‘Those who cannot remember the past are condemned to repeat it.’
This quote, attributed to novelist and philosopher George Santayana, is ringing sound and strong today in the IT sector, post the shocker of a result from Infosys. As the pandemic-induced need for digitisation, combined with unprecedented fiscal and monetary stimulus, resulted in a significant but temporary bump-up in technology spending, the so called ‘digital transformation’ wave erased memories of the past.
Stock valuations across the board zoomed way past historical range and the fact that the Indian IT sector was a mature industry with at best long-term growth prospects of high single-digit to low double-digit growth was forgotten. Analysts, market commentators, investors and fund managers and even a few managements fell prey, again.
Overly optimistic sell side earnings growth estimate and price targets, investors pouring in money at any price and managements fixing share buyback price at irrational levels are some examples and serve as a stark reminder of the past cycles forgotten.
However, at bl.portfolio, we had started flashing the red signal on the IT stocks by June 2021 by when we had recommended investors to book profits in the top 3 IT stocks then — TCS, Infosys and Wipro — and followed up with recommendations to book profits in most of the mid-cap IT stocks, which were trading at their most expensive valuations post the dotcom mania.
The rationale for caution was simple. While the fundamentals of the sector were strong, with many Indian IT services players being the best-in-class companies, valuations across the board (barring a few) had way outpaced fundamentals.
In the investing world, that is akin to binging on the next few days’ lunch today, which means you will have to end up rationing or may be even going without food over the subsequent days.
That call played out, with investors in the sector being starved of returns since the Nifty IT index peaked in January 2022 at 39,370. It is down 32 per cent since then. Quite a carnage it has been, with stocks like Wipro and a few other mid-cap stocks down by 50 per cent or more. You will have to travel back to 2007-09 to witness this level of carnage in the Indian IT sector.
Exactly a year back, we had given our IT sector outlook in our Big Story titled, ‘Is the party over for IT stocks’ in bl.portfolio edition dated April 24, 2022, wherein we had outlined reasons why it was time for bullish investors to sober up. With stocks indeed sobering up, let us now assess where things stand a year on and what’s in store.
Valuations are better now
‘What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.’ – Warren Buffett
In the two-year period from February 2020 (pre-Covid highs) to March 2022, the Nifty IT index was up by 120 per cent. Guess what the increase in revenue and earnings of the index in the same time period were? A more sober 15 and 27 per cent respectively!
What exactly justifies paying 120 per cent more for a product whose productivity increased by 27 per cent? Probably the nice stories of how digital transformation will ensure high growth rate for longer, and the facts that inflation is transitory and interest rates will remain low for longer if not forever.
As these tales got debunked one by one, so did the irrational exuberance on stocks in the sector. In the short run, stories can rule stock prices, but in the long run, it is always the numbers that matter. This is the way things have played out in the IT sector from the time of the Y2K/dotcom boom till now, and the longer the stories took time to get debunked in the markets, the more painful the correction was.
One logical justification for the share prices being decoupled from earnings growth could be if shares were undervalued earlier. However, this does not apply to much of IT sector/IT stocks, which were very well discovered by markets. Just before the pandemic hit, on a trailing PE basis, the Nifty IT index was trading at around a 5 per cent premium to its 5 and 10-year average of around 19 times, implying that it was definitely not undervalued. In the absence of any significant acceleration in long-term earnings growth potential (which was absent), there was not much of a case for the stock prices to significantly outperform earnings growth in 2020-2022.
Analysis also shows that the trailing 5-year earnings CAGR (since 2017) of the Nifty IT index and the top 4 IT services companies has ranged 7-12 per cent. There is no significant evidence of sustainable acceleration in earnings growth rate to warrant higher valuation versus historical range.
Now, after the correction, are numbers and stock prices in sync? While not entirely, it is more reasonable with the index up by 60 per cent from February 2020 to now, while earnings are up by 36 per cent in the same period. The takeaway here is that, much of the froth has been squeezed out.
Under normal situations, it might be ok to start buying into IT stocks gradually. However, it is not clear how the global economy is going to be over the next few years, which makes the decision to invest dicier.
Bleak global growth outlook
Until before the collapse of the Silicon Valley Bank in March, the range of economic predictions on the US economy was as wide as it could ever be. Expectations of economists and market participants ranged from hard landing to soft landing to no landing. While the first possibility was what the bears were expecting, the other possibilities were more supportive of the bulls’ outlook. However, post the banking crisis, the outlook for the economy has got more gloomy, tilting it more in favour of bears.
