Here is the news: it's safe to return to media stocks

Deal fever makes it okay to go where investors have long feared to tread, says James Daley

Investors have long memories. Six years ago, it was the collapse of the technology, media and telecoms (TMT) bubble that prompted a vicious downturn on many world stock markets, including the UK's three-year collapse. So, while markets have recovered since the lows hit at the end of 2002, and continued to post good gains this year, many private investors have been reluctant to revisit the sector.

With some justification. It has only been in the past year that TMT stocks' fortunes have finally begun to turn around - first, in the telecoms and technology arenas and, more recently, in the media sector as well.

Private equity groups have recently swooped for the business publishers Informa and Incisive Media, while the bid battle for ITV heated up last weekend, when BSkyB bought an 18 per cent stake in the company, prompting ITV to reject a £4.7bn bid from NTL. Now the Daily Mirror could be up for sale too.

As a result, Richard Buxton, the head of UK equities at Schroders, believes the media sector now looks more interesting than it has for many years.

"Media has remained something of a pariah in terms of investor enthusiasm until quite recently, when we've seen approaches for a number of companies," he says. "These companies are quite stable cash-generative businesses that appeal to private equity houses."

Paul Richards, a media analyst at Numis Securities, points out that companies such as Informa and Incisive, which focus on business-to-business publishing ventures, have performed very well in recent years, as they are more responsive to fluctuations in corporate profits than consumer confidence.

However, he cautions that there are still a number of serious structural problems facing many other media stocks. He points to the case of ITV which, like many other television and radio companies, has lost audience share due to the proliferation of digital television. Its shares are now down by more than 25 per cent since it was formed by the merger of Carlton and Granada three years ago, and regulatory restrictions have held it back from improving revenues by raising its advertising rates.

This set of rules - known as contract rights renewal (CRR) - has actually forced ITV to lower its rates each year as it has continued to lose audience share. Richards believes the knock-on effects of CRR have stretched beyond television, into radio and even publishing.

"What it's led to is a lot of money being switched out of ITV," he says. "And this has led to a deflationary effect on advertising across the industry - although some of the advertising has gone to Channel 4, many companies have put the money into in-store marketing instead, or into the internet."

David Boyle, a fund manager at Aberdeen Asset Management, says investors hope the regulator will review the CRR rules next year. If they are diluted or scrapped, it could have a positive effect on stocks across the sector. "If NTL does manage to buy ITV, and a new chief executive comes in and manages to reverse the CRR issue, that would be significant for the sector as a whole," he says.

However, Boyle points out that Sky's stake-building in ITV could be a concern. If Sky managed to take over ITV, the company's dominance in the British commercial broadcasting market would ensure that the regulator would not reverse the CRR regulations.

Outside the television market, Boyle says, both newspaper and magazine publishers are generally still suffering from a continued decline in readership, with the exception of the business-to-business sector. He says it is the companies that are making the effort to adapt to new forms of media that are faring best.

Buxton believes that one way to avoid losing out, given the structural changes in the media sector, is to hold the large advertising companies, such as WPP, which operate across all forms of media. Schroders expects prospects for the advertising market as a whole to improve over the next two years, in the run up to 2008, the year of both the Olympic Games and the US presidential elections. Historically, these events have represented the peak of the global advertising cycle.

Boyle warns, however, that smaller advertising companies can prove relatively risky investments. "The problem with the advertising market is that the barriers to entry are very low," he says. "All it takes is for a director to leave and to take their clients with them for a company to be left in a lot of trouble."

As this is a small sector, there are few collective investment funds that focus on media stocks; so one of the only ways to get exposure to the sector is by doing the stock-picking yourself.

However, for more experienced investors, with larger portfolios, Ben Yearsley, an investment adviser at the financial adviser Hargreaves Lansdown, says there is a handful of venture capital trusts that specialise in the media arena.

Edge Performance and Ingenious Live are two funds available this year, both investing in live music and theatre performances.

Proven also has a range of VCTs that invest up to 50 per cent of their funds in fledgling media companies. However, Yearsley warns that VCTs are generally high-risk, and only for those with a substantial portfolio. They also come with certain tax breaks but, in return, have to meet strict tax rules - which is an added complication.

How to bet on the media sector

* David Boyle, of Aberdeen Asset Management, likes music distributor EMI. Although CD sales are in decline, he points out that EMI has been quick to find new ways of cashing in on the digital revolution. With one of the largest and best-managed back catalogues, the company has been selling the rights to its music to makers of computer games and films.

* Edward Collins, manager of the New Star UK Dynamic Fund, suggests BSkyB. "BSkyB enjoys a highly dominant position in UK pay television and is excellent at maintaining its competitive advantage through domination of football rights, the move into broadband and, more recently, taking a surprise strategic stake in ITV," he says. "Sky is targeting higher revenues through its new telephony and broadband services. I expect these products to lower customer turnover and increase the rate of new subscribers to the television business, combining to increase profitability."

* Nick Raynor, of the Share Centre, a stockbroker, recommends WPP. "We have remained underweight in the media sector for a long time," he says. "But WPP, one of the world's leading advertising agencies, is our favourite stock here." With businesses in the US, the UK, Latin America and Asia, WPP is well diversified.