Two to Tango: Indian IT Meets Nasdaq?

The outperformance of NASDAQ is not broad-based and is primarily led by a few companies that are dominant in new emerging technologies and are leading the wave. Indian IT companies and many other traditional IT companies will see a temporary slowdown till the time they do the catching up either organically or inorganically 

The U.S. equity market continues to stand out as one of the top-performing equity markets globally. The S&P 500, a key indicator of U.S. market performance, has surged by 10.35 per cent year-to-date (YTD). This remarkable performance can be attributed, in large part, to the impressive showing of technology stocks. Among these, a select group—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla—have particularly stood out, collectively posting a staggering 21 per cent average increase since the start of this year. 

This exceptional growth far exceeds the performance of the other 493 companies in the S&P 500. These seven stocks have come to be known as the ‘Magnificent Seven’, a term coined in 2023 by Bank of America analyst Michael Hartnett, borrowing from the 1960s ensemble Western movie of the same name. Apart from being among the most valuable companies in the stock market, these companies are at the forefront of secular technology growth trends, including artificial intelligence, cloud computing, online gaming, and cutting-edge hardware and software. [EasyDNNnews:PaidContentStart]

In 2023, the Magnificent Seven collectively delivered returns exceeding 106 per cent, doubling the NASDAQ 100’s gain of nearly 54 per cent and significantly surpassing the S&P 500’s gain of 24 per cent. Even within these indices, a majority of the gain is due to huge momentum in Magnificent Seven. For example, 60 per cent of the S&P 500 gain was driven by these companies and if we exclude these companies, the gain would have been a modest 15 per cent. As of now, it appears that the Magnificent Seven are continuing their streak of outperforming the broader indexes in 2024 even though lately companies like Apple and Tesla have started underperforming. 

The significant surge in a handful of stocks has resulted in the U.S. stock market becoming almost as concentrated as it has ever been, with the only exception being the late 1920s—an era often associated with caution. These select companies now represent nearly 32 per cent of the total market capitalisation of the S&P 500. Remarkably, the combined market capitalisation of these companies exceeds that of all the other stock markets worldwide, excluding the U.S.. To put this into perspective, the Magnificent Seven collectively outweigh the entire Chinese market, doubling the size of the Japanese market, and surpassing the UK market by over fourfold.

Performance of Indian IT Companies 

It’s widely believed that Indian IT companies typically mirror the trends of their counterparts in the U.S., closely tracking movements in the technology-heavy NASDAQ index. However, this correlation isn’t apparent at the moment. While NASDAQ has seen a robust rally of 11.65 per cent since the start of the year, Indian IT and technology stocks have shown little response to this surge, with some IT companies even recording negative returns. The Indian IT index represented by Nifty IT index has also experienced a downturn during this period.

Historical Relationship between Nifty IT and NASDAQ 

Taking a deeper dive, we conducted a regression analysis of Nifty IT and NASDAQ to uncover their historical relationship and identify any recent shifts. Our analysis spanned from the beginning of September 2007, examining weekly returns data for both indices. Rather than analysing the entire period in one sweep, we opted for a rolling regression analysis over a roughly one-year period of 52 weeks, allowing us to gauge the evolving relationship between the two indices across different timeframes. In total, we studied 811 periods. On an average, the weekly returns of the IT index were influenced by NASDAQ to the extent of 26 per cent, with a median influence of 22 per cent. 

The accompanying graph vividly illustrates the fluctuating nature of this relationship. Currently, the influence of NASDAQ on the Indian IT index is among the lowest observed. Notably, from 2016 to 2017, over 50 per cent of Nifty IT’s returns were explained by NASDAQ—a stark contrast to the current 8 per cent. It’s worth mentioning that all relationships analysed hold statistical significance at a 95 per cent confidence level. Thus, the ascent of the Magnificent Seven in NASDAQ is not necessarily translating into gains for the Indian IT sector. Let’s delve into the underlying reasons behind this phenomenon.
 

