Valuation of IT Stocks: Tactical Retreat or Irreversible Ramp-down?

Markets are magnifying machines. On the way up, it is all about what can go right as they magnify the greener pastures. On the way down, projection of pitfalls takes the primacy, as the magnification shifts to the murky side. Nature of the beast is such that it can never take a realistic or objective view. It swings between over-shooting and under-shooting. Since markets are born with the magnifying lens, it is investor’s job to wear the contra gear to keep off from the market’s fallacy.

One sector that is at the receiving end of this manic behavior is the IT sector. After two years of one-way run, stocks in this sector are getting brutally punished in the current downturn. Looking at the data points, in this calendar year, YTD, IT index is down by near 26%. In comparison, the Sensex is down only by 7.6%. In month of May (MTD) alone, the IT index is down by over 11%. If the fall at index level is 26%, one would fret to imagine the slump at the stock levels, esp. at the mid-cap end. In the pecking order of falling-from-grace, the one standing tall in this inglorious list is LTI (L&T Infotech) with a fall of over 47.8% followed by Mindtree at a touching distance. Even larger names like Wipro and TechM are not far away with a fall near 40% (all above data points as on 25th May).

One wonders, what has happened to all that sound-bites about super-digitization cycle, secular cloud transformation etc. that drove the valuations in this sector to stratospheric level in the last 2 years. Has anything materially changed or is it only a change of lens? Why is there a sudden rush among brokers to downgrade IT stocks? It started with JP Morgan and Nomura. Now, no brokerage wants to be left behind on this new down-grade rush. What explains this?

In our view, it is more of a valuation-reset than of any material change in growth projections or sector prospects. It is more of a narrative- following-price-action than the other way. As it happens always in the markets, price-action leads and then the narrative follows. Ironically, though the brokerages downgraded their target prices, none of them has downgraded their growth forecast for FY23. Even for FY24, they are less certain about the slowdown in tech spending. Downgrades are fast coming on fears of further price erosion.

So the next question to ask is, what triggered such a sharp price-action in the IT index relative to the Sensex and Nifty? For that, one needs to look at what is happening to NASDAQ stocks, because they are the lead indicators for the sentiment in the tech space. Taking that argument, probably, the rout in NASDAQ stocks explains the deadly derating that we are witnessing in Indian IT stocks. It was a common knowledge that the NASDAQ stocks were in a bubble zone and Fed action came as a much needed blow to prick it. As is to be expected, the meltdown in the NASDAQ had a massive rub-off effect on tech stocks globally. Indian IT stocks which were way off in valuations from their historical averages, had to bear much of the brunt from NASDAQ effect. Even after this sharp correction, the valuation in this sector is still far off from their historical levels and is yet to come to a fair valuation levels, esp. in the mid-cap IT space.

Having said that, none of the medium to long-term drivers for growth in IT space have gone away. Enterprises’ willingness to spend on digital and cloud transformation will continue to feed into above average earnings growth for the sector. But the growth in earnings is unlikely to translate into valuation growth as much of the stocks are still trading well above their historical averages. So in essence, nothing much would happen on the valuation front and the story going forward will be more of earnings catching up with the expensive valuation than anything else. That is the best-case scenario one can hope for IT stocks. To conclude, is it time for time correction for tech stocks? Only time will tell. Watch out for interesting times!

This article of mine was published in the online edition of Economic Times (05/06/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/valuation-of-it-stocks-tactical-retreat-or-irreversible-ramp-down/articleshow/92018927.cms