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Rise of the Cloud - Have European Investors Underestimated its Potential? | SKYY

While US investors have started to pour considerable assets into Cloud technology companies since beginning of 2019, Europeans have ignored this sector altogether so far. What is the reason for this divergence and who made the better decision? In order to decide this question, our analysis looks at the fundamentals underpinning the Cloud sector and its potential future growth drivers, as well as its historical financial performance.

Clouds are Gathering across the Pond... 

Investors who are already familiar with thematic investments and who are monitoring the multitude of available funds in this space, might have noticed that one particular theme has started to attract a rapidly increasing flow of net new assets in 2019. The theme in question is broadly referred to as the Cloud. And it is not a particularly new theme. The first ETF tracking this sector was launched in the US back in 2011. It quickly attracted inflows from early movers, but it took until 2017 for investors to truly start believing in the Cloud’s potential. As depicted in figure 1. assets in Cloud ETFs globally more than quadrupled over the period 2017-2019 reaching $2.7 bn. However, not all investors seem equally convinced yet. Taking a closer look at the geographic distribution of inflows, we can see a stark divide between US and European investors. Literally 99% of assets went into US domiciled ETFs and are likely held by local investors, with European ETFs currently only amounting to $26m. This divergence cannot be explained by a lack of availability as investors in both regions are already able to choose from three different ETFs tracking the Cloud sector.

Figure 1. Assets in US and European based Cloud ETFs (as of September 2019). 

Source: HANetf, Bloomberg, 08. September 2019. 

So, What is Causing this Divergence? 

Are US investors too optimistic about the Cloud, or have Europeans simply not yet embraced or maybe realised this sector’s potential? One reason might be US investors’ proximity to companies from the Cloud sector. Out of the top 50 Cloud companies, more than 90% are based in North America, with the remainder mostly in Asia. Investors in North America will be more likely to encounter news about these companies in the local media and hence be more aware of the sector’s development and its positive outlook. Also, investors tend to exhibit home bias when investing and hence might be prone to focus their efforts more on local companies, which again would explain why US investors might have realised the potential of cloud companies earlier than investors in other geographic regions.

Cloud ETFs - Hype or Reality? Taking a Look at the Fundamentals

Just because a sub-set of investors decides to invest in a particular group of companies does not mean that others should blindly follow. Sometimes when being too close to a particularly trendy subject, one can get blindsided by exuberant media reports and overly optimistic growth estimates. So let’s take a look at the fundamentals underlying the Cloud sector in order to evaluate the recent vote of confidence from US investors

Figure 2. shows revenue estimates for the sector for the next five years. There are two observations to be made. First, as of 2018, revenues for the sector amounted to $184bn. As an absolute value this is a high number and shows that the sector is already a fundamental part of the wider Information Technology industry. Second, and more important for investors, the sector also shows a high and steady estimated growth rate of 16% for the next couple of years. This number is particularly strong when viewed in the context that the Cloud is not a fundamentally new technology, but it represents a redistribution of existing IT expenditures. Instead of spending money on internal IT, companies can now pay specialised Cloud companies who manage their IT needs in a more secure, scalable and cost-efficient manner. As a result, Cloud companies have two sources of revenue growth, one from redistributing the existing IT expenditure pie to benefit themselves and one from organically growing that pie by adding and improving services.

This is a powerful proposition, because once Cloud companies have a proof of concept, showing that they provide services superior to traditional methods, it should only be a matter of time for them to harvest those traditional revenue streams, potentially on a global scale.

Figure 2. Cloud Revenues Growing at 16% Annually 

Source: HANetf; Gartner, April 2019; Statista, August 2019. 

Another exciting fact that investors should take notice of, is the upward revision for Cloud revenue estimates over recent years, which is shown in figure 3. Often, analysts’ predictions of growth rates for new technologies and industries can be overly upbeat and actual numbers tend to underperform estimates, leading to somewhat weaker performance for the underlying companies than originally predicted. However, the Cloud seems to be an exception in this regard. Comparing revenue estimates in 2017 and 2019 made by Gartner, a leading research and advisory company in the technology space, we can see that within the space of only two years estimates have increased by $40-50bn per year, a big relative jump. These types of unexpected upward revisions tend to be catalysts for strong equity performance, as buyside analysts and investors upgrade their equity valuation models based on those improved earnings predictions and then invest in those companies as they are now deemed undervalued based on the new data.

Figure 3. Cloud Revenues Estimates Experiencing Upward Revision 

Source: HANetf; Gartner February 2017 & April 2019.

Has a Cloud ETF Investment Paid off so Far? 

Fundamentally we have showed that the sector looks robust, but has this also been reflected in stock prices of the underlying companies? The short answer is, yes. A more detailed analysis can be found in figure 4. which shows a table comparing the performance of the cloud sector against a range of equity market indices. The Cloud sector is represented by an index which has been in existence since 2011, so it represents actual live data and not a back-test. We can see that on a cumulative five-year basis it clearly outperforms the broader technology market, represented by the Nasdaq 100, as well as the broader US and world equity markets, represented by the S&P 500 as we as the MSCI World. If we return to our initial question whether US investors made the right decision by investing in this sector over the past three years, we can conclude that indeed it was a good choice.

Figure 4. Equity Market Returns for the Cloud Sector

1-year time periods, starting 4th October  Cloud Index Nasdaq 100 S&P 500 Index MSCI World Index
2014/15 7% 7% 1% -2%
2015/16 17% 13% 9% 5%
2016/17 24% 24% 18%  17%
2017/18 28% 22% 13% 7%
2018/19 4% 5% 2% 0%
Cumulative return  108% 93% 50% 29%

Source: HANetf, Bloomberg, 04 October 2019. 

It is difficult to predict whether the mentioned asset growth in ETFs or the upward revisions in revenues will continue into the future. Our analysis might be prone to the same overly upbeat expectations that we cautioned against earlier. But having looked at both the fundamental underlying megatrend that drives the expansion of the Cloud, as well as a range of economic and financial metrics, and also taking into account the strong vote of confidence from a large base of US investors, we believe that companies in the Cloud sector are well positioned to deliver future growth that is both significantly higher than the average economy, and also long lasting.   

Want to invest in Cloud Technology? Find out about the HAN-GINS Cloud Technology UCITS ETF (SKYY) here.

Read our Whitepaper 'Ahead in the Clouds' to learn more about the importance of Cloud Computing.

 Article Date: 13th November 2019.

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