Information Technology: Investing Essentials

In a world of increasing complexity, businesses are often looking to information technology in order to develop or reinforce a competitive advantage -- or at least to become more competitive. While the rapidly changing environment of information technology stocks makes investing in the sector a challenging task that would require lots of research, the lucrative characteristics of the industry means winners could pay out handsomely. Here are the industry basics that investors who are interested in the space should understand.

IBM's idea of what a next-generation data center would look like. IBM is often viewed as the go-to source for information technology services among the Fortune 500. Source: IBM.

What is information technology?

Meriam-Webster defines information technology as "the technology involving the development, maintenance, and use of computer systems, software, and networks for the processing and distribution of data."

Broadly, information technology businesses usually fall under one of these categories.

• Developing and maintaining software to organize and make sense of data.
• Analyzing data for clients.
• Providing servers and computer systems to store and organize data.
• A hybrid of one or more of the above categories.

More specifically, "Companies in this industry provide services such as software support, computer systems design, and data processing facilities management," according to Hoovers' industry research.

How big is the information technology industry?

Global IT spending in 2013 totaled around $3.7 trillion, according to Garter. In 2014, global IT spending is expected to grow by 2.8% when measured in constant currency. Between 2015 and 2018, Gartner expects spending to increase at rates between 3% and 4%.

Information technology sales can be broken up by subsector. Gartner categorized 2013 sales like this:

How do information technology businesses work?

Collecting, storing, analyzing, and sharing data and information is a profitable business. With very little capital expenditure spending required, Information Technology companies typically boast a handsome return on equity, with an average of 40.5%. The broader technology sector, for comparison, earns a return on equity of 14.5% on average.

The infrastructure needed for IT businesses is typically inexpensive relative to the revenue potential the infrastructure creates. Consider, for instance, an information technology business that designs, markets, and maintains IT software. The primary expense would be research and development and the human resources needed to market and maintain the software. Even businesses that provide servers for storing and organizing complex data can easily make up the cost of the servers by charging annual fees for the equipment's use over very long periods of time before the servers need to be overhauled with new technology.

With such a lucrative business model, it's not uncommon for some of the IT pure plays to boast gross profit margins of around 50%. For instance, consider some of these larger players in IT, all with gross profit margins between 45% and 82%: IBM (49%), Gartner (61%), Qlik Technologies (86%), VMWare (86%), and Oracle (81%).

But despite information technology businesses' lucrative gross profit margins, research and development, sales, general, and administrative expenses weigh on profitability, bringing the sector's net margin more closely in line with the broader tech sector. The average net profit margin for information technology companies is 10.8%. Comparably, the net profit margin for the tech sector as a whole is 8.3%.

Profitability, of course, can differ immensely from one company to another. A company's specific levels of profitability in the information technology sector are a factor of its technical expertise, quality of services, and effectiveness of marketing. And large companies, of course, have advantages in scale of offerings and global reach, making profitability both more attainable and sustainable.

What are the drivers of information technology businesses?

The driving factor for demand for information technology services is, unsurprisingly, technological advances. This year, for instance, Apple and IBM partnered to capitalize on the need for better mobile solutions in information technology. The explosive use of smartphones and tablets for business applications has opened a door for information technologies to capitalize on the shift.

While demand is driven primarily by technological advances, overall spending often depends on the health of the economy, according to Hoovers.

Information technology is here to stay. As long as technology continues to evolve (and it will) and the global GDP continues to grow (while this is never certain in the short term, it's is basically inevitable over the long haul), demand for this important service will persist.