IT SHARES - Thrills and spills

The summer saw shares soar, but just as confidence hit an all-time high, the freefall began. IT investors had to hang on tight to survive. Will their bravery now pay dividend?

If the graph of IT share performance this year was the trace of ae high, the freefall began. IT investors had to hang on tight to survive. Will their bravery now pay dividend? patient's vital signs, then doctors would be worried. Soaring highs followed by crashing lows suggest a highly unstable constitution. The readings may now be steadying, but predicting the future path is still as much a matter of faith as of science.

Investment banking group Granville's IT All Share index shows technology share prices have experienced a roller-coaster ride in 1998. Individual share prices have fluctuated wildly.

Admiral shares (IT services), trading at 922.5p as of 26 November, recorded a 52-week high of 1,492.5p and a low of 592.5p - a six-month high-low fluctuation of 900 points which typifies the volatility of the market.

In the first six months of the year, technology stocks soared on average by almost 100 per cent, only to tumble dramatically shortly after the mid-summer high. After an October low, IT stocks rose again and, after another recent backward slip, now appear to be stabilising.

But although share prices are still way below the summer's highs, investors need not be too disappointed. 'IT companies are still up about 44 per cent on the year as a whole,' says Richard Donner, head of Granville's technology team. He points out that even in mid-to-late October, when they were at their lowest, IT share prices were still about 15 per cent higher than in January. 'You have to keep these things in context,' Donner stresses.

That said, IT shares have clearly performed in a far more extreme fashion than those of other sectors on the FTSE All Share index. But what caused those soaring share prices in the first place?

'It was the fantastic numbers people were putting out,' says Guy Feld, head of research at broker Teather & Greenwood. 'The City rightly believed this was a growth area.'

IT companies have been doing well, boosted by obvious factors such as the millennium bug and preparations for the introduction of the euro, so institutions wanted to buy into the sector. That demand pushed up prices, partly because there aren't a huge number of IT companies to invest in.

'As institutions fought to get in, they chased prices and valuations up,' says Feld.

One of the reasons that institutional interest in IT shares has increased is that these shares became more visible this year. In January, FTSE International introduced a separate subsector and index for IT companies within the support services category - the first time that a subsector had been given its own index. Next year, FTSE is starting a new, dedicated IT economic group, itself containing two sectors, one for computer hardware companies and one for software and service companies.

A survey of fund managers conducted by Granville this summer confirmed the increased institutional investor interest in the sector. Overall, 82 per cent of fund managers said their exposure to IT stocks had changed within the past 12 months, with 40 per cent admitting to increasing their exposure as a direct result of FTSE International's IT subsector.

The survey also found evidence of a bandwagon effect, with 18 per cent of fund managers confessing to increasing their exposure simply because other institutions were buying. One fund manager commented: 'It would be difficult to justify why we had no exposure to what is a rapidly expanding sector, so we have therefore jumped on the bandwagon.'

When asked why they thought IT share prices had been so buoyant, 38 per cent of fund managers attributed it to purchasing ahead of a full IT classification, while 33 per cent named the increased visibility of the sector. Buying on the prospect of further price increases was also cited.

One fund manager said: 'The increased visibility of the IT share price performance relative to the index has started a virtuous circle.' Another commented: 'Institutions have been playing two games. Not only have they been buying because of underlying earnings, they have also been buying because everyone else is. Those institutions which did not see any value in IT stocks were still under pressure to have some exposure to IT stocks.'

Ken Olisa, managing director of IT advisory company Interregnum Venture Marketing, says: 'If you have a sector in the FTSE listing, then institutions have to invest in it. If they say they invest funds across all sectors, they can't avoid IT companies. At the moment they can, because IT companies are spread across four or five sectors.

If you are a mid-tier IT company listed in support services you won't be noticed. But when there is a separate IT sector, you will be. That will put their prices up and their valuations.'

But clearly this year, what went up then came down. IT stocks were affected, as was the rest of the London stock market, by the uncertainty in the world economy, and in particular by the 'Asian flu' and the Russian economic crisis. Accepted theory states that IT companies tend to be among the first affected by an economic downturn. IT projects can be placed on the back burner until times improve, and IT companies gain a significant amount of business from financial institutions, themselves among the earliest affected by a global economic slowdown.

If IT share prices dropped more dramatically than the market in general, that is partly because IT stocks are known to be volatile. If the whole market moves 10 per cent, then IT stocks may move 15 per cent.

Feld explains that the high volatility is partly due to the relative lack of liquidity in the sector. 'The very high values and ratings also make companies very vulnerable to any downturn in the market,' he says.

'There was concern that ratings were too high. I think it was healthy that IT came back (down) with the market. It's healthy because it's knocked some of the froth off.'

Granville's Donner agrees. 'IT stocks had risen further, so arguably they had further to fall,' he says. 'People took the opportunity to re-price those stocks that had got ahead of themselves.'

How each individual IT company has fared this year is itself due to a number of factors. Relative performance is obviously one, as is the nature of its business.

Granville has been studying the performance and prospects for resellers, focusing particularly on Compel and Computacenter. 'They are having a very good time of things at the moment,' says Granville IT analyst Roger Phillips. 'I would expect both companies to beat analysts' forecasts for the current financial year.'

