Cloud Investing, Buffett-Style

IBM is a member of the ISE Cloud Computing Index. Launched in July, the index consists of companies "supporting or utilizing" cloud computing, according to its creator, the International Securities Exchange. Alongside the likes of IBM are younger pure-play companies such as Salesforce.com, Rackspace Hosting and VMware. One key difference: IBM sells for 14 times this year’s earnings forecast, while the others fetch three to six times as much.

Cloud computing is a catch-all term for the shift of programs and data storage away from user machines and onto the Internet. Investors are enamored of the trend; the ISE index is up 277% over the past three years, versus 11% for the Standard & Poor’s 500-stock index.

Investors can buy into the index via an exchange-traded fund offered by First Trust or an exchange-traded note from UBS that seeks to (gulp) double the index’s monthly return using leverage.

But cloud investing carries big risk. The median of 40 ISE index members sells for 25 times projected earnings for its current fiscal year, nearly double the S&P 500 index median.

"It’s shark-infested waters with some of the younger, high-price cloud stocks," says David Rolfe, chief investment officer at Wedgewood Partners, a St. Louis asset manager. "If these companies stumble, the market reaction will be swift."

Consider Salesforce.com, a provider of web-based customer relationship management, or CRM, software, which allows companies to track customer inquiries and sales pitches. Its sales have surged in recent years and its shares until recently fetched more than 100 times earnings. But on Thursday the company projected a fourth-quarter profit that left investors wanting more. Shares fell 9% on Friday.

Well-diversified, less-expensive companies like Mr. Buffett’s new prize offer a safer way to invest in cloud computing, says Robert Cihra, an analyst with Evercore Partners, a New York investment bank. Although its hardware sales expose it to broad spending downturns, its strong base of recurring service revenues offers protection, he says.

IBM also has "unique technologies for setting up cloud-based networks than can’t be matched with commodity, off-the-shelf products," Mr. Cihra says.

Mr. Rolfe sees EMC, a seller of external storage systems, as a similarly undervalued cloud stock. "For cloud computing you need massive amounts of storage," he says. "EMC is the key arms merchant for companies that need more storage."

It also owns a majority position in VMware, which makes so-called virtualization software that helps companies get more use from the servers they own. But whereas VM Ware trades at 45 times earnings, EMC is at 15.

Joseph Doyle, a money manager with Morris Capital Advisors in Malvern, Pa., likes software giant Oracle, which long has enjoyed a big share of the CRM market and last month announced it will buy Rightnow Technologies, a Salesforce.com rival. "If there’s a way to make money on the cloud, count on [Oracle Chief Executive] Larry Ellison to do it," Mr. Doyle says. Oracle sells for 13 times earnings.

Microsoft would seem to be under threat from centralized computing, since its programs run on millions of personal computers. But the company has launched its own cloud-computing platform called Azure; has tailored its forthcoming Windows 8 operating system to work better on tablet computers; and has launched Office 365, a cloud-based version of its lucrative productivity software.

"The market under-appreciates how big a move they’ve made into the cloud," says Mark Moerdler, an analyst with Bernstein Research. Office 365 should keep large customers happy while convincing small ones using old or pirated Office versions to pay small monthly fees for access, he says.

Microsoft has a price/earnings ratio in single digits and offers something rare in the cloud: a juicy dividend yield of 3%, compared with a median of 2.3% for dividend-paying members of the S&P 500.

For some seasoned tech companies, the effect of cloud computing on profits isn’t yet clear, Mr. Cihra says. Hard-disk makers like Western Digital Group and Seagate Technology stand to sell plenty of storage for servers but could sell less for personal computers, he says. The same holds for Intel with its computer chips.

Mr. Doyle says companies that can adapt will not only survive the cloud shift but thrive. "When I started in this business in the mid-1980s, I was told IBM wouldn’t make it until the end of the century," he says. "That’s all changed because of the Internet."