Great hopes for smaller IT

LARGE information technology companies have dramatically outperformed their smaller peers on the stock market in the past few years, a report out today shows. However, this means small IT stocks now offer better value for investors.

The research, prepared by the investment bank Granville Davies, shows that since the beginning of 1996 the largest IT companies have produced the best returns. During that period, the IT stocks which are among the 350 largest companies increased their value more than fivefold.

Smaller IT companies, while also producing strong returns compared to the rest of the market, have lagged behind the large groups. IT stocks ranked in the Small Cap index have quadrupled in value while companies in the Fledgling index and firms listed on the Alternative Investment Market have trebled.

Granville says investors are willing to attach higher valuations to large stocks because they are seen as less risky. Large IT companies, especially software manufacturers such as Sage and Misys, are usually less dependent on large one-off contracts than smaller ones.

As a result, IT stocks in the FTSE 350 index now trade on a prospective earnings multiple of more than 50 while the smaller stocks change hands on multiples of less than 35.

Large stocks have also performed better because fund managers, who have been trying to build up their exposure to the sector since the Stock Exchange announced plans to create a separate IT index at the end of last year, have preferred to buy the larger stocks which are more easy to trade.

But this does not mean that larger stocks will always produce better performances. Ian Spence, IT analyst at Granville, recommends spotting smaller growth companies which have the potential to become large.

"Investment in high-growth, high-quality smaller IT stocks will produce a better return, because the investor will enjoy above-average earnings growth combined with a significant upward re-rating," he says.