How fortunes change! IT sector equity funds today face the ignominy of being the worst-performing category, down a massive 27 per cent year to date (YTD). In our bl.portfolio edition dated January 23, 2022, we had recommended investors to avoid these funds at least a 25 per cent correction in sectoral tech funds in India. We had noted that the case to have exposure to this sector is very high given a long runway of growth with exponential growth in innovation, but at cheaper valuations. This has played out well, with the 27 per cent YTD correction seen in the IT sector funds.

The performance of the funds this year is in stark contrast to when IT sector funds as a group were up a whopping 64 per cent, earning them the best-performer in calendar year 2021. Even in the Covid-ravaged year of 2020, when markets initially fell and then rose like a phoenix from ashes, IT sector funds were a close second-best with a robust 58 per cent gains. Here we take a look at how the funds are positioned in a challenging environment and whether they can bounce back.

Back to the future

After two blockbuster years in 2020 and 2021, the Nifty IT index in YTD CY22 (down 30 per cent) has underperformed the Nifty (down 3 per cent) by a giant 27 percentage points. The starting point for the underperformance was the runaway valuation of both Tier-1 and Tier-2 IT companies in the backdrop of higher interest rates on the horizon, which are always a dampener for overvalued stocks. The second point was the concern developing around earnings in FY23 and FY24 in the context of potential cut back on IT budgets and spending by top customers.

In terms of returns, the one-year returns of actively-managed tech funds range between -14 and -21 per cent, while the NAVs of Nifty IT ETFs declined nearly 22 per cent. However, the superlative performance in 2020 and 2021 has meant that three-year returns range between 21 and 31 per cent CAGR, while five-year returns fall in 19-28 per cent CAGR. Nifty IT ETFs do not have a long-term track record.

Portfolio positioning

Though some IT sector funds have slightly different mandates than others in terms of international exposure, at a broad level, portfolios are quite similar and concentrated. The same set of five-six stocks — Infosys (down 17 per cent YTD), TCS (down 21 per cent YTD), Tech Mahindra (down 28 per cent YTD), HCL Technologies (down 28 per cent YTD), Bharti Airtel (up 12 per cent YTD) and Wipro (down 39 per cent YTD) account for 50-70 per cent weight in the five tech funds. Software and telecom are the dominant sectors across the five actively-managed funds. The difference is either in stock allocation weight, market-cap exposure (60-70 per cent range in large-caps) and presence of international stocks. Mid- and small-cap IT services companies account for 9-22 per cent exposure currently. This segment did well in the last two completed calendar years, but has seen stock prices drop by up to 60-70 per cent this year. Portfolio constituents such as Birlasoft, Coforge, Mphasis, Mindtree and Persistent have seen steep falls.

Sector outlook

While the Indian IT sector emerged stronger post-Covid, the valuation multiples had significantly outpaced earnings growth. This has been corrected to some extent this year, but excessive valuation has not been completely purged. After a couple of quarters of margin disappointment, demand concerns are now getting elevated due to serious macro-economic issues in the main geographies that IT sector is exposed to – North America and Europe. The nature of slowdown in the US — a soft landing or deep recession, how Europe navigates its inflation/energy crisis may decide the near-term tech sector fortunes going forward. With macros not in favour, European enterprises may pull back their IT spending at least for the time being.

We had earlier asked investors to wait for a 25 per cent correction and with that having played out now, investors with a five-year horizon can gradually start biting into IT sector funds through the systematic investment plan (SIP) route now. While there may be some more pain, it is not possible to perfectly time markets. Hence starting an SIP is ideal in the current context given the fact that the long-term prospects for the sector, given India’s dominance in the IT services space remains solid.

with inputs from Hari Viswanath