conclusion – Investing in cloud computing stocks
Competition in the cloud technology industry is likely to increase in the coming years. This means you will need to focus on the high-quality companies and the leaders in each market segment. Nevertheless, there is still a long way to go before the digital economy will be saturated, and some of the best growth stories are likely to come from the cloud space.