Since the beginning of this fiscal (April 2004), stocks from the software sector have gained much attraction. Investors' seem to be buying software stocks based on the presumption that the sector is insulated from uncertainties on account of factors like high inflation and fears of an interest rate hike.

Therefore, software stocks have been recently quoted as 'defensives'.

Apart from the above factor, higher earnings growth expectations also seem to have played an important part in the buying spree.

What we gather from the managements of software companies is that billing rates are expected to stabilize at the current levels and the contribution from value added services is likely to increase. Volumes are also expected to grow strongly as a result of offshoring gaining further steam.

"BPO and IT can change the face of India in 10 years time," said Akshaya Bhargava, the CEO of Progeon, Infosys' BPO subsidiary. He further emphasized on the fact that, over the past twelve months, clients are increasingly bidding for projects that combine IT services with BPO. Managements of large and medium-sized Indian IT companies like Infosys, Wipro and MphasiS (who provide BPO also) have stressed on the fact that Indian players need to move on to a high pedestal of the value chain i.e. they need to provide high value services in the BPO space as well, in order to ward of any threat from other cost competitive nations like China, Thailand and the Philippines.

During the past two months, all the managements whom we have met have spelled out a positive outlook for the Indian offshoring story, especially for BPO services.

This is indicated from the fact that, apart from IT services, these companies have been hiring rapidly on the BPO front.

Wipro and MphasiS, for instance, hired 1,449 and 457 employees respectively in 1QFY05 in the BPO space, which was 48% and 60% respectively of total employees added in the quarter.

As seen from the graph above, at current prices, the large horizontal players -- Infosys, Wipro and Satyam -- are trading at valuations that are above the average P/E of the Indian software sector. And this is the result of the high expectations that have been built-up ahead of the second quarter results. Notably, a large proportion of the P/E (24.9 times) is on account of these software majors.

If one were to exclude them, the average P/E of the sector is lower at 18 times, which is still at the higher end of the spectrum considering the expected earnings growth for FY05.

On the other hand, valuations for vertical players like Geometric Software and Hughes Software are below the average P/E. This is indicative of the higher risks that investors associate with these relatively small and focused players.

However, this is not to say that these companies, due to their respective domain competencies, have a high potential to grow in the future.

All in all, despite the recent spurt in valuations of Indian software companies, we believe that investors could still benefit from a long-term investment strategy. However, they need to pick and choose rather than following an all out approach.

Software companies, being in a globally competitive space, require management vision and capabilities on the delivery and execution fronts. As such, investors would benefit from investing in companies with sound business models and visionary managements.

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