Have a high risk appetite? Just hold on to IT funds, say analysts

Investors with low to moderate tolerance must stand by diversified funds

After fetching sound returns since 2017, technology (tech) sector funds are witnessing steep corrections. The category has declined 15.5 per cent year-to-date.  

High valuations, failing sentiment

Valuations of information technology (IT) stocks had expanded significantly between March 2020 and December 2021.

“Stocks within the sector used to trade at multiples of 18x to 20x. They rose as high as 30x, and in the case of some mid-cap stocks, above 40x. Such expansion in valuations produced phenomenal returns, and led to profit-taking by investors,” says Meeta Shetty, senior analyst and fund manager, Tata Mutual Fund.

Currently, the stock market sentiment is weak.

“When bad news hits a sector trading at above-average valuations, the impact on stock prices gets amplified,” says Kunal Valia, chief investment officer-listed investments, Waterfield Advisors.

US tech stocks have corrected due to growing apprehensions over the pace and quantum of the US Federal Reserve’s rate hikes. When global tech stocks correct, there is usually a spillover impact on domestic tech stocks.  

The sector’s margins rose over the past two years due to savings on travel, facility maintenance, etc.

“Those costs are now coming back. In recent quarters, most companies have indicated some pressure on their margins. Earnings per share (EPS) upgrades have either stagnated or reversed marginally in some cases,” says Shetty.

Analysts are already pricing in the possibility of some developed world economies entering a recession.

“If demand subsides, businesses could curb their expenditure on IT,” says Valia.

Many large Indian IT firms have faced high attrition rates. “Investors feel they will have to spend more on human resources, which could add to margin pressure amid sluggish business growth,” he adds.

Foreign institutional investors (FIIs) have been heavy sellers in the Indian market for over eight months now.

“FIIs invest in high-quality businesses, including IT. Hence, this sector has borne the brunt of their selling,” says Valia.

Long-term outlook positive

The IT sector’s longer-term outlook, however, remains positive.

“According to market research agencies, global IT spending was growing at 3-4 per cent annually in the pre-pandemic period. It is expected to grow at 7-8 per cent annually over the next few years,” says Shetty.

Companies within the sector mostly have low debt. The rupee touched an all-time closing low of 77.46 against the dollar on Monday.

“IT companies get 60-80 per cent of their revenue from the US market. A fall in the rupee is a positive development as it will help improve margins, EPS, and the stock price. Every 1 per cent fall is likely to result in an EPS expansion of 1-2.5 per cent,” says Vaibhav Dusad, fund manager, ICICI Prudential Asset Management Company.

Reassess your risk tolerance

Markets are likely to be volatile in the foreseeable future. If you already own these sector funds, which are more volatile than their diversified counterparts due to their concentrated portfolios, reassess whether you have the ability to tolerate such volatility.

“Investors wanting to benefit from the structural shift in IT spending may stay invested with a three- to five-year horizon,” says Shetty. They must, however, moderate their expectations.

“The multiple rerating has already happened. In the near to medium term, returns will be in line with earnings growth,” adds Shetty.

Valia suggests investing via the systematic investment plan route to benefit from declining valuations. Viral Bhatt, founder, Money Mantra, also thinks existing investors should stay put.

“The ambit of tech funds has expanded. Now they invest in global majors, digital communication firms, and start-ups. They are not just proxies for IT services companies,” he says.

New investors may enter these funds, provided they have a high tolerance for volatility and have already built a diversified portfolio.

“Hold these funds in the satellite portion of your portfolio,” says Bhatt. He suggests limiting allocation to all sector funds to 10 per cent of the equity portfolio.

Investors with low to moderate risk appetite should stick to diversified equity funds.