SKYY ETF Is A Buy For Exposure To Cloud Computing Growth (NASDAQ:SKYY)

Investment Thesis

The United States has the most advanced software and IT services industry in the world. In addition, more than 34% of the $5.2 trillion global IT market is in North America, primarily the U.S. U.S. software firms generally operate in a mature, harmonized market and have a reputation for producing reliable and effective solutions that are adopted quickly by the market. International companies and top international talent have shown a keen interest in the U.S. market because of its strong intellectual property rights laws and enforcement, as well as to access one of the leading financial markets. U.S. companies lead the world’s packaged and custom-software markets and are competitive in nearly all other market segments with a stable overseas market share.

Cloud computing, in particular, is one of the areas of focus given the segment’s high growth potential. According to Business Wire, the global cloud computing market is expected to grow from $445.3 billion in 2021 to $947.3 billion by 2026, at a compound annual growth rate of 16.3%, which is much higher than the forecasted US GDP growth rate over the same period. Some of the growth catalysts include the inclination of enterprises toward automation, the need for enhanced customer experience, and the surging demand for remote workspaces. In this article, I will be reviewing the First Trust Cloud Computing ETF (NYSEARCA:SKYY) which invests in a basket of cloud computing companies.

Strategy Details

The First Trust Cloud Computing ETF tracks the performance of the ISE CTA Cloud Computing Index. The index is a modified equal-weighted index designed to track the performance of companies involved in the cloud computing industry. To be included in the index, a security must be classified as a Cloud Computing company by the Consumer Technology Association (CTA) and meet the following criteria:

• A minimum market capitalization of $500 million.
• Minimum free float of 20%.
• Minimum three-month average daily dollar trading volume (ADDTV) of $5 million.

Each security is then classified according to the following three business categories:

• Infrastructure-as-a-Service (IaaS): Companies that deliver cloud computing infrastructure – servers, storage, and networks – as an on-demand service.
• Platform-as-a-Service (PaaS): Companies that deliver a platform for the creation of software in the form of virtualization, middleware, and/or operating systems, which are then delivered over the Internet.
• Software-as-a-Service (SaaS): Companies that deliver software applications over the Internet enabling other companies to conduct their operations using the application.

If you want to learn more about the strategy, please click here.

Portfolio Composition

From the industry allocation chart below, we can see the index places a high weight on the software industry (representing around 48% of the index) followed by IT services (accounting for 22% of the index) and Technology Hardware, Storage & Peripherals (representing around 7.5% of the fund). The largest three industries have a combined allocation of approximately 78%.

In terms of geographical allocation, the top seven countries represent approximately 99.9% of the portfolio. The United States accounts for 87.57% whereas other countries such as the Netherlands seem to be underrepresented given the low weight (only a 0.36% allocation to the Netherlands).

The fund is currently invested in 67 different stocks. The top ten holdings account for ~37% of the portfolio, with no single stock weighting more than 5%. All in all, I would say that SKYY is pretty well-diversified across constituents.

Since we are dealing with equities, one important characteristic is the valuation of the portfolio. According to First Trust, the fund currently trades at an average price-to-book ratio of 5.62 and an average price-to-sales ratio of 4.06. Although these multiples might seem high, keep in mind we are dealing with software companies that generally have an asset-light business model. For this reason, I am not surprised to see that SKYY has a price to book ratio above 5. If we turn to the price-to-sales multiples, I wouldn’t say it is egregiously expensive. For instance, Microsoft Corp. (NASDAQ:MSFT) is currently trading at more than 12x TTM revenue.

Is This ETF Right for Me?

SKYY has a distribution rate of ~1%. Given the low dividend yield, this ETF is not suitable for the dividend investor. However, if you are looking for capital appreciation, SKYY offers you a way to potentially outperform the S&P 500. I have compared below the price performance of SKYY against the price performance of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and the Invesco QQQ ETF (NYSEARCA:QQQ) over 5 years to assess which one was a better investment. Over that period, SKYY outperformed SPY. Compared to the S&P 500, SKYY rose by more than 48 percentage points. To put it into perspective, a $100 investment in SKYY five years ago would now be worth $236.54. This represents a CAGR of ~19%, which is a very good absolute return. However, it is worth noting that SKYY failed to outperform QQQ over that period, although SKYY was leading up until late 2021.

If we take a step back and look at the performance from a 10-year perspective, the results don’t change much. QQQ finished once again on top, and SKYY clearly outperformed the S&P 500.

Key Takeaways

In my opinion, the Tech sector, and particularly cloud computing, is going to continue on a strong growth trajectory. I think that SKYY is a great tool to get exposure to this megatrend. This ETF is a cost-effective way to buy a basket of leaders in this field. Moreover, I like the fact that SKYY is well diversified across constituents, with no single issuer weighing more than 5% of the portfolio. In my opinion, the recent pullback provides an entry point, and if SKYY goes lower, it is an opportunity to accumulate at lower prices and build a position around it.