When stock markets crash, it is generally the “most expensive” stocks that suffer most and see the biggest drops in their valuation. Investor psychology means that risk appetite plunges when investors are presented with losses. Stocks with valuations seen as stretched, usually because hopes were high for future growth in revenues and profits when markets were feeling optimistic, usually drop quickest.

That often starts a tailspin as more investors sell out in protest at losses incurred (even if they are still in profit over the lifetime of the investment), depressing valuations further.

It’s a scenario veteran investors will be familiar with from the dotcom crash in 2000 and, though less tech-centric, the stock market plunge of 2008/09 during the international financial crisis.

The high growth tech sector has also suffered badly this time around and, like in 2000, has led the stock market slump of 2022. The tech-focused Nasdaq index is, despite something of a recovery over the height of summer, down almost 20% this year and many analysts expect further pain before a sustainable recovery eventually establishes itself.

But while tech valuations were undoubtedly pumped up by a combination of years of easy money flooding the system, something in common with the run-up to the bursting of the dotcom bubble, there are also profound differences.

Ben Rogoff, the lead manager of the Polar Capital Technology Trust, which controls assets of around £3 billion, describes the lead-up to the dotcom crash as featuring a ”much higher level of capital intensity, a lack of profits — or, indeed, revenue — and a far briefer timeline between inception and initial public offering on the stock market”.

While it’s a description that does hold true for some tech stocks, EV start-ups spring immediately to mind, Mr Rogoff believes those factors are much less of an influence this time around. He is broadly hopeful about the general economic outlook and believes that “some of the inflation will, in time, be best understood as another pandemic hangover.”

If that turns out to be the case, inflation may start to drop with less aggressive interest rate hikes by central banks, especially the Fed, than were predicted a couple of months ago. That would be expected to benefit the suffering tech sector, especially companies with strong fundamentals (revenues and profits). However, it will most likely take longer for investors to return en mass to more speculative bets on companies that are yet to generate significant revenues or even profit.

Why cloud computing providers are expected to lead the tech recovery

There is one sub-sector of tech that many believe is particularly well-positioned to see valuations roaring back when market confidence starts to return – cloud computing providers.

Like the broader tech sector, cloud computing stocks suffered sharp falls in their valuations earlier this year. But there is a feeling among many analysts and market commentators that much of that was being swept up in the general market and sector sell-off. As Elliott Robinson, a partner at Bessemer Venture Partners recently stated “we haven’t seen the fundamentals of that basket of businesses really fall off a cliff”.

As a result, and after strong quarterly results and optimistic full-year forecasts, cloud companies have recently regained some ground. And in the mid-to-long term the prospects for cloud computing providers, and companies which offer products and services that enable cloud computing, look very positive.

It’s a generally high-margin sector that benefits from huge scaleability and the sector’s growth prospects for the next several years look very strong. Statista data indicates a 21.27% leap in revenues for public cloud service providers worldwide from $494.65 billion this year to $599.84 billion in 2023.

Public cloud services end-user spending worldwide from 2017 to 2023(in billion U.S. dollars)

Source: Statista

A research report by Market Research Future (MRFR), titled “Public Cloud Market”, states the market could be worth as much as $1386.14 billion by 2030, growing at a compound annual growth rate of 21.4%. That’s huge growth and possible because the cloud computing market is, while already huge, still at a relatively early stage in its maturity cycle as a sector.

Rogoff explains the remaining potential for growth for cloud computing companies with:

“The cloud is still, we believe, around mid-20s-penetrated, so there’s still three times more computing happening outside of the cloud than in the cloud. That says to me we should have years ahead of growth for those companies.”

Cloud computing sector stocks that are bouncing back strong

Almost all the cloud computing stocks and investment vehicles UK-based investors can target for significant or direct exposure to the market are U.S. based. The UK, and Europe, havn’t produced many really significant cloud computing companies yet, with the arguable exception of France’s OVHcloud, whose share price hasn’t yet shown any signs of recovery.

Some of the cloud computing market companies that have recently done well include:

GitLab

GitLab develops tools that help software developers manage source code and saw its valuation plunge by 75% during the tech sell-off that played out between November and April this year. However, despite missing analysts’ forecasts, the company registering 75% year-on-year revenue growth in its latest set of result saw Goldman Sachs upgrade its rating on the stock from the equivalent of hold to buy, writing in a note to investors:

“In the near-term, GTLB is likely to see a more steady demand backdrop (relative to discretionary and complex IT solutions) as it provides key cost savings and operational efficiencies.”

The company’s share price has doubled in three months and could have plenty of growth left in it over the next several years.

Confluent

Another big gainer in the cloud computing sector has been data processing software developer Confluent, which is up around 80% since mid-May and earlier this month posted 58% revenue growth for the second quarter. It also forecast growth for the year to be a minimum 46%.

Confluent has riden out the storm because, as CEO Jay Kreps told analysts at the most recent earnings call, its technology:

“…sits in the operational stack powering applications that directly serve critical business operations and real-time customer experiences. Given this criticality, it can’t be switched off without a complete disruption to the operations of the business.”

Atlassian

Atlassian, which provides collaboration tools commonly used by software developers, is another stock closely tied to the cloud computing sector that has seen strong recent share price growth. Its valuation jumped 36% after Confluent’s quarterly results were published and has gained around 65% in the past three months.

Big Tech – Cloud Computing Providers

The three biggest public cloud computing platforms, Amazon Web Services (AWS), Microsoft Azure, and Google Cloud Platform, are owned by three of the world’s biggest companies. While they are now big enough and profitable enough that they are a big influence on the overall valuation of these companies (AWS has the biggest influence on its parent company’s valuation and Google Cloud Platform the least), the don’t offer direct exposure to the sector because they are one part of bigger groups.

Alibaba, IBM and Oracle are also larger tech groups with significant exposure to cloud computing.

Source: Statista

The Amazon share price is still down over 21% for the year and AWS’s dominant position in the public cloud market could make it worth a look at its current levels. There is also a chance that AWS will be spun out of Amazon as an independent company at some point, something which many analysts believe would see its valuation rocket.

A much higher margin business than retail, in 2021 AWS accounted for just 13% of Amazon’s revenue but nearly three-quarters of their operating profit. This year that share of the group’s operating profit will almost certainly rise again.

Source: The Visual Capitalist

WisdomTree Cloud Computing Fund

Finally, broad, diversified exposure to the cloud computing sector can be achieved through the WisdomTree Cloud Computing Fund, which is exchange traded and invests in normally 90-100 companies exposed to the sector. However, one thing to keep in mind is that the fund is also invested in cloud computing sector companies heavily exposed to consumer spending, like Shopify, which are recovering less well.

There is a growing choice when it comes to investment exposure to the cloud computing market and it’s one investors would do well to have on their radar. Like the rest of the economy, the sector may still experience further volatility and potential valuation losses in the near term. But mid to long term, the successful companies in this sector should enjoy some of the best rates of growth available to investors.