The Loosening Relation 

The rally in NASDAQ can be attributed to strong Quarterly Results from key index heavyweights and promising prospects for major companies within the index. Contrary to a broader market sentiment shift, NASDAQ’s surge is primarily driven by a selective approach from investors, focusing on specific stocks. Companies like Meta, among NASDAQ’s heavyweights, have reported impressive quarterly performances, attracting bullish sentiment on Wall Street. Similar is the case with Nvidia, whose new flagship AI processor is expected to ship later this year and is chasing a data centre market potentially greater than USD 250 billion. 

Earlier, the company had reported that its revenue in its fiscal fourth quarter had more than tripled from a year earlier to USD 22.1 billion, while its profit soared nearly nine-fold to USD 12.3 billion. Its revenue was well above the USD 20 billion the company predicted in November 2022 and above Wall Street estimates of USD 20.4 billion. Overall, these companies witnessed an impressive 55 per cent increase in average earnings per share during the fourth quarter with December ending compared to the previous year’s same quarter, as reported by Bloomberg. However, concerns about economic slowdown and inflation persist, affecting Indian IT and IT-enabled technology companies, which rely heavily on the U.S. and European markets. 

Their order books have yet to regain their usual momentum. Despite some Indian IT firms reporting improved Q3 results, they continue to face challenges in retaining employees and addressing attrition, as their margins remain under pressure. The Indian information technology sector, reflecting the global downturn in IT spends, sustained a lacklustre performance. The industry experienced a marginal 3 per cent year-on-year revenue growth while recording a 1.5 per cent aggregate decline in net profit. A noticeable trend surfaced wherein despite industry leaders aligning revenue figures with those of the same quarter last year, they struggled to improve profitability. 

Conversely, smaller companies and those involved in artificial intelligence operations took the lead in terms of profits even among Indian IT companies. Fundamentally, what is also supporting NASDAQ’s rally is movement in the dollar index that has recently hit a 10-month low. Consequently, investors who had positions in currencies are now booking profits and redirecting their investments towards U.S.’ equity markets. With the U.S. Federal Reserve’s interest rate hikes nearing a peak, investors are reallocating their capital to equities. In this scenario, NASDAQ-listed stocks with strong quarterly performances are attracting significant attention and investment.
 

The Indian IT Company Challenges 

Initially, following the Q3FY24 results, Indian IT companies appeared to be on solid ground. Despite subdued results from some Tier 1 companies, investor confidence was buoyed by positive management commentary, reflected in notable stock price movements for companies like Infosys and Wipro. The market, amidst a flurry of significant deals announced by TCS and Infosys, anticipated a rebound. However, on March 21, the announcement of lacklustre results by U.S.-listed Accenture cast a shadow over the hopes of a recovery for Indian IT companies in the latter half of CY24. 

Despite the market closing in the green on March 22, the Nifty IT index plummeted by more than 2 per cent. Accenture’s underwhelming performance in the latest quarter, coupled with discouraging guidance, has raised concerns regarding the trajectory of Indian IT companies into the financial year 2024-25. The earlier optimism among investors about a potential uptick in performance during the second half of the calendar year has waned in light of Accenture’s subdued results. 

Accenture’s revelation that future revenue growth may only range between 1-3 per cent—significantly lower than previous projections—came as a shock. 

This downward revision, coupled with the reliance on inorganic growth through acquisitions, marks a significant departure from past expectations. Notably, Accenture’s focus on Generative AI deals, while initially positive, has implications for IT companies globally, as it signals a shift in client spending away from other areas towards artificial intelligence. Now the IT spend by the clients has reduced and is directed more towards Generative AI. This is a type of artificial intelligence that uses generative models to create new content such as text, images, videos, audio and music. 

The revision cites economic uncertainty and reduced spending, particularly in communication, media and technology and financial services, on consulting services by clients. These are the particular sectors where Indian IT companies are strong. It is not only Accenture that has seen cut it guidance. In the last three months, we have seen various domestic as well as international companies cutting their guidance. Even Infosys had cut its higher end of revenue guidance. The following table shows the change in guidance by some major IT companies both domestically and globally. 

