The reason why most institutional investors are staying away from IT stocks is not just because of the worsening growth outlook but also because even after the dip Nifty IT index is still trading at a 10% premium of 21.3x to its 10-year average valuations of 19.4x.
All the large 5 IT stocks – TCS, Infosys, HCL Tech, Wipro and Tech Mahindra – are also trading above their pre-Covid valuation levels. Midcap IT stocks, on the other hand, are trading at a 25% premium to largecaps.
The 12-month forward PE of Infosys has now fallen to 20x from March 2022’s 31x but is still trading above the 18x PE seen in March 2019. Its shares have fallen over 24% from a 52-week high level of Rs 1,672.
Similarly, TCS shares are down 10% from peak but it is still trading at 24x PE against pre-Covid level of 22x.
“The forward PE ratios of largecap IT stocks suggest that they might not be the best value buys at this moment, despite a correction in prices. This could be attributed to the fact that projected forward earnings have also been adjusted downward, which keeps these stocks at higher multiples,” said Sonam Srivastava, smallcase manager & Founder of Wright Research.Indian IT exports have grown at a compound annual growth rate (CAGR) of 9-10% over the last decade. However, in FY22, the exports experienced an astonishing growth of 18% due to one-time spends driven by savings related to the COVID-19 pandemic.
“Given this context, we believe that the sector’s export growth is likely to normalize to its historical growth levels of 8-10% CAGR. This is because most of the core sectors, such as US and European banks, auto original equipment manufacturers (OEMs), and ancillaries, have returned to pre-pandemic levels of spending,” Hemang Kapasi, Head of Equities, Sanctum Wealth, pointed out.
From this point onward, rather than expecting a significant correction in valuations, the sector may experience a time correction over the next couple of quarters, he said.
Analysts anticipate that the IT industry will face challenges for a couple of quarters due to sluggish worldwide demand.
Global brokerage Jefferies has warned that rising risks to demand recovery in 2HFY24 may also lead to further PE derating. “Our recent channel checks and interactions with companies point to a worsening demand outlook with discretionary IT spending still under pressure and 1Q being softer than expected. We cut our FY24 growth estimates by 50-150 bps and lower our below-consensus FY24-26 EPS estimates further by up to 4% to factor this,” said Jefferies analysts Akshat Agarwal and Ankur Pant.
Midcap vs largecap
Midcap IT stocks are also trading at relatively high multiples, ranging between 25x to 30x. “This valuation range can be considered as expensive. Considering the current pressures in the market, it appears that there may be more potential for midcap IT stocks to experience a further decline compared to large-cap IT stocks,” Kapasi said, adding that the scope for de-rating in valuations is lower for largecap IT stocks.
Calculations done by Jefferies shows that midcap IT stocks are at PE of 26.3x against the long-term average of 24.5x.
Sonam Srivastava of Wright Research believes that the blend of growth potential and relative resilience from global events make midcap IT stocks an attractive proposition.
“The appeal of midcap IT stocks over their large-cap counterparts stems from their potential for higher growth, increased innovation scope, and a stronger reliance on the domestic economy. As market rallies broaden, these midcap stocks stand to gain significantly,” the fund manager said.
Should you buy or sell?
Despite the challenges faced by the sector, many IT companies continue to generate strong cash flows and offer decent dividend yields.
According to Jefferies, the average FY24 dividend yield of top 5 IT stocks comes to around 3.8% with Tech Mahindra commanding the highest dividend yield of 5.4% followed by HCL Tech’s 5%.
“If the US economy manages to regain stability, leading to a resurgence of deal wins for the Indian IT sector, or if the Indian IT industry successfully innovates and makes notable strides in the realm of generative AI, the earnings outlook for these companies could improve substantially. In such a case, their current valuations might appear quite appealing based on revised earnings projections,” said Srivastava.
For pure long-term investors with a 5-10 year horizon, it may be a good time to buy IT stocks gradually in SIP mode before the next leg of the bull run begins.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)