The results of Infosys and TCS have had their usual impact on the infotech sector. In broad terms, TCS has so far, ridden out recession better. However, rupee depreciation hasn’t been enough to offset the global slowdown.
TCS will probably outperform most IT players and the sector will outperform physical exports in general. But the absolute performance of IT will be nothing to write home about.
The double-dip in the global economy between 2008-12 has highlighted certain aspects of the Indian IT industry.
One is that it’s highly cyclical. Second, Indian IT has long matured past the stage where it could assume 20 per cent growth as given.
A major acceleration in growth would require key IT players to deconstruct their business models and change their operating paradigms. In a nutshell, they need to open new markets and this means developing new skill sets and accepting new risks. One way is to move up the value chain and develop a presence in the products market and high-end consultancy.
It may also mean a wider spread in geographies. For example, Indian IT services penetration in East Asia and Japan is low. There are language barriers and there has been a lack of interest in learning how to operate in those environments. Domestic penetration is also low. Here one barrier is tax-structure that encourages exports. But Indian IT does need to find ways to exploit relatively higher growth prospects in Asia-Pacific including at “home”.
The case could be made for holding positions in IT anyway. Compared to historic levels, valuations are moderate and they’ve corrected down to reflect poor growth prospects. Again, in comparison to many sectors with only domestic exposures, IT companies in general have stronger balance sheets with less debt. That’s useful in a downturn.
In the long run, if we assume rupee weakness continues, that should also count. Export growth and higher margins do correlate strongly in the long-term with a weaker currency. Right now, most developed economies are not increasing IT spends. As and when they do, Indian firms will remain among the most competitive and hence, see the quickest growth.
In the circumstances, is it worth looking for the market leaders in the sector? Or is it more logical to hold broad sectoral exposure? Or to cut back and wait until there are clearer signs of recovery? There are pros and cons in favour of any of these decisions.
The market response to Infy and TCS suggests that the sector may not deliver positive returns in absolute terms though it could outperform the overall market. The implication is that there could be some capital losses in the next six months or so. Market leaders, such as TCS, are more likely to hold value if there is a continuing phase of bearishness. In that sense, they are safer to hold.
However, as and when a recovery starts, the stocks that have been most beaten down are the most likely to respond with quick capital gains. In that sense, the worst performing stocks in the sector would have the most upside during the turnaround and recovery phase.
If you wish to hold a broad sectoral exposure to infotech through the next six months, it probably doesn’t make sense to look for market leaders. The second rank of IT stocks will lose more ground during that period. But they will also recover faster and that will balance off. The returns in this case will be closely aligned to the CNXIT index.
If you wish to hold a narrow-focussed IT exposure, then it would be better to take exposure only in the market leaders. Preservation of capital would be better if the downturn continues. However, such a narrow portfolio of front rank stocks will underperform the CNXIT during the recovery phase. This is the price of extra safety.
If you intend to exit and re-enter at lower levels, then a focus on the worst performers could pay the highest returns. This is counter-intuitive and difficult for a fundamental investor to accept emotionally. But it is also true and not just of the Infotech sector.
The worst performers in a bear market tend to see the biggest turnarounds in the early stages of the next bull market. So the best returns arise from identifying the worse performers and taking a call on the ones likely to stay in business. Such a strategy - of buying the dogs at the bottom of a bear market - is obviously high-risk. But it’s also often very high-return and it should outperform the CNXIT.