QUALIPORT
Time To Turn To IT?

By Maynard Paton (TMFMayn)
April 4, 2002

Over the long term, ordinary investors will never get rich pursuing a follow-the-crowd investment philosophy. Instead, they should always consider companies or sectors that have fallen out of favour with the stock market. After being asked where he looked for investment opportunities, Sir John Templeton responded:

"I would say where there are shares which are most depressed in price, where there is the point of maximum pessimism."

"If you want to buy shares when they are depressed, you look for a point when everybody is trying to sell... Where in the world are people extremely pessimistic? Then if there is a change, you can make a lot of money... I would spend some time asking myself which industry, which nation is almost everyone trying to get out of?"

Without doubt, one sector that investors are generally pessimistic about at the moment is Information Technology. But on the face of it, an involvement in a supposed long-term 'growth' industry could make for an attarctive investment. So are there any bargains? Here are three possibilities:

Logica       

To June 30th              1997    1998    1999    2000    2001      

Turnover (£m)              338     473     659     847    1133 
Pre-tax profits (£m)        28      32      63      97     156
Earnings per share (p)     5.8     8.1    11.6    16.6    25.1
Dividend per share (p)     1.8     2.2     2.9     3.8     5.0

To April 30th             1997    1998    1999    2000    2001      

Turnover (£m)               99     162     214     278     391 
Pre-tax profits (£m)         6      11      17      27      42
Earnings per share (p)     2.2     3.7     5.8     7.7     9.3
Dividend per share (p)     0.8     1.3     1.9     2.7     3.2

To September 30th         1997    1998    1999    2000    2001      

Turnover (£m)              110     131     162     208     242 
Pre-tax profits (£m)         8      10      12      16      17
Earnings per share (p)     6.3     7.7     9.7    15.0    13.3
Dividend per share (p)     1.9     2.3     2.9     3.5     4.2

Logica (LSE: LOG), Xansa (LSE: XAN) and RM (LSE: RM.) all supply a variety of IT software packages and services. Requiring plenty of highly skilled employees, Logica specialises in the mobile communication and energy industries, Xansa has a significant presence in banking and insurance circles, while RM concentrates on the IT requirements of the education sector.

Here's how they stand on the valuation front:

                  Historic              Historic
                    P/E                  Yield

Logica              17.3                  1.2%
Xansa               25.0                  1.4%
RM                   5.9                  5.3%

So are those three shares, or the IT sector as a whole, worth considering for the Qualiport? In short: no. Here's why:

* Circle of competence

Nobody can know everything. As Warren Buffett writes: "What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know."

At the moment, the Qualiport watch list covers a wide range of industries, including media, retailing, banking, beverages, tobacco, conservatories, share trading, condoms, metrology and fall arrest equipment. Although adding IT services will widen the portfolio's knowledge, the overall depth of that knowledge will be watered down.

* Obvious merits

Of course, certain incumbents on the watch list could be replaced. But there's nothing immediately obvious to suggest those three IT companies are great 'franchise' businesses. Even during the boom years of the late 1990s, the highest operating margin achieved by any of the three was 12%.

To most people, the products of, say Ultraframe (LSE: UTF), are as unfamiliar as the IT services of, say, Xansa. But at least Ultraframe's 30% operating margin suggests a market leader with little competition, and is a good sign for worthwhile further investigation.

* Sustainable competitive advantage

Back to Buffett: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Without any specialised insight, it's difficult to determine how durable the competitive strengths of Logica, Xansa and RM are. In such people-based industries, a lot obviously rests with the management team. Certainly the boardrooms of Logica and Xansa have great past records, but can those records be maintained?

The difficulty here is that the IT industry is regularly subject to major change. For instance, Logica have had great success with its mobile communications software. But can that achievement be repeated as and when the next technological innovation comes along?

Where margins are relatively low and management are key, investors want as simpler, straightforward businesses as possible. In comparison to the IT firms, DFS Furniture (LSE: DFS) provides a good analogy. The DFS management just have to focus on what style of sofas their customers want, rather than having to judge whether the general popularity of the sofa will be superseded by some other piece of furniture as well.

Summary

This dismissal of the IT sector may appear superficial to some. But the ability to quickly reject a share is a good characteristic for the prudent long-term investor. There's no point in delving into companies when, on the surface, they don't immediately match up to the obvious strengths and simplicity of other, more familiar, businesses. There may be bargains in the pessimistic IT sector at the moment, but the Qualiport is happy for others to find them.

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