IT rally may pause after recent run-up, investors need to analyse bottom-up

A bottom-up bet on stocks of companies proactive in digital and other new technology areas could still pay off

The NSE Nifty IT Index has rallied 24.3 per cent over the past year. This makes it the best sectoral performer over this period. Experts, however, warn that after this rally, valuations within the sector are no longer inexpensive (see table). Investors who choose to invest need to do careful bottom-up analysis of stocks, and select them on individual merit, as the sector as a whole may not outperform in the near term.  

Several factors contributed to the rally in these stocks over the past year. “At the end of 2017, Donald Trump announced a significant cut in corporate tax rates after he became the president. This had a multiplier effect — boosting earnings growth of US corporates — which in turn enhanced their willingness to invest in IT infrastructure projects,” says Anup Upadhyay, fund manager, SBI Technology Opportunities Fund. 

Bottoming out of the sector’s valuations in December 2017 also made it attractive. “The strengthening of the dollar against the rupee during the past year also helped. Many IT companies went in for buybacks during the past six months, as a more tax-efficient way of rewarding investors, instead of paying out a dividend. This, too, led to better valuations for these stocks,” says Pritam Deuskar, fund manager, Bonanza Portfolio.

Currently, a strong deal pipeline, which has grown at a double-digit rate over the past year, is providing a positive impetus to the Indian IT firms. The sector continues to be a cash-flow generator, and has strong corporate governance practices. However, strong demand has created a shortage of skilled manpower, especially in the emerging fields such as data analytics, digital technology, and so on. This is leading to a spike in salary costs, which could impact profit margins. “Companies better at managing such spikes in salary cost will outperform others,” says Upadhyay. 

According to experts, the rally is largely behind us now. Returns in the near future may not match those witnessed over the past 15 months. The reason: valuations are no longer as attractive as they were 15 months ago. Average valuation for the sector is at around 17-17.5 times one-year forward price to earnings (P/E) ratio. This has reduced the scope for significant re-rating in the near term. “Over the next one-two years, economic activity is expected to slow down in both the US and the Eurozone, which could impact demand,” adds Upadhyay. 

Investors will henceforth need to adopt a bottom-up approach. “Cloud in the form of software-as-service, Internet of things (IoT), and so on, are big themes. Companies able to adapt to these themes more quickly will grow at a faster pace,” says Upadhyay. 

On whether large-caps or mid-caps are a better bet currently, the former offer an advantage of managing downside risk in the macro economy better. The advantage of mid-caps is that for some, the revenue from newer technologies (digital, cloud computing, data analytics, etc) can form a larger part of their overall revenue, and hence result in faster earnings growth. In case of bigger firms, the share of these new, fast-growing areas in the total revenue will rise more slowly. 

Besides adverse currency movement, concentration is another risk investors should watch out for. “The top 10 clients should not contribute more than 40-50 per cent of a company’s revenue. A diversified client base is a safer bet,” adds Deuskar.