Technology stocks: why this slump has gone too far

The tech-stock crash at the start of the decade left many investors with badly burned fingers. After years of soaring valuations and rampant expansion, tech stocks peaked in 2000 and began to fall. Then, to make matters worse, IT budgets were slashed heading into the 2001 recession. Stock prices even those of the more respectable technology firms collapsed across the sector.

The next few years saw a recovery, but the bad times are back. Now that the global economy is slowing again, Aim-listed IT stocks have been hammered sold off by fund managers who fear IT budgets will be slashed, just as in 2001. But what the market is ignoring is the extent to which technology has become a part of the fabric of the economy over the last ten years. A recent YouGov survey of 15 million broadband users in Britain found that only one in ten people would consider giving up their connection to economise during the downturn. Nearly a third said they'd give up cigarettes and alcohol before they cancelled their broadband connection.

Private equity and the big technology groups have recognised this and they've been quick to take advantage of cheap prices in the sector to snap up small IT companies with strong balance sheets. There were 440 takeover deals in the sector over the past year, according to data provider Capital IQ, accounting for about 14% of all merger and acquisition activity. That consolidation will continue. Spending on IT should also hold up well. In fact, Goldman Sachs expects that IT spending will rise by 5% this year. Sure, it's hardly the stuff of the tech boom but when you consider that most sectors will see spending cuts over the next few years, any growth is impressive.

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So who is doing all that spending? Well, just about anyone who wants to cut costs or streamline their businesses ahead of the recession, says Paul Hill in his Precision Guided Investments newsletter. A car manufacturer, for example, could outsource the handling of customer orders to a software firm. In fact, according to Edison Investment Research, global revenues from outsourcing software services are set to grow to $11.5bn by 2011, from $5.1bn today.

But it's IT spending in defensive sectors healthcare and utilities, for example that will be most insulated from market turmoil, says Malar Velaigam in Investors Chronicle. According to research group Computer Economics, IT budgets for utilities and the energy sector are expected to grow by 8% this year, with healthcare expected to see a 3% jump in IT spending. This makes sense. After all, a company such as Customvis, which makes the only solid-state laser surgical device for the correction of eyesight, is not about to be taken off the operating table, recession or no. And in the energy sector, ViaLogy, whose signal-processing technology helps determine the size of deposits left behind in abandoned oil wells, isn't about to lose its market.

The point is that there are plenty of niche technologies with large markets that have been written off simply because they are a) small and b) in a sector that dredges up all sorts of bad memories for the City. But with IT budgets holding up strong, and many of these small companies on single-digit p/es, the City is turning its back on some attractive opportunities. We have a look at one stock that could benefit from companies cutting costs during the recession below.

The best stock in the sector

One of Paul Hill's favourite small-cap tech stocks at the moment is Touchstone (Aim:TSE). Touchstone is involved in implementing business software, helping firms to be more efficient by handling customer information, cost control, and organising financial and customer data across an organisation. Clients include British Energy and Rolls Royce and organisations, such as the Bank of England. Touchstone has teamed up with Microsoft to implement its business software system Microsoft Dynamics, which helps companies manage their finances, supply chain and customer relations. Sales of the system have achieved worldwide sales of more than $1bn, growing at a 20% annual rate over the last six quarters. The firm recently reported a 7% jump in like-for-like sales, with 30% attributable to its partnership with Microsoft.

However, the share price has more than halved over the last year, after recent contract delays and a fall in profit margins due to higher research an development spending. But these problems are temporary, says Hill the result of the firm moving up the food chain and targeting larger contracts. On a forward p/e of 5.7, it looks cheap and if the market doesn't take notice, it may not be long before the company attracts takeover interest, Hill reckons. The stock offers a dividend yield of 4.1%.