big country
introduce
First Trust Cloud Computing ETF (NASDAQ: SKYY) is an exchange-traded fund that provides investors with exposure to companies involved in the cloud computing industry.The fund has an expense ratio of 0.60% and total assets As of September 1, 2023, the scale under management is US$2.87 billion.net amount Capital flows While SKYY itself has performed strongly in terms of price recently, it has lost about $943 million over the past year.
My last report on SKYY was published in May 2023, in which I expressed my opinion that the fund was too volatile to be worth owning. I don’t think it’s overrated, it’s just too variable. Also, my IRR forecast is slightly over 8% per annum, which, combined and given the volatility characteristics of this fund, is not attractive in my opinion.Since then, SKYY has risen 25.77%, while the S&P 500 U.S. stock index The index rose 9.11%. So while you may say I’m “wrong”, it’s worth recalibrating my thinking and trying to see if my perspective would be different today. The implication based solely on the above information is that SKYY is more likely to be overvalued today given the upside.
new perspective
In this article, I’ll outline my view that SKYY remains overvalued relative to earnings growth expectations given its above-average volatility. Volatility has spiked recently, only upwards, which I think is a better signal of short-term irrational demand and optimism than a sustainable and critical shift in the company’s fundamental trajectory that SKYY faces.
Fund Benchmark and Portfolio
SKYY’s benchmark is the ISE CTA Cloud Computing Index, which is designed to track the performance of major US public companies operating or participating in the cloud computing industry. The index has only 64 constituent stocks, correspondingly SKYY holds 64 stocks. There is a minimum market capitalization of $500 million per holding, and some other basic requirements to filter out illiquid stocks, etc.
Each security selected for SKYY is divided into IaaS, PaaS, SaaS: they stand for Infrastructure as a Service, Platform as a Service and Software as a Service respectively. Therefore, companies may be selected if they operate infrastructure (servers, storage, networking), platforms (virtualization software, middleware, operating systems) or software (over the Internet). Of course, many companies will operate in more than one category. Additional weight is applied to IaaS, followed by PaaS and finally SaaS. So SKYY is actually more of a “hardware” and “backend” bias than investing primarily in software as one might think.
Individual weights are capped at 4.5% and have a minimum of 0.25%, which is a prudent way of managing costs and keeping the fund sufficiently concentrated, which helps if people see potential alpha in the sector. Therefore, a total of 80 securities is a limitation. The portfolio is rebalanced quarterly.
The largest holding is Pure Storage, Inc. (PSTG), a California-based manufacturer of all-flash data storage hardware and software products. The company’s fiscal year 2023 revenue is $2.75 billion and net income is $73.1 million. PSTG represents 4.61% of the portfolio as of September 1, 2023, so due to its outperformance, it will be rebalanced at the next rebalance. However, given the low concentration in any particular holding, the fund is unlikely to rebalance materially across its portfolio.
Other top holdings include Arista Networks, Inc. (ANET), a California-based company that designs and sells multilayer network switches for large data centers, cloud computing operations, high-performance computing and high-frequency trading environments. Software Defined Networking. The company’s fiscal year 2022 revenue is $4.38 billion and net profit is $1.35 billion. ANET represents 4.10% of the portfolio.
Other better-known names include IBM (IBM) (3.98%), Amazon.com, Inc. (AMZN) (3.96%), Oracle Corporation (ORCL) (3.95%), Alphabet Inc. (GOOGL) ( 3.82%) and Microsoft Corporation (3.82%). Microsoft Financial Services (MSFT) has a rate of 3.46%. You can find the full list here, but note that I missed many other companies in these top companies that work on the less consumer-oriented side of the cloud computing industry.
Base Forecasts and Valuations
Benchmark data is limited, but I can refer to Morningstar data for analyst forecasts. This reveals an estimate of 11.17% average three- to five-year earnings growth, a forward P/E ratio of 27.33x (24.90x in my May article), and a P/B ratio of 6.20x (vs. 3.79x previously), implying Including forward return on equity of 22.69% (previously 15.22%). These changes will be due to changes in estimates by the same data provider and rebalancing of the portfolio. Now, on average, the portfolio can generate a higher return on equity, but it’s also more expensive as a result.
I think it makes sense to assume slightly below consensus earnings growth forecasts than being less conservative. I also think that, as before, it’s wise to assume that by year five the P/E ratio will mature and the P/E ratio will be lower. I’m going to assume 22x to keep it consistent with my previous assumptions. This assumes a mature real earnings growth rate of zero over the long run, plus an equity risk premium of approximately 4.50%. That’s likely too conservative, but given the balance of risks, it’s a good place to start.
Based on these inputs, my IRR forecast is similar to before at 8.01% per annum. For simplicity, and considering that the portfolio is overwhelmingly invested and listed in the U.S., I use a U.S. risk-free rate of 4.18% (10-year yield) to arrive at an implied equity risk premium of 3.83%, at fair within range.
author’s calculation
However, as shown in the lower right portion of the chart above, the fund is highly volatile with a three-year beta of 1.46. So, on a volatility-adjusted basis, ERP is closer to a much lower 2.6%. This suggests overvaluation, as ERP in mature markets should actually be in the 3.2-5.5% range. Granted, SKYY’s portfolio has above-average earnings growth potential. Still, one should always make some maturity assumptions, and it’s unlikely that the fund will maintain a super-high average P/E ratio forever and above-average earnings growth rate (excluding the effects of rebalancing).
The goal is to build a model that values SKYY based on what SKYY currently owns, because that’s really what you’re buying. SKYY still seems overvalued to me at the moment, so since my last article (2.89x size), SKYY’s recent gain of 26% compared to the 9% gain of the S&P 500 suggests short-term demand has beyond reason. I believe there are better sources of value in the market, and higher priced ETFs should not be purchased based solely on business quality and valuation. I wouldn’t be surprised to see SKYY underperform in the short term, but as always, it’s worth revisiting again soon.
paper risk
As before, as long as SKYY can continue to rise and outperform, I must be wrong. However, after having already outperformed sharply recently, risks should be reduced and valuations are already looking tight. I can’t control the market, but based on the information available today, I don’t think it is wise to allocate a significant portion of a portfolio to SKYY if one is involved in active management. Given the importance of the cloud computing industry, long-term shareholders may still do well, but short-term performance should be limited by current prices.
