WisdomTree Cloud Computing ETF (NASDAQ:WCLD) owns a diversified portfolio of companies with extraordinary growth rates and offering exposure to exponential opportunities over the long term. Cloud computing stocks were already thriving before the pandemic, and recent developments are accelerating the adoption of these technologies in many cases.

Cloud computing stocks are still expensive from a valuation perspective, but it is very hard to put a fair value estimate on companies benefiting from accelerating demand and abundant room for further growth. When the quality of the business is so good, the fair price is hard to assess.

WisdomTree Cloud Computing ETF is in a strong uptrend, and it has recently pulled back from overbought levels. For investors with moderate risk tolerance who are looking to gain exposure to many of the most promising growth companies in the market, this could be a good entry point to start buying the cloud computing ETF in small size.

The cloud computing revolution is not only transforming the software industry, but it is also having a major impact across all areas of the economy and our lives. The transformative impact of the cloud still has enormous room for growth in the years ahead, and demand is even accelerating in many areas due to the pandemic.

Source: WisdomTree

The business model is exceptionally attractive. Companies in cloud software generate recurrent revenue, attractive growth rates, and huge gross profit margins. This combination of recurrent revenue from customers and abundant potential for long-term growth is practically impossible to find in other sectors.

Aggressive investments in R&D and marketing generally take a toll on operating margins, so most of these companies are reporting losses at the operating level on a GAAP basis. However, for investors who can look beyond the short-term numbers and into the long-term potential, this should be no reason to stay away from cloud stocks.

The table below shows the top 10 positions in WisdomTree Cloud Computing ETF. These names account for nearly 30% of the portfolio, so the fund is well diversified.

Source: Seeking Alpha

Depending on the specific companies and their market niches, some of these names could be hurt by declining corporate spending during the pandemic and the recession. However, many of the companies in the portfolio also benefit from accelerating adoption for all kinds of cloud technologies in areas such as communications, productivity, digitalization, online content, and online commerce, to name a few examples.

In the words of Twilio (TWLO) CEO, Jeff Lawson, during the company's earnings conference call:

While we wouldn't have wished it this way, in many ways, Twilio was built for this. Our platform provides three things the world needs, digital engagement, software agility, and cloud scale. Technologies such as messaging, email, voice and video have enabled many parts of the economy to continue working, while keeping its participants safe. Moving quickly, building prototypes and iterating as our needs evolve has been critical for nearly every kind of organization. That's the essence of agility. And Twilio has enabled organizations to reimagine many of their communications workloads in days and weeks, not months and years.

The portfolio of WisdomTree Cloud Computing ETF has a high proportion of relatively young companies in the software sector. This provides superior performance in terms of both revenue growth and gross profitability. Not only in comparison to the market in general and growth stocks, in particular, but also when measured against the larger and more mature software companies.

Source: WisdomTree

Source: WisdomTree

Looking at the price chart over the past several months, WisdomTree Cloud Computing ETF has been in a strong uptrend, and it has pulled back considerably within that uptrend over the past three days. The ETF is nowhere near oversold, but it is not too overbought either at current prices, and the uptrend remains intact for the time being.

In order to assess the timing for an entry in WisdomTree Cloud Computing ETF from a quantitative perspective, we can take look at the instrument through the ETF Timing Algorithm. This is a quantitative ranking system that places different ETFs in order based on momentum and trend indicators. The factors that go into the algorithm and their respective weightings are available below.

The algorithm looks for ETFs that are delivering consistently high momentum metrics across different time frames: The past 3 months, the 3 months periods 3 months ago, and so forth. Winners tend to keep on winning more often than not in the stock market, and there is plenty of statistical research proving that capitalizing on momentum can be a powerful strategy for superior returns.

However, the algorithm also gives a negative weight to one-month momentum. The main idea is looking for consistent strength across different timeframes but also giving a negative weight to short-term momentum in order to look for assets that are not too overextended in the short term.

The chart below shows the historical returns for ETFs in different ranking segments versus the 60/40 benchmark. ETFs with a high ranking tend to significantly outperform the benchmark, and there is a direct relationship between the ETF Timing ranking and performance.

Data from S&P Global via Portfolio123

WisdomTree Cloud Computing has a timing ranking above 98, meaning that the ETF is in the top 2% among thousands of ETFs ranked in the comparison. The instrument has unquestionable strength over different time periods, and it fits the description quite well if you are looking to buy assets in an uptrend but not too overbought in the short term.

Momentum is a double-edged sword, and assets that deliver big gains on the way up can many times be the same ones that deliver big losses on the way down. A position in WisdomTree Cloud Computing necessarily carries substantial volatility, for better or for worse.

The stocks in the portfolio are also relatively expensive when looking at traditional valuation ratios such as price to sales or enterprise value to EBITDA. Companies with superior growth prospects obviously deserve above-average valuations, and valuation ratios should always be assessed for each specific company in the context of other return drivers, considering not only the price tag but also the quality of the business.

However, it is fair to say that demanding valuations is a major risk factor for investors WisdomTree Cloud Computing ETF. At these prices, there is not much room for error, and the stocks in the portfolio could suffer serious drawdowns if the companies fail to deliver in accordance with growth expectations.

Valuation risk cannot be avoided in these kinds of companies, but it makes sense to manage it via position size. Cloud computing stocks are generally very volatile, so you don't need to build big positions in these names in order to benefit from rising prices when they work out well.

It can make sense to consider buying WisdomTree Cloud Computing in a small size at these prices, always keeping some cash on the sidelines to buy more, in case there is any correction and valuations become more attractive.

It is important to keep in mind that risk is not only what you buy but also how much you buy. Having a moderately-sized exposure to a diversified group of high-growth stocks in the cloud computing segment makes a lot of sense when considering the potential reward versus the risk over the years ahead.

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Performance as of July 14, 2020

Disclosure: I am/we are long FSLY, DOCU, TWLO, CRWD, PYPL, SQ, CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own several of the stocks in the WisdomTree Cloud Computing ETF portfolio, and I may initiate a position in WCLD over the next 72 hours.

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WisdomTree Cloud Computing ETF: Explosive Growth And Solid Timing - Seeking Alpha