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Cloud computing could be the next big thing. With Steve Jobs’ official introduction of Apple’s (AAPL) iCloud service, the word “cloud computing” was swirling once again in the media last Monday. Speculators may get excited already by the event, but prudent investors want to plan carefully before dipping their toes into the water.

It’s recommended to always prepare for the best, normal, and the worst when it comes to investment. Specifically to cloud computing, the best would be a dramatic growth that rewards investors smartly.

But cloud computing is not a new concept. All its technology building-blocks were ready years ago. If it didn’t make a real splash before, nobody knows whether or when it will take off. The normal case scenario is the expected growth turns out to be yet another mirage.

Investors may also have concerns on tarnished economic growth and lagging employment data. In the worst case, the economy might slip into a recession once the Fed rolls back QE2. If an economic tide ebbs, rich valuation propped by growth expectation would collapse.

We have come up with a three-legged strategy to help investors

  • Profit from dramatic growth of cloud computing
  • Still beat the market by a rich margin if dramatic growth does not materialize
  • Survive an economic downturn if there is any

First, we need to assemble a portfolio of cloud computing companies to profit from dramatic growth of the industry.

Dramatic growth can be nasty. It is often a product of technology revolution fueled by violent competition. In many historical examples such as Railway Mania 170 years ago and the Internet Bubble 10 years ago, technology revolution and violent competition were really two sides of the same coin. The entire society benefited from the former, while investors by and large lost their shirts because of the latter.

Warren Buffett in his 2009 letter to shareholders suggested avoiding dramatic growth, because technology revolution typically had unpredictable financial outcome. Cloud computing investors may have similarly unpleasant experiences. The competitive dynamics could decimate almost all of the companies in the industry. Even survivors may not walk away unscratched.

Because few can be sure about which company will benefit financially at the end, a practical solution is to assemble a representative portfolio of the industry. A portfolio helps investors broaden coverage and diversify risks.

We start with a basket of cloud computing-related software companies recommended by Canaccord Genuity analyst Richard Davis as briefed in a recent Tech Trader Daily blog post on Barron’s. Collectively they represent the industry and have promising growth perspectives. For next steps we will filter out names that may not bode well for our normal or worst case scenario.

Secondly, we consult our fundamental ranking system to gain insight on which company is likely to outperform when growth is stripped off.

We summarize below key attributes of the ranking system. Details can be found in our methodology article: “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return."

  • The ranking system is based on fundamentals. Stocks are ranked by their valuation, financial condition and return on capital.
  • It has predictive power. The ranking system drives short-term return. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100. As a mater of fact, the S&P 500 (NYSEARCA:SPY) Index returned an annualized 2.5% in the same period.
  • Growth is stripped off. Readers may have noticed already that growth is not fabricated into the ranking system. Stocks with rich valuation simply due to their growth potential are not going to have rosy ranks.

We list the names in our basket and their fundamental ranks in the table below. A highly ranked company has sound fundamentals and tends to outperform the market with or without outsized growth. Please ignore “Balance Sheet Rank” for now. We will discuss it later.

Company

Fundamental Rank

Balance Sheet Rank

Autodesk (ADSK)

94.74

98.04

LivePerson (LPSN) *

91.36

91.12

Bottomline(EPAY)

89.39

98.26

Pegasystems (PEGA)

88.93

95.45

Parametric (PMTC)

79.86

97.88

SuccessFactors (SFSF)

79.73

91.12

Constant Contact (CTCT)

76.58

91.12

Descartes (DSGX)

76.48

99.35

SPS Commerce(SPSC)

76.09

98.14

Oracle (ORCL)

75.06

56.91

Monotype (TYPE)

69.82

50.28

Ansys (ANSS)

68.61

75.21

Vocus (VOCS) *

66.31

65.74

Ultimate Software (ULTI)

54.67

76.72

Nuance (NUAN)

54.51

39.15

Intuit (INTU)

54.50

64.77

NetSuite (N)

50.09

92.51

AspenTech (AZPN)

36.91

25.69

Lionbridge (LIOX)

16.59

26.05

Salesforce.com (CRM)

13.02

50.32

* From another Barron's article "Three Cloud-Computing Stocks Set to Rebound"

Personally we are comfortable with ranks above 80. We would also take in Parametric and SuccessFactors as their ranks are just slightly below 80. This shrinks the portfolio to the top six names in the basket.

A stock ranked at 80 has an expected annualized return that is three times market return. The aggregated rank of the entire market should be 50 since it is generally an average of all stocks whose ranks range from 0 to 100. Because in the past 10 years 10 rank points translated to an extra annualized 1.7%, a stock ranked at 80 would have outperformed the market (ranked at 50) by 1.7% x (80 – 50) / 10 = 5.1% annually. Plus a market return at an annualized 2.5%, the total annualized return would have been 7.6%, which is more than three times 2.5%, the market return in past 10 years. That said, historical returns do not guarantee future performance.

Thirdly, we require companies to have solid balance sheet to survive an economic downturn.

A research note by Morgan Stanley showed that strength of a company’s balance sheet is critical in a bear market. A company equipped with low Debt to Equity Ratio, low Debt to Assets Ratio, low Capitalization Ratio, and high Interest Coverage Ratio is likely to stay afloat in a bear market. An Interactive Investor blog post offered a nice introduction.

To quantify strength of balance sheet, we compile Balance Sheet Ranks for companies based on the four ratios. The ranks are listed in the same table. Fortunately, all the top six companies’ balance sheets are ranked above 90, indicating their balance sheets are stronger than that of 90% of companies in the market.

Therefore our final cloud-computing portfolio consists of Autodesk (ADSK), LivePerson (LPSN), Bottomline (EPAY), Pegasystems (PEGA), Parametric (PMTC), and SuccessFactors (SFSF). The portfolio is prepared to benefit from exceptional growth of cloud-computing. If growth fails to take off, the portfolio is expected to still beat the market by three times. And it would survive an economic downturn if there is any.

Lastly we would recommend that investors assign equal weights to those companies in the portfolio. A market weight portfolio favors large caps, while an equal weight portfolio favors small caps. Small caps in general have more room to grow and large caps have more resource to survive. Because downside risk is limited by solid balance sheets, investors may want to favor small caps for better growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Cloud Computing: Design a Portfolio for the Best, Normal and Worst