Furthermore, the backdrop of global elections, including those in the U.S., UK and India, introduces additional uncertainty. Past elections, notably during Donald Trump’s presidency in 2016, have led to concerns over H1B visas, upon which IT companies rely heavily. The outcome of these elections poses risks for IT companies, with client discretionary spending remaining subdued. Lastly, recent trends indicate a decline in European revenues, posing challenges for companies reliant on this market. Accenture’s results often serve as a precursor to the broader market, suggesting potential risks for TCS, Infosys and Wipro in the upcoming release of their results. 

Morgan Stanley expects a gradual recovery in the Indian information technology sector following the pace of the 2023 slowdown, unlike the sharp bounce back the companies witnessed after the 2008 financial crisis and the coronavirus pandemic. The brokerage expects this recovery to be better than the "slow and protracted growth" after the Brexit referendum. 

Morgan Stanley said the underlying technology cycle would support recovery in the first and second quarters of the new financial year. Globally, it said, the growth is bottoming out, but the pace of recovery has come down as against previous estimates. 

The downturn in European revenues underscores the broader challenges faced by companies dependent on European markets for growth. What is also impacting the share price performance of many traditional IT companies is delayed rate cut by the U.S. Federal Reserve. There is inverse relation between interest rate and performance of growth stocks such as IT companies. Historically, we have seen IT companies perform better in a benign interest rate environment. Based on the latest U.S. Federal Reserve’s actions, they are still expecting three rate cuts this year. Hence, we may see performance of the IT companies improving from the second half of the current year.
 

IT Valuations: Not Very Attractive

The following chart depicts the two key valuation metrics commonly utilised by investors to assess the sector’s attractiveness. The price-to-earnings (PE) ratio of the Nifty IT index currently stands at 29.93 times, surpassing its long-term average but marginally lower than its one standard deviation. Future growth prospects play a crucial role in determining the PE ratio, with higher growth expectations typically resulting in elevated ratios. However, in the current environment, there is a lack of substantial growth expectations factored into the PE ratio. Additionally, the price-to-book value (PB) ratio also exceeds its long-term average. Purely based on valuation metrics, the sector does not appear to be at an attractive level, and further correction may be anticipated.
 

Conclusion

Discretionary spending continues to lag as we enter 2024, leading to sustained revenue challenges despite a robust intake of deals in recent quarters. These deals have primarily focused on cost reduction and efficiency programmes, emphasising vendor consolidation. The BFSI (banking, financial services and insurance) vertical remains particularly vulnerable in the current landscape with communications also experiencing sluggish growth. As uncertainty persists, companies are prioritising cost reduction, vendor consolidation, data and process modernisation, and productivity enhancement. 

The concept of Generative AI remains an emerging theme with demand steadily increasing. Forrester, a London-based research and advisory company, predicts 36 per cent CAGR for Generative AI through 2030, with a projected capture of 55 per cent of the AI software market. Most Indian IT firms including top-tier firms TCS, Infosys, Wipro and others have made efforts to cash in on the opportunity by building specified AI services for clientele. Infosys introduced Topaz, an AI-first set of services, solutions and platforms using Generative AI technologies. 

Wipro launched Wipro ai360, an AI-first innovation ecosystem and also committed to making a USD 1 billion investment in advancing AI capabilities over the next three years. Nonetheless, the opportunities in Generative AI are yet to replace the softness that the industry is witnessing in other traditional areas. Guidance from industry leaders such as Accenture, Capgemini and Cognizant for the upcoming calendar year too reflects short-term weakness. 

While companies anticipate gradual improvement over the year as macroeconomic uncertainties diminish, a slower-thanexpected recovery could pose a risk to the high single-digit growth estimates projected for FY25. Given the outlook for a slower recovery, Indian IT companies too will see a lower growth rate in the coming quarters. The above analysis clearly shows that the outperformance of NASDAQ is not broad-based and is primarily led by a few companies that are dominant in new emerging technologies and are leading the wave. Indian IT companies and many other traditional IT companies will see a temporary slowdown till the time they do the catching up either organically or inorganically. 

Click here to download list of Companies With Net Profit CAGR > 20% and PE < Industry PE

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