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Darkest before dawn?

The bearish sentiment in the information technology sector—which a section of analysts feels is overdone— may actually be a good opportunity to pick select stocks on the cheap, for the long term. Virendra Verma goes into the details.

Virendra Verma        Print Edition: May 17, 2009

Pervasive pessimism is a contrarian’s best friend. When stocks are beaten down, such investors move against the crowd and start buying, with the expectation of a turnaround in the medium-to-long term. For instance, in early March, when the BSE Sensex was hovering over 8,000 levels, conventional thinkers were punting on the benchmark index falling below 7,000. But within a month, the Sensex was headed the other direction, and till last fortnight had gained some 40 per cent from the March bottom.

Is something similar taking place in IT stocks, in the wake of the disappointing results turned out by the top tier of software services? The poor sequential and year-on-year growth as well as the dismal guidance for the new fiscal don’t seem to be reflected in the stock prices. Infosys, for instance, has increased marginally by 3 per cent since it declared its results. Ditto with TCS, which is up 1.5 per cent—this despite many equity analysts putting out sell reports on these stocks.

So, what’s the contrarian’s story? “IT companies have huge cash flows and at current prices these stocks are not very expensive,” says Gaurav Dua, Head of Research, Sharekhan, a Mumbai-based brokerage. The price/earnings multiple (P/E) of the sector currently hovers around 13-14 (on 2010 earnings) as against the Sensex’s P/E of 13.

Yet, the concerns for the conventional investor are many. The biggest is the cloud of uncertainty that hovers over the sector, what with clients slashing budgets and deferring investment decisions. Traders can stomach a bleak picture but what they can’t deal with is uncertainty; so when there’s no clear path ahead, they avoid the entire sector, and prefer to deploy their money in other places where there’s more clarity.

The insecurities of the IT industry have plenty to do with the woes of the economies in the US and Europe, from where Indian IT services players derive most of their revenues.

The reluctance of clients in these continents to spend is impacting volume growth and putting pricing pressure on billings. Add to this unfavourable currency movements and higher tax rates in the year following the current fiscal, and the dismal picture for the sector is complete. The larger picture is that IT services will recover only once the global economy does. Till then, lower revenue and profit growth—perhaps in single-digit territory—or even a decline in growth rates, are on the cards over the next few quarters.

A further dampener could be the new US policy on offshoring. “Protectionist measures by the US government could also take their toll of the Indian software sector,” says Ajay Parmar, Head of Research, Emkay Global Financial Services.

There are market participants who think that the results for the quarter ended March 2009 could have been worse, had it not been for the rupee depreciation. “Last year, the rupee depreciated by 27 per cent, but this year it will not depreciate so much,” says V.K. Sharma, Director and Head of Research, Anagram Capital. In fact, Sharma doesn’t rule out the rupee appreciating in the year ahead. Needless to say, he’s bearish on the sector as he doesn’t see much growth coming.

It’s indeed a dark picture. For the contrarians, though, it’s always darkest before dawn. They point to the situation just after the terrorist attacks of 9/11. The conventional fear at that time was that the US economy would take a tumble and, with it, the Indian IT sector. But that gloom didn’t extend beyond a couple of quarters, and the sector duly got back on the growth path. This time round too, the optimists are counting on a recovery in the US economy, and that should provide a huge fillip to IT services. “There is a possibility of substantial improvement in the global economy by the yearend,” says Dua of Sharekhan. He expects an improvement in the outlook for the sector by the end of the current fiscal. But it’s going to be a rough road till then.

So, till this situation arises, which way will stock prices go? “There will be consolidation or sideways movement in the next few quarters in terms of price,” says Dua. But there are people who think that the sector is still over-owned; institutions hold a large quantity of IT stocks and most of these players are avoiding giving sell orders in order to prevent a crash in stock prices. “There is selling in IT stocks on the upside in small quantities,” says a dealer with a domestic broking firm. He adds that most fund managers are steering clear of the panic route.

Parmar of Emkay says IT stocks will not outperform the market, but adds that they will not fall much from the current levels either. “The IT sector will not be ignored as these companies’ operating profits, return on equity and return on capital employed are much better than in other sectors.” Another reason cited by market players for such a trend is that these stocks are defensive in nature—like fast moving consumer goods and pharmaceuticals—and are relatively safe investments in recessionary times.

If you are keen to put your money where the contrarian’s mouth is, analysts point out that in the short term it makes sense to look for companies with some of their eggs in the faster-growing domestic market, as they will be less exposed to the vagaries of the global economy. A few second-tier IT companies that are growing faster than their larger peers may also be worth looking at. It’s a brave approach, and not all contrarians win—that’s why there are so few of them.

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