Digitisation trend makes IT a sound long-term bet, but stay cautious

After the recent rally, direct investors need to be cautious about valuations

Information technology (IT) sector funds have witnessed a category average return of 17.6 per cent over the past month and 31.2 per cent over the past three months. The S&P BSE IT Index, too, is up 23.45 per cent and 36.46 per cent over these periods.  

Several factors have contributed to this rally. IT companies had begun to turn optimistic in their commentary from April. They expected the impact on first-quarter (Q1) earnings to be harsh, but were confident that things would stabilise thereafter.

“In Q1 results, while the revenue figures were in line with or slightly better than expected, there were positive surprises on the margin front. That provided a fillip to the rally,” says Meeta Shetty, fund manager, Tata Digital India Fund.

The rupee has been stable against the dollar but has depreciated against the euro and the pound. Indian IT companies derive 20-30 per cent of their revenue from Europe and the UK. “This cross-currency tailwind provided a boost to margins,” says Jyoti Roy, deputy vice-president, equity strategy, Angel Broking.

The sector has also benefited from a shift in allocation. “Prior to the Covid-19 crisis, allocation to the IT sector was low. Since then, a lot of money has moved from sectors like banking, financial services and insurance (BFSI) and consumer discretionary to IT,” adds Roy.

The sector’s medium- to long-term prospects remain positive. Indian IT companies are expected to benefit from the migration to Cloud computing. This segment allows headroom for growth for another five to seven years at least. “The Covid crisis has lent further impetus to the adoption of Cloud computing,” says Shetty. Well-entrenched Indian IT companies also stand to gain from the trend towards vendor consolidation.

 

 

The improvement in margins is expected to sustain. Earlier, clients demanded on-site employees from their service providers. But the Covid crisis has demonstrated that many tasks can be handled offshore or remotely. This trend is expected to result in sustained cost savings for IT companies. Investors, however, need to be prepared for a few risks.

One is the possibility of a second wave of Covid infections during winter in both US and Europe. Two, developed economies are being propped up by massive doses of liquidity infusion. Some could falter once this tapers off, which could affect consumer spending and hence, the retail sector’s IT spend. Spending cuts by the BFSI sector, the largest spender on IT, can also not be ruled out if the global economy falters.

Investors with a five-year horizon may invest up to 5 per cent of their equity portfolio in an IT sector fund using the systematic investment plan route. “When selecting a fund, make sure it is well-diversified across market capitalisations, and across businesses like engineering and R&D, IT services, and product companies,” says Shetty.

After the recent rally, direct investors especially need to be careful about valuations. “You cannot buy at any valuation and expect to make money, so be careful about your entry price,” says E A Sundaram, chief investment officer, o3 Capital.

After the recent rally, reasonable valuations are more likely to be found among mid- and smaller-sized IT companies.

According to Sundaram, the IT companies you bet on should have a diversified client base and not be overly dependent on one sector or company.

Direct equity investors should also pay heed to the percentage of revenue coming from digital technologies — the higher the better. They should also avoid IT companies with high exposure to verticals like travel and tourism, hospitality, and retail, which are expected to take more time to recover.