The CNX Information Technology(IT) index rose by over 60 per cent last year, with nine per cent of the gains in the last month. This is the highest return from any sector. The CNX Pharmaceutical index, with a return of 26 per cent, was second best and Fast-Moving Consumer Goods (up 10 per cent) the third.
Mindtree, HCL Tech and Tech Mahindra have gained 100 per cent or more. About half of the CNX IT's 20 stocks are in touching distance of their 52-week or all-time highs and many registered the latter in December.
So, the IT sector is obviously in favour. A closer look makes it evident that this can be explained almost entirely by foreign exchange market variations, coupled to a reversal of investor sentiment that caused an upward revaluation of Price-to-Earnings (PE) discounts.
The revaluation in terms of PE discounts is substantial. As late as April, the CNX IT index was trading at an averaged PE of 15-16 (last four quarters). The sectoral PE has now risen to about 24. Averaged earnings per share for the index have risen 10 per cent in the past four quarters. Averaged earnings projections for the next financial year (2014-15) would be in the range of 15 per cent.
These are in rupee terms. The businesses concerned earn almost all their revenues in forex. The rupee has slid by around 13 per cent against the dollar since January 2013 and dropped 15 per cent against the pound and 18 per cent against the euro.
Once adjustments are made for exchange rates, it is apparent there hasn't been much organic growth in earnings. Now that the US economy is picking up, advisories from the sector have become more positive. Even so, in strict valuation terms, an expected 15 per cent rise in earnings cannot be justified by a PE of 24.
Nevertheless, there are reasons why the bull run in IT could continue. On the whole, it has a reputation for clean, sensible management. Second, balance sheets are clean and most of the sector is low-debt. Given that rupee interest rates are very likely to continue heading up, this is useful.
Third, there is a positive upside visible in terms of business growth in the US, unlike sectors dependent on domestic Indian economic conditions. Fourth, the prospects are unlikely to be damaged by political turmoil in India or changes in policy, regardless of changes in government. Neither UPA nor NDA or any other conceivable front, will bring the hammer down on IT. Finally, the rupee is likely to see volatility over the next year and it could nosedive versus the dollar again. That would further boost IT earnings.
There are two or three possible scenarios where the downside for IT would be serious. One is a breakdown in US recovery. The second is a scenario where the rupee strengthens in a major way. Neither seems very likely. The third is an imponderable like a repeat of the Satyam scandal. Balanced against that, the reputation as a counter-cyclical could result in an increased focus on IT if the rupee slides or the broader Indian market sees a big correction.
The worry for an investor is that this could eventually result in another IT bubble. This would not be of the epic dimensions of 1999-2000 but could be considerable. The IT index has seen peak valuations in the range of PE 29-30 in the past three years. Assuming 15 per cent earnings growth, a PE discount of 29 could push the CNX IT index up another 40-45 per cent from current levels. Things would start looking distinctly bubbly if such price levels are hit.
