Is it a good time to invest in IT Sector?

Indian IT companies have been under pressure triggered by an imminent global slowdown and recent events in US Banks triggering fears of a global banking crisis. Cautiousness among Indian IT companies also emanates from the fact that ~30% of its revenue is derived from the BFSI (Banking, Financial Services and Insurance) sector. While it is natural to see a moderation in growth following heightened tech spends over the past two years, the growth in IT spending over the long term is likely to be relatively attractive.

The current environment looks better than the ones during Global Financial Crisis in 2009 and the growth slowdown during CY17-19 during the advent of digital adoption. Exposure to affected banks is minimal for most Indian IT companies with a share of <3%. The threat of a technology shift like CY17-19 looks low. Given the recent negativity in the sector, it is worthwhile to look at the popular rhetoric during past downcycles.

An excerpt from a prominent research house in 2009 says: “While client budgets for FY10 seem down 5-10%, client hesitancy in spending even budgeted amount is making these budgets irrelevant. While instances of project cancellations in Mar-09 quarter have been few, project ramp-ups have been delayed and project scope has been reduced in several cases.” What really happened was completely opposite. Pent-up demand picked up significantly in the subsequent quarters triggering a rally in IT stocks.

IT companies went through another rough patch of slow growth between 2017 and 2019 as demand shifted to digital technologies. The digital wave was characterized by a rapid pickup in cloud adoption and automation initiatives. The popular belief was a permanent slowdown in growth rates due to falling maintenance spend following cloud adoption and automation. While Indian IT firms slowed down during the initial phase of digital adoption, they picked up significantly in the subsequent period as the implementation stage kicked in. Rising US protectionism was another factor that impacted Indian IT companies in the same period. Indian firms overcame by opening more near shore centers and ramping up local hiring.

The fundamental reason IT firms were able to overcome the difficult phases in the past  is  the relevance of long-term drivers like cost arbitrage, low capital intensity, the presence of a large tech pool and the persistence of global tech spends. India continues to be a low-cost employee base where the cost of an Indian IT engineer is roughly 1/3^rd of developed market peers.

Given the prominence of software systems and digital platforms in businesses, technology spend is only likely to increase in the long term. Global IT services spending has grown at ~8.1% (Currency: INR) over the past decade while the Indian IT sector for the same time frame has grown at ~14% (INR). Indian IT’s aggregate revenue is estimated to be ~19.7% of global IT spending compared to 11.1% a decade back. Low penetration of Indian IT services leaves ample room for reasonable growth in the coming decades.

What should an investor do?

Historically, Nifty IT has outperformed broader markets barring periods of disruption. The average 3 year rolling CAGR (Compounded Annual Growth Rate) of Nifty IT since FY09 stands at ~13.7% compared to ~10.4% of Nifty (Data as of April 27, 2023). 

Nifty IT has largely outperformed the broader index:

Data as of April 27,2023

Past performance may or may not be sustained in the future

An effective way to gauge the attractiveness from an investment perspective is to understand the market expectations factored in the current stock prices. If I were to reverse calculate the growth rates of the Top 5 index weights of the Nifty IT index with a cost of capital assumed as 14%, embedded growth rates are at a reasonable discount to the industry growth rates over the past decade. In the case of companies with a history of muted growth rates, factored growth rates are at a decent discount to the industry. Moreover, the historic valuation bands mayn’t be representative as the IT companies have improved their capital allocation policy over the recent years. Notwithstanding the potential near-term volatility, current levels offer a good chance to earn reasonable long-term returns as the environment normalizes. Investors with a long-term horizon may consider the current opportunity to build their allocation over the next few months.

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