Fool's Eye View

[ June 2, 2000 ]

Sky High Software

By Stuart Watson (TMFTiger)

Great Titchfield Street, London -- As a private investor it has always been hard to see the bigger picture. You do your homework on a particular stock, check its past growth rate, its cashflow and its prospects and you make your decision. But what about the industry it operates in? How many investors take the time to look into this as well? It is a bit like buying a house without checking out the local neighbourhood.

Thanks to the Internet it is becoming easier by the day to find out some background details about industries. One of my favourite sectors is "Software and Computer Services". There is an excellent resource for industry information in the form of the Richard Holway website. Earlier this week they published their annual review of the UK industry. At £3,000 it is a little pricey for the private investor but its key message its plain to see from the basic press release.

Quite simply the ratings of these companies have increased dramatically at a time when their revenue and profit growth is actually slowing. The industry grew 25% in 1998 but this slowed down to 16% in 1999. A growth rate of 14% is expected for 2000 and for the next three years after that as well. This is still one of the fastest growing sectors of the economy. But the current ratings of the 50 plus companies that sit in the FTSE sector index on an average historic price to earnings (P/E) ratio of a milk-curdling 96 times still look a little rich to me.

As is the market's wont, it tends to look at industries as one big group. As all the excitement started last year, virtually every company saw its price rise, regardless of its position in the industry. This certainly seems to a characteristic of the stock market. As a group investors often find it difficult to distinguish the good from the bad. As a result buying occurs across the board. The same thing has happened, only in reverse, in the last few months. Despite the recent falls a lot the major companies in the sector still look pretty pricey.

Software & Computer Services Index



Top Ten Companies      Forecast P/E
                             ratio


Sage (LSE: SGE)                 114
Logica (LSE: LOG)               108
CMG (LSE: CMG)                   73
Sema (LSE: SEM)                  54
Misys (LSE: MSY)                 35
Baltimore Technologies (LSE: BLM) -
FI Group (LSE: FI.)              65
Freeserve (LSE: FRE)              -
Computacenter (LSE: CCC)         23
London Bridge (LSE: LNB)         92

It is all very well making general observations about the industry as a whole but investors need to be considering how it is made up too. Within every industry there are normally sectors that are growing, some that are standing still and others that are falling away.

Software and computer services is no exception. The fastest growth, nearer 20% per annum, is expected from the outsourcing sectors and application service provision. Companies like FI Group (LSE: FI.) and ITNet (LSE: ITN) are two of the biggest outsourcing companies on the London Stock Exchange. Application service provision is a relatively new area and firms such as Sage and QSP Group (LSE: QSP) are heading the field here. Revenues from e-commerce and other Internet-related activities are expected to grow from 7% of the industry total at the moment to around 30% in three or four years time. On the bottom rungs of the ladder are "legacy" skills and hardware maintenance, where revenues are not expected to grow much at all. We saw further evidence of this with the recent profit warning by Compel (LSE: CGR)

So what are investors to do? It is the eternal dilemma -- how much should you pay for growth? Your investing timescale is crucial to this decision. If you are looking to cash in your chips within five years then the sector remains risky. Even if profits continue to grow this may not be reflected in share price increases. Likewise if you are risk-averse and trying to minimise any downside this is also a no-go area. But longer-term it still looks a good place for investment. Just be prepared for those short-term wobbles.

Related Links

• Software & Computer Services discussion board
• Holway Report