Can IT sector emerge as the next driver of the Nifty?

There are a number of factors that are working in favour of the IT stocks. These IT companies are still among the most profitable in the Indian market.

Jul 23, 2020 08:07 IST India Infoline News Service

As we speak, the IT stocks in the Nifty are gradually acquiring heft. Their weightage in the Nifty is up from 13% last year to a shade above 15% in July 2020. Banks have lost their charisma in the last few months of COVID-19. PSU banks have been under pressure anyways. The private banks and financials are also facing question marks about the likely scenario once the EMI moratorium is lifted. Economists are already warning about a possible surge in gross NPAs of banks by the end of FY21 as the lag effect of the lockdown becomes evident.

Why IT could be in a sweet spot

There are a number of factors that are working in favour of the IT stocks. These IT companies are still among the most profitable in the Indian market. They have maintained consistently high ROE and there is not a single loss making IT Company among the top 15 IT companies. This is the only sector where large cap and mid cap names are both showing traction. Above all, most of the IT companies are absolutely low on debt.

Data Source: NSE

What really stands out about the IT sector is that it has given returns of 55% since the lockdown began in late March. Of course, even the Nifty has given 46% returns but that has been largely contributed by the IT heavyweights and Reliance Industries. IT companies are unique in that they are high on ROE and also very attractively valued in terms of P/E. Let us look at how the combination of high ROE and low P/E makes them an attractive bet.

How IT companies have rediscovered high ROEs

For a sector that has been traditionally low on debt, the return on equity or ROE has been the most important measure. The leading IT companies in India have managed to sustain ROE in the range of 18-25. That roughly means your capital gets churned in the form of profits once every 3-4 years. That kind of ROE is not available in any other industry other than FMCG, but there the valuations are extremely steep. But we will come back to the topic of P/E valuations later and focus on ROE for now.

Data Source: NSE

Of course, TCS may be an exceptional outlier with an ROE of above 36% but even if you normalize that it would be a sizable number. For the first quarter ended June 2020, TCS continues to report operating margins of over 23% so ROE should continue to be high. On an average the ROE of IT sector is averaging around 20% and that means a 3.5 year payback period on equity which is extremely attractive. That is also because; the IT sector continues to contribute a very big chunk to the Nifty profits.

Valuations are also extremely attractive for IT stocks

That is an area where the IT stocks score vis-à-vis the FMCG stocks. FMCG stocks also enjoy high levels of ROE but valuations are already rich and most of the stocks are trading close to their historic highs. That does not leave too much margin of safety. On the contrary, the IT sector still offers substantial margin of safety in P/E terms. Check the comparative chart below to get an idea of the median P/E ratio of the IT sector.

Data Source: NSE

The second big story in favour of the Indian IT stocks is that their valuations in terms of P/E ratio is nowhere close to what we saw in 1999 or even in 2010. That gives a lot of comfort as you have a combination of attractive ROE and reasonable P/E. When you are looking at an average industry wide P/E of around 20, you are talking about earnings yield of around 5%. That is very close to the yield on top rated bonds and that is normally the signal for a positive re-rating of the sector.

Are there are risks to the IT story?

Indian IT industry went through a tumultuous period in the last 5-6 years as it adjusted from the old BFSI model to the new digital model. Today, for most of the large IT players, 40-50% of their revenues comes from emerging growth areas like mobility, analytics, cloud, social media, IOT, artificial intelligence, machine learning etc. That substantially de-risks the IT business model for the next few years.

There is a risk of fall in IT spending as Gartner has projected an 8% contraction in IT spending by global companies in 2020. However, the balance sheets of Indian IT companies have enough buffers to tweak costs to adapt to the change. For now, IT seems to be poised in a sweet spot with attractive ROEs and a reasonable P/E valuation. COVID-19 may have just about exposed the chinks in the financial sector’s armour. Indian IT sector could be the gainer; definitely in terms of heft in the Nifty.

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