For what is the only corner of the London stock market to have received three cash takeover bids in the space of six weeks, the software and computer services sector remains firmly out of favour.

That grouping, whose standard-bearer is Sage Group, its only FTSE 100 constituent, has underperformed the FTSE all-share index by 23 per cent over the past 12months — a dismal run that shows no immediate signs of reversing.

That is despite last month's £593 million bid for Northgate Information Solutions from Kohlberg Kravis Roberts (KKR), the American private equity house, and a £160 million swoop on NSB Retail Systems by Epicor Software, of California.

This week, Coda, the developer of accountancy software, agreed a £160 million offer from its Dutch rival Unit 4 Agresso.

Neither is this flurry of activity wholly without precedent. In the past six months there have been bids for Xansa and Vega Group, from French and Italian competitors respectively.

Part of the explanation is that the UK IT sector is diverse and highly fragmented, serving a wide array of niches: NSB's clients are American department stores, Vega's the likes of BAE Systems and Lockheed Martin.

So, in an era where corporate buyers of software increasingly prefer to deal with fewer suppliers, the pressure for the big to swallow the small remains strong.

Yet it is notable that, with the exception of KKR, all of these bids have come from trade buyers, suggesting that corporate entities have a more bullish view of the sector's prospects than does the stock market.

Over the past six months, the forward price-earnings multiple of the sector has fallen from about 16 times to just over 13 times.

However, the fact that share prices have roughly kept pace with that decline indicates that it is only the price side of the ratio that has come under strain: indeed, the sector's profit forecasts remain broadly unchanged.

As with other corners of the FTSE all-share index, the dilemma for investors is discerning to what extent those forecasts can be trusted.

According to data provided by Hemscott, only one of the sector's 22 constituents is expected to deliver a drop in earnings this year: RM, the developer of educational software, and that of less than 1 per cent.

Even if the turbocharged Autonomy is excluded, the sector's average forecast earnings growth this year is still a heady 16 per cent.

Given historic sales growth in recent years of about 12 per cent, that assumption would appear to be far too optimistic — especially given predictions from the likes of IDC and Forrester that industry revenues will rise by between 3 per cent and 5 per cent in 2008.

Holway, the respected UK IT report, is even less bullish and expects no growth at all. On that basis, it would be prudent to assume that consensus earnings forecasts are too high and that the investors should be braced for profit warnings.

As to from which niches they are likely to come, the stock market has already provided an answer: those companies exposed to the financial services and telecoms sectors, which have already seen the sharpest share price falls.

Shares in Anite, the telecoms software specialist, have underperformed by 49 per cent over the past six months.

Misys and Fidessa, which are heavily dependent on the banking sector, have lagged the stock market by 20 per cent over the same period. However, only last week, Misys reassured that it had seen no change in buying patterns.

KBC Peel Hunt prefers to distinguish between companies with short-term order books and those with long-term contracted revenues — commonly a split between pure software providers and their more service-orientated peers.

Software companies tend to have high fixed costs and high gross margins — sometimes of up to 90 per cent — meaning that falls in revenues can have a disproportionate effect on profits. Conversely, service companies can operate under multiyear agreements that give them the ability to forecast up to 80 per cent of current-year revenues.

Companies in this camp, albeit at the lower end of the stock market, include Phoenix IT, which provides emergency back-up services, recently floated Craneware, a Scottish company focused on the healthcare sector, and SSP Holdings, a developer of insurance administration software.

Of course, there are software companies whose competitive strengths and stellar earnings growth have left them unscathed: notably, Autonomy, and Aveva, which serves the booming energy sector, whose shares, having surged in 2007, continue to advance: up a further 10 per cent and 6 per cent this year respectively.

Size is also useful in a stock market where money has switched from small to large caps, a phenomenon that has helped Sage, which updates on trading on Monday.

For the rest, fears of a slowdown in corporate IT spending suggests sentiment is likely to remain adverse, even if more bids emerge.

On the view that a lowly valuation and good cash generation provide a useful guide to the next likely candidates, Altium Securities flags Anite, Axon, Civica and Phoenix, among others.

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