Information Technology: The Contrarian Bet Now?

The IT sector appears to be out of favour with its valuation falling by almost 31 per cent year-to-date (YTD). Furthermore, Nifty IT has dropped more than 23 per cent YTD, behind Nifty 50, which has gained around 0.75 per cent. So, does this seem like a good time to buy great IT companies the contrarian way? This article is an effort towards finding out the same 

According to Statista, the Information Technology (IT) industry contributed 8 per cent to India’s Gross Domestic Product (GDP). This is somewhat higher than in FY21 which was at 7.7 per cent but significantly lower than in FY15 at 9.5 per cent. Furthermore, it accounts for around 59 per cent of the worldwide services’ sourcing industry. In reality, the year 2021 proved to be a blockbuster for IT stocks and their investors, with Nifty IT returning over 58 per cent and Nifty 50 returning close to 24 per cent. In reality, after the pandemic wreaked devastation on the world, IT firms performed exceptionally well and many IT-specific new fund offers (NFOs) were launched in 2021. 

As shown in the graph above, Nifty IT outpaced Nifty 50 by a wide margin. However, as can be seen, the Nifty IT has been falling since January 2022 and is presently trading at the levels of July 2021. However, this raises the question of whether it is prudent to invest in IT businesses the contrarian way. We will examine herewith the current state of the industry, sector valuations, the performance of Large-Cap IT businesses, and understand if it makes sense to bet on this sector. Technology was the solution that allowed businesses to not only keep the lights on but also pivot their business models to online mode, adapt goods and services to growing market dynamics and customer wants, and enable cooperation in a remote work paradigm for both international and Indian end-user organisations. 

As a result, FY 2022 turned out to be a great year for India’s IT industry. It increased income by 15.5 per cent – the highest ever – to USD 227 billion. To address margin constraints, the industry increased its focus on operational efficiency, and the offline plus online model gained traction in the e-commerce sector. Another significant achievement for the sector was the crossing of the five million mark in total direct employees. As a result of the industry’s ‘people first, employee-centric’ attitude, technology businesses swiftly adapted to hybrid work models and scaled up the industry’s digital capacity development initiatives. The proportion of digital revenue in overall revenue ranges from 30 per cent to 32 per cent, with one in every three employees being digitally proficient, cementing India’s status as the Global Digital Talent Nation. 

These factors have increased India’s share of the global sourcing market to 59 per cent. The computer software and hardware industries get the second biggest amount of foreign direct investment (FDI). It attracted around USD 85 billion between April 2000 and March 2022. When it comes to establishing global capability centres (GCCs), India is one of the most popular locations. In FY21, around 1,400 GCCs have over 2,300 GCC units in India, employing over 1.38 million professionals. Software-as-a-Service (SaaS) investment has climbed 62.5 per cent since 2021 and is predicted to reach USD 6.5 billion in 2022. There are around 1,150 active Indian SaaS start-ups, 17 of which have attained unicorn status. 

Valuations

To better comprehend the valuation of the IT sector, we examined the Nifty IT price-to-earnings (PE) and price-tobook (PB) ratios.

The valuations of Nifty IT in terms of PE and PB have dropped significantly from the highs achieved in January 2022, as seen in the two graphs above. The Nifty IT PE and PB ratios have corrected by around 30.5 per cent and 30.8 per cent, respectively. In terms of valuation, it has been somewhat corrected but remains over its historical average. 

Performance

We examined the performance of large-cap IT businesses to better understand the performance of the IT sector. Large-cap IT companies account for 90 per cent of the total sector’s market capitalisation. As a result, examining their performance might provide us with a solid indication of the overall understanding of the sector.

The table above displays large-cap IT companies’ year-on-year (YoY) and quarterly YoY net sales. The sector’s sales growth was excellent on average with a YoY increase of roughly 23.5 per cent and a quarterly YoY increase of 24.6 per cent.

This sector’s profitability is also fairly good with average earnings before interest, tax, depreciation and amortisation (EBITDA) standing at 21.7 per cent YoY and 18 per cent quarterly YoY. On the other hand, average profit after tax (PAT) was 27.4 per cent YoY and 14.6 per cent quarterly YoY.

These large-cap IT businesses had average return on equity (ROE) and return on capital employed (ROCE) of 28.51 per cent and 37.44 per cent, respectively. When it comes to ROE and ROCE growth, on an average it shows a YoY increase of 10.8 per cent for ROE and 8.1 per cent for ROCE. Though a few corporations demonstrated de-growth, the industry as a whole exhibited a solid increase in returns to shareholders. 

Conclusion

End-user industries (enterprise sector) are estimated to contribute USD 350-400 billion to India’s aim of creating a trillion dollar digital economy over the next several years. According to NASSCOM’s Enterprise CXO Survey 2022, 70 per cent of end-user organisations worldwide want to considerably boost their digital expenditures in 2022. Furthermore, 60 per cent of CXOs anticipate a 6 per cent increase in IT spending in 2022 over 2021, with an emphasis on customer service, supply chain and sales and marketing. The technology industry’s growth predictions for FY23 echo the optimism of FY22 with research and development spending predicted to increase by 10 per cent to 20 per cent over last year. 

Looking ahead to FY23, infrastructure and managed services, consultancy, platform business process management (BPM), data management and robotic process automation (RPA) and engineering research and development (ERD) will witness further penetration of engineering cloud. Productivity software and cyber security solutions will be more popular in the software product area. Finally, the fast-growing interest in metaverse, driven by the demand for more personalised experiences, is expected to further disrupt the e-commerce business. Furthermore, Federal Reserve Chairman Jerome Powell emphasised that he does not believe the US economy is in recession, noting a solid labour market. 

He went on to say that future hikes will be driven by data, which takes time to collect. This would be a windfall to the IT sector, which is more export-focused. Despite their lower-thananticipated performance, IT businesses are expected to maintain their revenue guidance. However, according to foreign portfolio investors’ (FPI) statistics, they exited close to ₹4,665 crore in July 2022, which is one of the highest among other sectors. As a result, we feel that this offers you with an opportunity to gradually begin accumulating shares of excellent IT businesses using a contrarian approach with a three-year investment horizon.