Some Sunlight for Cloud Computing Stocks

While it's been tough for momentum investors to find opportunities, there have been some bright spots -- like Chinese IPOs and cloud-computing companies. Many of these stocks have soared this year, and the rally has been broad.

The problem? The hot money can suddenly go cold -- as happened Wednesday with cloud-computing stocks. Equinix (EQIX), which provides hosting services, gave slightly weaker guidance. The company's revenue outlook for Q3 dropped from $335 to $338 million to $328 to $330 million, with the annual forecast falling to $1.22 billion from $1.23 to $1.24.

On its face, these seem like inconsequential changes. But not for investors. Shares of Equinix plunged 33%. More importantly, many other stocks in the sector also sold off. Citrix Systems (CTXS) was off by 14%, VMware (VMW) lost 9% and Salesforce.com (CRM) fell by 11%.

No doubt, cloud-computing stocks needed a correction and investors had a catalyst with the weakness from Equinix. But is the reaction something more? Is the cloud-computing space maturing and seeing more competition?

The Cloud-Computing Pioneers

The origins of cloud computing go back to the late 1990s, with the efforts of pioneering companies like Salesforce.com and NetSuite (N). Up until this time, the enterprise software market was vulnerable to disruptions. The industry's business model was to develop complex software and sell it for high upfront prices to customers. Ironically, this was often the cheapest part of the transaction since there was usually a need for high-priced consultants to install and maintain the software.

But with cloud computing, the approach was different. Customers could access the software via the Internet, which made it easier to update. There was also lower investment requirements for servers and other infrastructure. In fact, the technology was easier to use. After all, the interface looked like Amazon.com or eBay. Finally, the business model involved a much more affordable subscription fee (usually based on the number of users).

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The adoption took time, as with any new technology. But the leader in the space, Salesforce.com, continued to rack up growth, even during the recent brutal recession. In other words, investors eventually realized that cloud computing was not a fad.

Another key development was that major companies like IBM (IBM), Hewlett-Packard (HPQ) and CA (CA) started to acquire cloud-computing companies. The opportunity was too big to ignore.

Look at the Dips as Opportunities

All major technology trends are dynamic. The competition intensifies and there will certainly be many losers. This happened with PCs, minicomputers, the Internet and mobile phones. The same will apply to cloud computing.

So going forward, investors need to do much more analysis when making their choices. This means finding companies with strong barriers to entry, big markets and top-notch teams. For example, NetSuite (N) looks like a good fit. The company develops software for enterprise resource planning (ERP), which helps companies manage their internal operations like inventory, payroll and HR. This kind of software is complicated and takes time to get customers. But NetSuite has been growing its business at a nice rate and it looks like things are starting to accelerate.

However, even when focusing on good companies, there will still be volatility in the stock prices. And while this may be stomach churning, the dips can provide opportunities to invest in companies likely to grow for the long haul.