Why there is excessive paranoia around IT/ITES stocks, and why mid-cap IT is still interesting

The lockdown acted as a catalyst for the IT/ITES sector. The adoption of digital products/services moved from a good to have to a must have. The same was reflected in the earnings growth of major IT/ITES companies.

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The current correction of the IT/ITES stocks is a much needed/healthy valuation correction and has less to do with the outlook of the earnings growth of these companies

By Sonal Minhas 

The recent correction in the stock prices of IT/ITES companies has been most severe when compared to the overall index. In the last one year the BSE IT Index has corrected by ~25% from its 52 week high when compared to the BSE Senex which has corrected by ~15%. If we step back and see from a longer term perspective, the Indian IT/ITES sector was one of the best performing sectors since the March 2020 lockdown.

IndexReturns between March 2020-Dec 2021Returns between Dec 2021-June 2022
BSE IT233%-25%
BSE FMCG54%-2%
BSE Auto115%1%
BSE Financials84%-13%
BSE Energy140%7%
BSE Metal246%-13%
BSE Healthcare129%-17%
Source: BSE

During the March 2020 lockdown, the markets assumed the worst case scenario for IT companies too, whereas the true story was exactly the opposite. The lockdown acted as a catalyst for the IT/ITES sector. The adoption of digital products/services moved from a good to have to a must have. The same was reflected in the earnings growth of major IT/ITES companies which compounded their earnings at a CAGR of ~25% between FY 19-22.   

We believe that the current correction of the IT/ITES stocks is a much needed/healthy valuation correction and has less to do with the outlook of the earnings growth of these companies. 

While the Indian IT/ITES sector didn’t exist when the US last went into an inflation driven recession in late 1970s-1980s, a good proxy is the Global Financial Crisis of 2008-2009. During the Global Financial Crisis, the growth of the leading Indian IT/ITES companies came down from the mid 20% range to a late single digit. The growth however quickly bounced back to the same levels the next year, and continued till 2018. Between 2010-18, leading industry players grew their sales at a CAGR of ~15%.

Source: Company Data

Post GFC, the IT companies have made significant investments in R&D (~2% of sales) and capability building. Their business risk is far lower as they have diversified both their client and sector base. IT companies have entered fast growing verticals such as digital, engineering/transportation services and enterprise cloud. 

Another mistake that the global asset allocators make is to bucket Indian IT/ITES companies and the US tech companies in the same category. While some of the big Tech companies are clients to the Indian IT companies, the actual client base is much more diversified across BFSI, Healthcare, Engineering/IOT and Travel verticals. Some of these verticals have a very strong multi year demand outlook. For example: take the growth of the cloud computing vertical of the three leading players (Google, Microsoft and Amazon). The adoption of the same is a multi year growth story that is getting implemented by IT/ITES companies. Refer chart below:

Source: Company Data

Coming back to the correction of the IT/ITES companies, some large cap IT/ITES companies had seen irrational buying at rich multiples that could not be justified by any future growth. We therefore find this correction as an opportunity. The correction has made the valuation of some mid/small cap names very interesting. These mid/small cap companies offer now the right trade-off between future growth and valuation.

NameFY 23 expected earnings growthTTM PEPrice to Earnings Growth (PEG ratio)
Mphasis30%31.31.03x
EClerx25%170.68x
R Systems25%180.72x
Mindtree22%29.41.33x
Coforge38%30.50.8x
Persistent30%391.3x

We draw our comfort on the FY 23 growth in earnings of these companies as the growth is based on their exit run rate (Q4 FY 22 annualised) and a strong order book (>25% YOY growth in order book across players). 

The equity markets react in a one size fits all approach. When leading analysts downgrade a sector, the same brush is used for large cap, mid cap and small cap companies. The emphasis shifts from earnings growth to multiple contraction. This is the easiest thing to do. In such markets bottoms up stock picking becomes critical. Sometimes a simple question to answer is to mask the name of the company and ask yourself, what multiple would you assign to a business that can grow its earnings at 15-20% for the next 5 years and has a return on capital employed of upward of 25% and is very high on corporate governance. The answer will be very close to the current trading multiple of some of the small/mid cap companies.

(The author Sonal Minhas is the founder of Prescient Capital, a public market investment firm. Views expressed are the author’s own.)

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