Technology stocks

Wait for value to emerge in tech stocks

Since the pre-pandemic market peak in early 2020, the IT sector has been one of the best performing players on the exchanges. The weights of the big five IT heavyweights (TCS, Infosys, HCL Tech, Wipro and Tech Mahindra) in the Nifty 50 fell from 13.28% in February 2020 to 17.42% at the time the index peaked in October 2021. These stocks outperformed the index and also did a good job on the index. Outside of the Nifty 50, mid-cap IT stocks fared even better, with many of the larger ones such as Mindtree, L&T Infotech and Coforge significantly outperforming large-cap companies.

Pandemic-induced lockdowns in most parts of the world have accelerated digitalization trends. Additionally, the rapid response in the form of unprecedented monetary and fiscal stimulus from central banks and governments, respectively, gave businesses the confidence to spend. So unlike past recessions, IT companies have seen record order flow that has translated into better growth and financial performance quarter after quarter since the initial negative impact. Mid-caps performed even better than large-caps as they were able to capitalize more on the digital push, which was large relative to their size, disproportionately benefiting them.

So far, among the large caps, with the exception of Wipro, the others have managed to weather the market volatility well over the past few months. Since the market peak in October last year, shares of TCS, Infosys, HCL Tech and Tech Mahindra have lost only 2% at most, compared to 10% for Nifty. Their valuations, which were already quite high (Trailing PE in a range of 29-37 times against a five-year average range of 17-27 times), therefore continue to remain so. Valuations are even more stretched for mid caps, although these stocks have corrected more in the range of 13-30% since the October market peak.

However, as disruption looms again with the Russia-Ukraine crisis increasing the possibilities of a global slowdown, the Covid playbook is unlikely to play out for the IT sector. Investors should be cautious for the following reasons: first, this time around, a slowdown in the global economy due to the conflict will not provide any additional boost to digitalization; second, with inflation at multi-decade highs in the United States and set to explode due to war-induced commodity spikes and supply chain disruptions, monetary or fiscal stimulus will not follow.

Third, the massive sanctions governments have imposed on Russia and the shock its economy is facing will impact the operations of many global banks. In addition, subdued confidence in markets and capital flows will also severely affect banks. The banking sector is essential for many IT companies, with BFSI accounting for more than 30% of the revenues of IT majors such as TCS, Infosys and Wipro.

According to many economists, the risks of stagflation in developed countries have now increased, and since the activities of IT companies are mainly export-oriented and dependent on these economies, this risk must be sufficiently taken into account.

The game book

High exposure to BFSI is a risk in the current environment

Investors should focus on value over growth

Good opportunities likely to emerge as risks manifest

We advised investors to book profits where stocks had significantly outperformed fundamentals and did not provide a sufficient margin of safety for the risks that could materialize. TCS, Wipro, Happiest Minds, Mindtree, Coforge, Persistent Systems, Tata Elixi and L&T Infotech are among them. However, all of those stocks for which we have a “book earnings” recommendation are high quality companies and can be bought at certain levels as the correction occurs.

At the same time, we also took a positive stance on some stocks such as HCL Technologies and Tech Mahindra and recommended investors to hold/buy HCL Technologies (up 26% since call), Tech Mahindra (up 58%)

Published on

March 12, 2022