Dazzling hi-tech stars that hide the darkness at the heart of the market

NEWS ANALYSIS: The FTSE index may have hit a new high, but the winner-loser gap has never been greater
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THERE ARE always under- and overperformers in the stock market, but the extent of the divergence in recent times has become startling. In the past month alone, increases in telecoms shares have accounted for about one-third of the advance in the FTSE 100 index and software, still a tiny sector, for about one-fifth. Looking back over the past year, as the charts show, a few star sectors have done spectacularly well, while others have at best marked time or fallen in both relative and absolute terms.

Along with the high-technology end of the spectrum, which also includes the even smaller but stellar information technology hardware sector and electronics, oil and gas shares have done well. So have the banks, while pharmaceuticals have put in a reasonable performance. Retailers, food manufacturers, household goods and textiles and utilities have been the real dullards.

This is not a classical late-cycle pattern. It raises the obvious and interesting question: to what extent is the "new economy" phenomenon affecting the stock market? For, clearly, it makes no sense for investors to assume there will be a continuing bull market in all shares. The rewards of making the right selection are immense - as many have already realised.

The place to start - the front line of the new economy - is with retailing. One big high-street name after another has hit the headlines with disappointing results, with Marks & Spencer and J Sainsbury heading the roll-call of the distressed.

Each suffering store group has succumbed to a unique combination of problems that the managements have failed to resolve. But the sector's troubles are not just the accumulation of a series of special circumstances. This is where competition has intensified fastest and most fiercely as a result of e-commerce and the Internet, coming as it has on top of over-capacity.

Michael Hughes, a strategist at Baring Asset Management, says: "Whenever competition intensifies, you get a narrower incidence of profitability. Stock-specific risks increase significantly." He points out that the United States, further along the path of implementing new technologies, has seen a dramatic narrowing in the incidence of profits.

Leo Doyle, an economist at Dresdner Kleinwort Benson, picks out, in a recent report, several areas where the Internet and other structural changes spell bad news for company profits. The problem for the losers is not just that it is extremely hard to raise prices, but that as prices fall consumers do not respond by buying more. There is no prospect of either volume growth or price rises.

"The reality for some is changing significantly," says Mr Doyle. "These changes put more emphasis on innovation, whether it's new products or new shopping experiences."

He picks out as losers many conventional retailers, whether selling non- durables such compact discs and clothes or food or conventional household appliances. Some retail financial services providers are also feeling the chilly hi-tech winds.

It is not just in retailing that competitive pressures have intensified, though. The effect has filtered back to manufacturers of consumer goods such as clothes, shoes, food products and beverages. These markets also tend to be very open to international trade, and companies have suffered from the strength of the pound for the past three years.

The winners are those where there is clear scope for volume growth, such as telecommunications and leisure services. Steven Wright, an analyst at CSFB, agrees with this. "If there is a real growth story, as in information technology, electronics or telecoms - and not just growth, but a huge amount of it - that is very attractive."

Mr Wright adds that the fact that the economic cycle is very different from the past also helps to explain the changed sectoral picture. The business cycle merely paused a year ago, and growth has resumed with scant sign of inflation for this stage of the cycle. Interest rates will rise further, but nowhere near as much as they have in the past. This will help interest-sensitive sectors such as construction, certainly compared to previous experience.

An additional change is the fact that in the new economy it is the biggest and smallest firms that seem to thrive. Ever more mega-mergers are driven by the imperatives of cutting costs and reaping the economies of scale.

The shake-up being administered by the European single currency, triggering pan-European industrial restructuring, is fuelling the process. Certainly, industries such as banking and telecommunications that have been at the forefront of this are among the top-performing sectors.

At the same time the rewards of innovation, which is often carried out by new or small companies, are extremely high, especially in some new sectors, such as the Internet, where businesses are starting up and capturing a small market. Subsequent growth for the success stories can be financed by venture capital and then a market flotation. These rapid growth stories tend to be in the software and computer hardware sectors.

Even among giant companies, success depends on continuing innovation. The fear that the series of mergers will lead to monopolies is tempered by the fact that technology is shifting so fast that consumers can find a route around any monopoly provider. Microsoft's dominance in personal computer operating systems will come to nothing if mobile phones turn out to be the principal means of Internet access in five years' time, regardless of anything the US Justice Department achieves.

That suggests that, no matter how narrowly based the strength of the stock market, it makes sense for investors to continue to pile into sectors whose explosive growth is guaranteed. A huge new millennium research project from CSFB concludes that telecoms is the key. It concludes: "The telecommunications industry is one of the most dynamic in the world, and one of the most important for investors."

The report predicts, for example, that mobile phone penetration will exceed 100 per cent - more than one each - in the developed world, that the Internet will shortly be a mass market, and that the quantity of data transmitted will grow twelvefold by 2010.

It would take a brave stock market investor indeed to ignore all this in favour of traditional thoughts about cyclical sector rotation.

d.coyle@independent.co.uk

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