IT index may underperform broader markets

Three majors players from the information technology (IT) sector have come through with results. Infosys and Tata Consultancy Services (TCS) both beat consensus estimates, while Wipro has hit the upper end. Infy’s stock prices were pushed to a new high on a strongly positive market response. The response to Wipro was initially positive but followed by heavy selling.

TCS has also seen some selling. It is under some pressure due to the lawsuit by Epic Systems, which could result in losses of $940 million (plus legal fees) and a major loss of reputation. But, the case has been appealed and if TCS wins a favourable verdict on appeal there could be positive price action. The case could however, also spark “copycat” allegations that impact other Indian IT firms. So, it does have potentially larger ramifications.

A stream of large, mid-sized and small IT companies will be releasing results over the next few weeks. Most of those outfits are smaller, with less wide regional footprints, and also more specialised in terms of verticals. But, the air of optimism created by the initial results should translate into good price action for the IT companies that beat expectations.

While size and scale have obvious advantages, smaller, more specialised firms could conceivably grow faster. So, we can expect some strong out-performances. But, we can also expect some under-performances, unless analysts have got industry growth estimates seriously wrong.  

The IT index has traditionally been a good hedge when the broad market goes bearish. It is low-beta for one thing although it is well correlated. The beta of the Nifty IT index with respect to the Nifty worked out at something like 0.7 over the past 16 months. The correlation is at around 0.68, which is quite strong. Taken together, this means that the IT index generally moves in the same direction as the Nifty but it fluctuates appreciably less.

There is a chain of causality underlying the defensive strength.  The IT index is correlated to the dollar. It tends to rise when dollar strengthens. The dollar often strengthens when there is foreign institutional investor (FII) selling due to dollar outflows. The Nifty goes bearish when there is FII selling. This is a major reason why the IT index tends to correct less when there is FII selling, the stronger dollar offers a cushion.

There are a few points to be noted at the current moment. The low-beta behaviour is very useful when the market is bearish. But, low-beta also means that the IT Index returns less when the broad market is up. There are signs that the broad market is going into a bull run. The IT Index may underperform the broad market during a bull run unless the IT index beta shifts upwards. A second negative point is that the dollar is actually weakening versus the rupee at the moment. This is due to strong FII inflows (and the US Fed recent policy statements). A strong rupee could retard gains for IT stocks.  

A third point is the increased focus on North America. Given very low macroeconomic growth in Europe and Asia, the dependency on North America for revenue growth is alarmingly high. If the US does become protectionist, this could hurt. Protectionist noises are being made by most candidates in a year when a new US president must be elected.

The IT sector may still deliver strong returns if other companies beat the consensus. There is a chance that the industry will see positive rerating and valuations will shift upwards, but if the recent beta and correlations remain more or less unchanged, the industry as a whole may underperform, even if it gives positive returns.

The author is a technical and equity analyst