The Indian technology sector has had a dream run since the Covid lows of March 2020 and investors in the top thematic funds tracking the tech sector have been rewarded well. As compared to the BSE Sensex returns of around 19 per cent in the last 1 year, benchmarks tracking the tech sector - the BSE Teck and BSE IT indices - have outperformed and returned around 34 and 40 per cent respectively for the same period. The Indian tech benchmarks have also outperformed the tech-heavy US bellwethers Nasdaq 100 and Nasdaq Composite, which have returned around 8 and 2 per cent respectively in the last one year.

The five actively managed IT/tech sector equity mutual funds have returned between 23.41 (Franklin India Technology Fund) and 59.38 per cent (ICICI Prudential Technology Fund). Barring Franklin India, the other three funds (besides ICICI Pru) – Aditya Birla Sun Life Digital Fund, SBI Technology Opportunities Fund and Tata Digital India fund have all returned above 40 per cent, outpacing the broader and sectoral indices.

There is not much difference in portfolio composition in IT sector funds with ‘digital’ in their names compared to those who don’t. Though ‘digital’ lends itself to a seemingly wider mandate and investible universe, the top holdings of all the 5 actively-managed funds, barring small differences in allocation or investment approach, are homogeneous.

Looking into the portfolio of these companies as on December 2020 and December 2021, and comparing the same, it does appear factors that enabled outperformance are appropriate tilt towards mid and small-cap IT services companies. While the entire IT services companies have outperformed over the last one year, mid-cap IT has strongly outperformed the Tier 1 IT services companies (TCS, Infosys, HCL Tech and Wipro) over the last year. Stock price returns of Tier 1 IT services companies over the last one year are in the range of 16 to 36 per cent. On the other hand the returns of the next 5 biggest IT services companies are in the range of 60-180 per cent over the last year.

While the digitisation wave has lifted everyone, the mid-cap companies have benefited more, given the large digitisation opportunity relative to their size. The broader mid-cap and small-cap stock rallies in other segments with technology have also aided the outperformance.

Another differentiating factor in performance is the right kind of international exposure. International exposure for the funds as of December 2021 ranges from around 4 per cent in Aditya Birla Sun Life Digital Fund to as high as 27 per cent in Franklin India Technology Fund. While at first look, given the underperformance of Franklin, it would appear international exposure has tempered performance, a deeper analysis indicates that is not the case. For example, SBI Technology Fund, with 23 per cent international exposure, has fared much better versus Franklin. Similarly, ICICI Pru, with around 9 per cent international exposure, has been the best performer. Thus, right international stock picking is the differentiator.

The other aspect to be noted is that given much higher elevated valuations of Indian IT services companies versus international technology companies, going forward, higher international exposure may turn out be a tailwind. For example, TCS has always traded at a discount versus global leader in IT services – Accenture. However, in recent months, TCS valuation multiples have outpaced that of Accenture for reasons that cannot be justified based on fundamentals.

How to play it

While technology as a theme has a long runway of growth with exponential growth in innovation, from a long-term investing perspective valuations matter. While Indian IT has emerged stronger post Covid, the valuation multiples have well outpaced earnings growth over the next few years. Such phases in markets are usually followed by extended periods of correction/consolidation.

Also, while the tech space in India can evolve, going forward, with the advent of new age tech companies, for them to make a meaningful impact to fund performance will take few more years. The number of companies is few as of now, and while some of the newly listed ones are big in terms of market cap they are trading at what appears to be unsustainable valuations. Most of the Indian new age companies are unprofitable or barely break even. In this context, it needs to be noted that as per recent reports, unprofitable tech firms in international markets have started correcting severely.

A Morgan Stanley basket of unprofitable tech firms has corrected by 40 per cent since a peak in November. Similarly, a Goldman Sachs basket of unprofitable tech firms is down 50 per cent from all-time highs. In such a scenario it would be challenging for the Indian new age companies to retain their elevated valuations for too long. Given these factors, for them to play a meaningful role in thematic funds, it is going to take some time.

Also, concerns on whether the US Federal Reserve has made a policy error by keeping monetary policy loose for too long has resulted in the tech-heavy Nasdaq Composite and Nasdaq 100 correcting by 13 per cent each (year to date). Similarly, for the Indian tech stocks, while corrections are not certain, the probability is high. Hence, similar to our recommendation for Nasdaq 100 funds at the start of the year, on waiting for at least a 25 per cent correction before taking exposure, we recommend investors looking to take fresh exposure in sectoral tech funds in India to wait for a correction to play out. The case to have exposure to this sector is very high, but at cheaper valuations.