IT? Computer services? Didn't the dot-com boom end years ago? Yes, it did - but the companies that survived it have matured into some impressive outfits, with high gross margins and strong positions in niche markets.
The Big Fact:
There isn't one. Some of the most interesting and compelling themes are the ones without the biggest headlines and the UK's burgeoning and highly profitable IT services sector is a case in point. If there were any headlines, it would be around the fact that they're growing fast, they're efficient users of their own capital, their shares look very cheap… and they're ignored by UK investors.
The Big Story:
Whenever any investor talks tech, they seem to instantly latch on to the sexy end of the industry - biotech firms developing drugs to save lives, chipset manufacturers developing new mobile phone processors or online video developers working with Web 2.0. But this hype and news- and agenda-driven approach hides a rather more interesting and compelling investing theme, namely that there's a growing army of highly profitable IT services companies (contained within the computer services FTSE sector) growing at an extraordinary rate, ranging from titans such as Logica through to tiddlers such as Portrait Software. The easiest way to witness this story is to run a quick stock screen on the sector - rule out really small firms completely off the City radar with market capitalisations below £10m and then order the resulting shares by their rolling PEG to produce a final list of 30 shares. This last measure compares the current price-to-earnings ratio with the estimated growth in earnings - with the lower the resulting number, the better the rating.
What's astonishing about the final list of firms is that they seem to be screaming buys - the average return on capital employed is just 50 per cent, the average projected (forward) PE ratio for the sector is 16, yet the average growth in estimated earnings is a speedy 56 per cent. With most analysts busily forecasting massive earnings falls throughout the FTSE 350, you'd have thought this sectoral growth would have been rewarded by decent share price performance, but you'd be wrong - over the past year, our 30 geeky IT specialists are down an average of 25 per cent. In part that dismal performance is a result of a number of factors, not least that most of the companies are small caps (disproportionately hurt in the market sell-off) and growing fast (also abandoned by investors looking for safety in non-banking, value-biased blue chips). But, even on a value basis, there seems to be an anomaly - in our top 10 list we've highlighted a disparate bunch of specialists who have outstanding PEG ratios yet their average forward PE ratio is a cheap nine times earnings, with an average dividend yield (bar the two that don't pay one) of just under 3 per cent. As value stocks go, our shortlist of 10 stocks is definitely cheap yet the average earnings growth rate is set for just under 90 per cent in the coming financial year.
Dig beneath the figures and you begin to understand what's motivating the sector. The UK has a huge pool of trained IT specialists, many of whom cut their teeth developing software for much bigger FTSE 100 IT departments. We also possess a strong venture capital sector that particularly likes EPS firms for their generous royalty and repeat revenue stream and their ability to generate huge margins for minimal deployment of cash. It's that last factor that's of crucial importance - cashflow. Many of these IT firms have now developed long-term service and product contracts in niches that generate extra revenues (or cut costs) for their much bigger global customers. Crucially in a looming recession, software that generates almost immediate returns tend not to be cut back by bigger customers looking for cost savings - if software can improve a firm's return on equity and improve the margin, it's likely to be softer budgets like marketing and capex that get cut back first.
Any benchmark index: You'll find most of the interesting outfits in the FTSE Computer Services sub-sector and more generally in the FTSE Techmark index.
How to access the theme
The simplest way to buy into this story is to buy the small number of firms directly. We ran a screen through this sector and then selected the 10 best, ranked by the rolling PEG factor - the 10 are in the box below. They're a motley bunch ranging from Portrait’s customer interaction optimisation software through to generalist IT services giant Logica.
Leading UK computer and IT firms:
| Name | TIDM | Price £ | ROCE (%) | F'cast PE ratio | F'cast EPS growth | Rolling PEG | Capital (£M) | Price change % (1 month 1 year) |
|---|---|---|---|---|---|---|---|---|
| Portrait Software | PST | 0.0962 | 10.24 | 213.33 | 0.08 | 11.4 | -63.77 | |
| Phoenix IT Group | PNX | 2.8775 | 9.84 | 94.93 | 0.16 | 216.2 | -48.9 | |
| Xploite | XPT | 0.455 | 8.21 | 222.09 | 0.17 | 18 | -7.6112.35 | |
| Sanderson Group | SND | 0.375 | 6.36 | 96.67 | 0.24 | 16.3 | 2.74-25 | |
| Patsystems | PTS | 0.2 | 18.4 | 13.33 | 50 | 0.29 | 35.9 | -54.54 |
| FDM Group | FDMG | 0.765 | 41 | 5.15 | 23.83 | 0.3 | 17.8 | -65.3 |
| AT Communications Group | ATCG | 0.275 | 37 | 4.15 | 6.42 | 0.31 | 21.2 | -46.34 |
| Tikit Group | TIK | 2.325 | 143 | 9.63 | 34.02 | 0.35 | 34.2 | -38.26 |
| NCC Group | NCC | 3.81 | 14.37 | 40.32 | 0.36 | 128.1 | -8.04 | |
| Logica | LOG | 1.0075 | 35.4 | 9.43 | 50.63 | 0.39 | 1473 | -51.23 |
Caveats:
Don't expect to find yourself jostling with other investors when you start buying these shares. Many of the smaller companies are already beaten up badly and they're likely to stay that way for some time as investors flee perceived risky small and mid caps. In addition, investors need to understand the key risk with any sector experiencing such rapid growth - these estimates are just that, estimates, and history teaches us to be cautious about forward-looking earnings projections.