However, there are a number of issues threatening their future growth, he warns. 'There is an issue about the slowdown in the market growth post year 2000,' says Phillips. Secondly, there are threats resulting from trends towards direct selling, as with Dell, and from the evolution of the internet as a direct sales channel. 'That is threatening the existence of the retail industry,' says Phillips. 'However, both Compel and Computacenter are very large and are probably big enough to survive. There will be a role for the reseller channel, although there is the question of volume growth after the year 2000.'

Whatever their long-term prospects as resellers, their stock market valuations will always be lower than those given to IT service or software companies.

'Compel and Computacenter are both extremely good companies with extremely good management,' stresses Phillips. 'But corporate resellers and people with an association with hardware tend to be the poor relations. The UK stock market really likes IT service companies, followed by software companies, but it doesn't like hardware companies.'

Comparing price/earnings (P/E) ratios illustrates this point. UK reseller Compel currently has a P/E of about 14, while IT service company CMG enjoys a P/E rating of more than 62.

The reason that IT service companies are so popular is that their future earnings are more predictable. 'Those who have performed strongest in the IT sector are those with long-term contracted revenue,' says Donner, naming FI Group and Sema as examples. 'People see the long-term contracted revenue and so are less concerned with cyclical dips.'

One company benefiting from this is disaster recovery specialist Guardian iT, which floated in March at 225p a share.

'It was very good timing,' says finance director Peter Jakob. 'We took advantage of the high IT sector at the time.'

But he stresses that the company is a distinctive one, partly because it generates no revenue from year 2000 work. 'Another important distinction is the high visibility of our earnings,' he says. At any point in time the company has high contracted revenues stretching ahead between three and five years.

The likely future performance of IT share prices is hard to predict accurately.

As long as people believe that growth in the sector will be dynamic, then share prices should rise, too. But not everyone does believe that.

'The growth of the IT sector is currently very strong. Most people do not believe these levels of growth are sustainable,' says Peter Wyatt, analyst at Credit Lyonnais. 'Will there be enough other work to replace year 2000 and keep the growth rate going? How much extra business will economic and monetary union (Emu) really generate? Such uncertainty has a knock-on effect on share prices.'

Alongside its survey of fund managers, Granville also asked IT companies for their opinions on the issues likely to have significant influence over future share prices. Key differences emerged. Fund managers cited issues such as Emu (78 per cent), the increasingly mission-critical nature of IT (75 per cent), skills and staff shortages (75 per cent) and year 2000 (73 per cent).

Only one-third cited the increasing use of the internet, which was considered more significant by the IT companies. Corporate respondents also cited the increasing integration of IT with telecoms as a key industry drivers - an issue fund managers did not rate highly. These differences suggest some analysts and fund managers still do not fully understand the IT sector.

The UK capital markets could perhaps take a lesson from the US, where there is plenty of high quality research conducted into quoted companies by analysts who develop specialist knowledge.

For example, investment banking giant CIBC Wood Gundy Oppenheimer has 41 analysts covering different aspects in the technology sector. 'We have four analyst teams covering spaces in semiconductors alone,' says executive director Adrian Merryman.

Generally speaking, European analysts simply don't have the same degree of specialist understanding, nor do they take a global outlook, working instead on a regional basis. 'Our people cover the sector on a global basis, but very narrowly,' says Merryman. 'The real issue in Europe is the evolution of analyst research towards a narrower coverage on a global basis. That will drive the credibility of the European markets. As this evolution towards the US model occurs, you will have better analysis of the stocks and, as a result, greater liquidity and greater investment in stocks.'

One way that companies can help improve their chances of being understood is by communicating clearly with the City. Tetra, for example - a UK developer and supplier of ERP systems - believes in speaking to the press.

Tetra floated in November 1997 at 165p, peaked at 285p, and was sitting at about 206p as of 20 November.

'We have been following the market,' says Tetra's marketing director Andrew Yuille. 'Some of our ups were of our own making, but when the market came back (down) a few months ago, we were there. It's one of those things.

You just do what you can to make sure you are better placed than most.'

One way to do that, Yuille says, is to explain what the company is up to. 'By being involved we have helped support the price. If you don't do it, nobody is going to follow you and you will drift around,' he says.

Another development that could improve the quality of analysis of IT stocks quoted in London would be a move toward quarterly reporting, as in the US.

'You value companies on projected earnings,' says Merryman. 'The quarterly reporting environment enables you to evaluate every quarter how those companies are doing in terms of meeting those projections. But if they report annually or semi-annually, you don't have the milestones to compare how they are doing against their projections.'

Without those milestones, values placed on IT companies on the London markets will remain less reliable and volatility in the sector is unlikely to cease.

 PERFORMANCE OF SELECTED IT SHARES (Prices in pence)
                    Share price     52-week     52-week      P/E
                    16 November     high        low          26 November
 Admiral            922.5           1492.5      592.5        42.6
 CMG                1505            2297.5      662.5        62.0
 Compel             307.5           499         265          14.1
 Computacenter      509             822.5       357.5        21.8
 FI Group           291             329.25      120.5        74.5
 Logica             416.5           462.5       199          49.2
 Misys              431             744.5       315          32.5
 Sema               488             849         323.75       46.0
 Tetra              200.5           285         171.5        n/a