The Case For Infotech Stocks
Three months back, before the present bear market reared its head, many market strategists thought that the risk-reward equation had turned in favour of the so-called Old Economy stocks. Their reasoning was simple. Agricultural production had been low last year, and that had led to a slowdown in rural demand. This, they argued, was clear from signs such as the slim growth in Hindustan Lever's volumes. And since agricultural production has followed a pattern of alternating high and low growth, there was little downside risk for the Indian economy this year. The Index of Industrial Production (IIP) showed robust growth. Combine that with the extremely low valuations of the traditional stocks, and you had a compelling argument for value investing after years of following the momentum investor.
But times have changed quickly. Several clouds now hang over the Indian economy. A state forecasting agency has predicted that the monsoons this year are likely to be poor. A severe drought has affected five states. The inflation rate has leaped upwards, while the government's massive borrowing programme has resulted in fears about the sustainability of low interest rates. All this means, or so runs the new argument, that economic recovery may not continue in full swing. The recovery so far seems to have been based on consumption demand, and investment demand is yet to pick up. The IIP figures show that not only has capital goods output fallen, the imports of capital goods have also shown a similar trend. So a decline in consumption demand as a result of lower rural purchasing power will hurt the recovery.
In contrast, the Indian IT sector is insulated from developments in the domestic economy. It is not merely a play on the US economy, as has been argued. But the fact is that with the e-revolution under way, corporates can scarcely afford to lower expenditure on infotech. This means that the Indian IT sector, which essentially services US corporates, is likely to continue to have enough work. A related positive factor is the diversification of many Indian IT companies into Europe, where prospects of continued economic growth are bright. So if the US economy somehow slows down, Europe could step in as an alternative market. Further, Indian IT companies are insulated from interest rate risk. Hence, it can be argued that this sector is actually a defensive play, a natural choice in uncertain times.
What about valuations? The recent bloodletting in the markets has reduced price-earnings to growth (PEG) ratios to more respectable levels for the frontline IT stocks. Their earnings growth has continued to be impressive, despite the warnings of doomsayers. And although the Nasdaq risk remains, it has been considerably lowered. The conclusion that emerges is that the risk-reward profile is still in favour of the IT majors.