The US Fed’s full year economic projections indicate the possibility of a recession in 2022. Further, the recently released World Economic Outlook by the IMF forecasts global growth to fall to 2.8 per cent in 2023, from 3.4 per cent in 2022. But the more important thing to note are these – one, the forecast for advanced economies is more dire, with growth expected to more than halve, from 2.7 per cent in 2022 to 1.3 per cent in 2023, with possibility of it slipping below 1 per cent if financial stress intensifies. Two, the IMF now expects global growth to settle at 3 per cent five years out, which is the lowest medium-term forecast in decades.
IT sector fortunes are directly linked to global economic prospects, especially the advanced economies. The US accounts for 50-60 per cent of revenues for the top 4 Indian IT services players and Europe accounts for 25-30 per cent of revenues. The global slowdown is already getting reflected in the outlook of companies, with Infosys now forecasting bruising decline in growth rates with constant currency (CC) revenue growth for FY24 expected at 4-7 per cent versus a stellar 15.4 per cent in FY23. HCLTech has guided for FY 24 CC growth of 6-8 per cent versus 13.7 per cent in FY23. TCS does not give guidance but was very cautious in its commentary.
Further, commentary from companies clearly indicates slowdown beyond the major BFSI vertical, implying a more broad-based slowdown taking hold.
IT spending will be strong when companies in advanced economies are benefitting from strong GDP growth, but when their revenue and margins get hit, at some level their tech spending will face the axe, too. Consensus forecasts (Bloomberg) are for profits of S&P 500 companies to decline by 7 per cent in 2023, but this can intensify if a recession plays out.
Every time a recession/slowdown has taken hold, the stocks too have had deep corrections. The one difference in 2020, though, was the quick rebound. That may not be forthcoming this time as the level of stimulus pumped into the economy was a key factor driving that rebound. Both Central Banks and governments having been jarred by inflation, will be very cautious in stimulating the economy this time around.
The tsunami of job cuts by tech companies like Amazon, Microsoft and Accenture, including in their cloud/digital businesses, does not lend optimism on a quick rebound.
Other moving parts
Besides broader macro uncertainties, there are a few other moving parts for companies in the sector to contend with. For one, what is going to be the impact of the new wave of disruptive artificial intelligence storming the technology space? Generative AI, as this space is called, has garnered a lot of attention since the release of ChatGPT. It has showcased immense potential for automation and displacing human tasks not just in non-tech jobs, but even in tech-related tasks like software coding. Thus, it requires monitoring on how this impacts the IT service companies.
That said, every time disruptive changes have played out, Indian IT has adapted well. For example, when the Cloud/SaaS wave was accelerating in the middle of last decade, there was 2-3 year adjustment period as the legacy business of IT companies shrank and it took a while for them to make their digital business the main driver. During this period IT stocks gave flattish to negative returns. Will there be similar disruption this time? Investors need to factor this. The winners and losers may be different from the previous phase of disruption.
Another thing to consider is, what will be the impact of a stable rupee versus the USD during a recession? During previous recessions, there was a significant depreciation in rupee vs the USD that acted as cushion for the financials of IT companies. With India being viewed now as shining light in a weak global economy, the rupee may fare better.
Thus, although as discussed under ‘Valuation’ the froth appears to have been squeezed out, the many uncertainties and disruptions discussed above continue to call for patience when it comes to investing in the IT sector now.
That there will be a significant slowdown in IT sector due to global headwinds was foreseeable at the start of the year. Yet the Nifty IT index rallied by 10 per cent from start of the year till mid-February, only to crash again! Thus, the endgames are usually tricky and can be quite volatile.
Fundamental investors must always be cautious to guard against market narratives and stick to a pure valuation-based approach. As discussed, the uncertainties are numerous now. The greater the uncertainty, the greater you must bargain for better value before buying stocks. One must treat the pandemic-induced excess growth in IT sector as an aberration (for now). The valuations during this phase were an even greater aberration.
The recent correction in the sector may be viewed as the beginning of the end of the bear market for IT stocks and value might emerge sometime during the course of the year. In this context, stock valuations preferably at a discount or at least in line with the average valuation of pre-Covid years might be a good starting point to consider investing in the stocks. While this is not a holy grail approach and can vary from stock to stock and as new information flows, for now it is a good benchmark for assessing the stocks.