Has the valuation run ahead of fundamentals in the IT space?
Crowd psychology is weird. If something sounds cool and esoteric at once, it assumes that there must be something great in it, esp. if it is difficult to understand. Huge fan following begins, not to be left behind by FOMO (Fear of Missing Out). Cycle feeds itself into a larger than life story. Sounds familiar? Look at the way how “SPAC” has emerged as a new story in US markets. SPAC of course sounds cool and not many will understand the heads or tails of it (Special Purpose Acquisition Companies). But robinhood rock stars are lapping them up as if there is no tomorrow, sending their stock prices to dizzy heights. Are we witnessing something like that in the cool “digital” wor(l)d? We will know soon.
Look at this. Here is a mature industry. Has been there over three decades. Growth cycle is more moderate now with single digit growth guidance and forecasts. In that setting, someone comes with a new share-sale offer and gets away with a hefty valuation, that too with a whopping 150 times over-subscription. Are we missing something? Look at it closely. What has been peddled is not a story of snail paced generic IT services, but the stellar story of digitization super cycle. You guessed it right, it is about Happiest Minds with its story of 98% digital revenues. In normal times, a float for a small-cap IT company would have invited nagging worries of sub-scale, risk of client concentration, liquidity risk etc. But these are not normal times. These are times where Digital is dignified as Divine. Lot can be hidden under the bits and bytes of digital. Nevertheless, one must credit IT the veteran founder of Happiest Minds for masquerading a mundane IT scrip as a stellar digital story which made investors fall over each other not to miss subscribing to the share offer.
Super digitization cycle has taken a form and life of its own. Favorable pandemic narratives like Work-from-home (WFH), OTT, Online commerce, Surge in online payments etc. have only added fuel to the fire. Add to that the market’s insatiable craving for pandemic proof stories. Further, with savings from WFH and travel restrictions, quarterly margins have positively surprised the analysts. All these came together in a miraculous fashion to fire up a frenzied rally in IT stocks. So far so good. But where one develops cold feet is when one looks at the growth versus valuation multiple closely. Valuation in terms of PE multiple (on trailing basis) is at a historic level while potential growth is far below its historic highs. Look at the multiple at which TCS is trading. It is at 30+ times, at similar levels last seen in 2006 when the growth was at a high double digit. Now, it is trading at similar multiples, but with growth guidance of high single digit or low double digit at best. Same is the case with so many mid-cap IT stocks that are trading at historic high multiples. How does one reconcile this inherent contradiction between low growth and high valuation multiple. The only way, one can reconcile is that over time, when economy normalizes post vaccines etc., when the rest of the sectors start doing well, premium valuation will start petering out for IT space.
How else one can explain the heavy insider selling in many IT stocks. Take for example the surge in selling in Mindtree from erstwhile founders team or for that matter, the opportune partial stake sale (6.27%) by Baring in Coforge (NIIT Tech) etc. Insiders of course know where to draw the line between hype and reality. As they see it, even with the super digitization cycle, growth outlook is unlikely to go back to even mid-double digit range. Similarly, boost in margins from pandemic induced travel restrictions/WFH, is unlikely to sustain when normalcy returns, as insiders observe.
Of course, not everything is just soundbites. There are some meaty string- bytes too because of digital prospects in cloud, automation and AI. It is an undisputable fact that Covid has accelerated the digital adoption across the world. While this will increase the prospects for digitization opportunities for Indian IT players, they are unlikely to take the growth to high double digit, given the mature stage of industry growth cycle. When that reality strikes, it will be time for markets to give up its premium multiple for IT.