Long Term Outlook for Software/Cloud Computing Seems Sunny

“Software is eating the world.”

Though Internet entrepreneur Marc Andreessen famously wrote those words eight years ago, the phrase is still—and maybe more—relevant today than ever. What product doesn’t have some software either embedded in it or connected to it, whether cars, clothes, appliances, homes, you name it. And more importantly for investors, the computing and artificial intelligence (AI) explosion is probably nowhere near done. Not even close.

Software, and cloud computing applications in particular, are proliferating like a weed. And not just for consumer facing applications, but practically in every business. Your local auto mechanic as well as the global giant bank JPMorgan rely heavily on software solutions, to make their processes more efficient and improve customer relations, among other things. I’d say that AI remains in the nascent phase of its life.

What about the software/cloud stocks? Many investors balk at the prices and valuations of software and cloud computing stocks, though the stocks are down. And really, from a traditional valuation metric, you can’t blame them.

Typically, they trade at nose-bleed price/earnings ratios, and pretty much any other metric you might choose. Take a look at the price/earnings (P/E) ratios in the table below. P/Es in the triple digits. They are not cheap at all, whether compared to the market, which trades at 15-16 times, nor to the older more established software companies, which trade at 20-40 times, nor other companies in the S&P 500 index.

Long Term Outlook for Software/Cloud Computing Seems Sunny
Source: FS Insight, FactSet

I wouldn’t blame you if you thought a $1.2 million Ferrari SF90 Stradale might seem a better value. But then the market isn’t growing anywhere nearly as fast as these companies will likely grow in the next five years. This is key.

And with the market sliding hard in May and June on various medium-term concerns, like the tariff wars, and the stocks themselves weak, it’s a good time to consider this sector for the long term, despite those high valuations.

Let’s take a look at some industry sales growth estimates from Gartner, a research and advisory company. According to recently released data, the worldwide public cloud services market is projected to grow 17.5% this year to $214.3 billion, up from $182.4 billion in 2018. From there, the company predicts sales of $331 billion in 2022, compound growth of about 13%.

There are few sectors that can compete with a number like that, which might even prove to be too low. Gartner went on in its report to say “we know of no vendor or service provider today whose business model offerings and revenue growth are not influenced by the increasing adoption of cloud-first strategies in organizations. What we see now is only the beginning…. Through 2022, Gartner projects the market size and growth of the cloud services industry at nearly 3x the growth of overall IT services.”

According to recent Gartner surveys, more than a third of organizations see cloud investments as a top three investing priority, which is impacting market offerings. Gartner expects that by the end of 2019, more than 30 percent of technology providers’ new software investments will shift from cloud-first to cloud-only. This means that license-based software consumption will further plummet, while SaaS and subscription-based cloud consumption models continue their rise.

Sure, a recession could certainly dent the thesis, but only temporarily, in my view. This is a long-term theme, with a strong return potential over the next five years for the patient investor.

Similarly, believe it or not, two decades ago, there were many naysayers in the case of Amazon and Google, and both were selling at very high valuation metrics. Some of these companies will grow into their high valuations and some won’t, which is why the exchange traded fund approach might be valuable at this stage of the sector’s evolution.

Long Term Outlook for Software/Cloud Computing Seems Sunny
Source: Gartner (April 2019)

You might ask, well how do I pick the next Amazon? We don’t pretend to know the answer, but you don’t have to. Exchange Trade Funds are simple ways to play various investment themes—there are thousands of them—and there are several for the software and cloud computing sectors. I’ll name just three—all of which are down about 6%-7% from highs—just as examples not recommendations: First Trust Cloud Computing ETF (SKYY), SPDR® S&P® Software & Services ETF, and Global X Cloud Computing ETF. You can find plenty more at www.etf.com or www.etfdb.com.

Where could I be wrong? These stocks go down in a market rout and they will go down hard. So if you are convinced a bear market is in the offing, then don’t buy them. On the other hand, this a long-term call and any rout today could be a distant memory five years out.

Disclosures (show)

Sign in to read the report!

We have detected you are an active member!

Ray: 30f886-168573-4a39f2-b1ca6b-006cca

Want to receive Regular Market Updates to your Inbox?

I am your default error :)

Events

Trending tickers in our research