Enterprise software companies had a stellar run in the market in 2020 as this industry was at the center of the thriving virtual world. Global X Cloud Computing ETF (CLOU, Financial) gained a staggering 70% in the last year as investors flocked to software names that were facilitating the work-from-home economy.
Even on the back of a very strong year, Mizuho Securities analysts believe there is more upside in software stocks if investors carefully differentiate between long-term winners and losers. In his annual outlook report, Mizuho analyst Gregg Moskowitz wrote:
"The software sector as a whole remains, perhaps uniquely, well-positioned to weather any lingering economic symptoms of the virus, due to its increasingly low-touch, cloud-delivered, recurring business model, and a range of products that have never been more valuable. Still, given the unusually strong levels of outperformance for the software sector over the past couple of years, we believe the 2021 returns will likely be more moderate."
Opportunities in this business sector should ideally be pursued by growth-oriented investors with an above-average risk appetite as many of the companies representing this industry are very young and susceptible to adverse developments.
Cloud computing will remain strong in the post-recession era
The industry might not be able to grow at the same pace it did in 2020 according to some experts, but there's reason to believe the cloud computing sector is nowhere near maturity from a growth perspective. The global recession and the growth of the stay-at-home economy exposed companies that had not paid attention to improving their cloud infrastructure, and these companies found it difficult to cope up with the new normal. On the other hand, companies who had been investing in improving their IT infrastructure over the last decade were able to transition smoothly, sending a wake-up call to companies who were reluctant to invest in developing their cloud computing capabilities.
According to data from IDC, corporate spending on cloud-related IT infrastructure surpassed non-cloud-related spending for the first time in the second quarter of 2020, growing at a stellar rate of over 34% year-over-year. Growth might accelerate in 2021 and the sector will remain hot according to Gartner Research. In a report published in December, Gartner Research vice president Sid Nag wrote:
"The pandemic validated cloud's value proposition. The ability to use on-demand, scalable cloud models to achieve cost efficiency and business continuity is providing the impetus for organizations to rapidly accelerate their digital business transformation plans. The increased use of public cloud services has reinforced cloud adoption to be the 'new normal,' now more than ever."
Gartner projects the total cloud market to grow exponentially in 2021 and 2022, at a much higher pace than 2020 as business spending on infrastructure development will increase along with the recovery of the global economy.
Source: Gartner Research
A catalyst that could help software stocks is the continued growth of the stay-at-home economy. Even after taking into account the rollout of the vaccination program, many employers and employees have shown a willingness to permanently shift to remote working culture. A study conducted by the Harvard Business School in 2020 found that many companies were benefiting from the work-from-home trend as it had increased the productivity of their employees.
Source: Harvard Business School
As expected, travel and transportation sectors reported productivity losses. The findings of this study highlight that remote working is likely to be a major theme in the future especially in the tech sector as it would help companies reduce their costs while allowing employees to strike a better balance between their work and family life. Cloud computing companies will play a critical role in facilitating this trend, which is one of the primary reasons why this industry can be expected to grow in the next few years.
Companies to look out for
Amazon.com, Inc. (AMZN, Financial), a holding of Warren Buffett (Trades, Portfolio), is the leading player in the cloud computing industry. According to data from Canalys, Amazon Web Services controlled 32% of the total cloud market in the third quarter of 2020, securing the top spot in the industry by a handsome margin.
Source: Canalys
Combined with its strong e-commerce business, Amazon stands out as one of the best companies to invest in to gain exposure to a couple of high-growth industries. There are, however, many other pure-play cloud computing and software companies that could deliver stellar returns because of the appeal of their specialized products and services. Mizuho Securities has identified 8 companies that could potentially deliver attractive returns in 2021 and beyond.
- Salesforce.com, Inc. (CRM, Financial)
- CrowdStrike Holdings, Inc. (CRWD, Financial)
- Palo Alto Networks, Inc. (PANW, Financial)
- RingCentral, Inc. (RNG, Financial)
- Intuit Inc. (INTU, Financial)
- Autodesk, Inc. (ADSK, Financial)
- PTC Inc. (PTC, Financial)
All these companies are trading at stretched valuation multiples. The market is attaching a very high value to the expected growth of these companies, which is not unusual considering the sweet spot the industry is in. If the U.S. economy recovers as expected in 2021, the cloud computing sector will be well-positioned to report strong earnings growth as corporate America is likely to allocate a significant portion of its CapEx budget to improve digital infrastructure.
Investing in the Global X Cloud Computing ETF is another prudent way to gain exposure to this sector because of the diversification benefits that come along with it. The top 10 holdings of the fund account for approximately 43% of the total fund value.
Source: Global X ETFs
Investing in an established player such as Amazon is relatively less risky but the best opportunities in this space might come from lesser-known companies.
Takeaway
Investing in the cloud computing industry is suitable for growth-oriented investors with a long investment time horizon. Many things could go wrong in the short term, but the long-term outlook is promising as the world is increasingly moving toward a digitized future. Corporate spending on IT infrastructure development will likely grow in the economic recovery phase as businesses try to become more resilient to future adverse developments by carefully planning their investments today. Thus, in my opinion, tactically allocating a small portion of a growth investor's portfolio to this high-growth sector could help investors beat the market in the long run.
Disclosure: The author does not own any shares mentioned in this article.
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