IT index outperforms Nifty in last 3 months: What should investors do now?

Technology stocks have seen a sharp run up not only since March lows, but also in last three months. In fact the sectoral index has outperformed Nifty50. All the credit goes to digitisation happening at a fast pace, expected growth in the coming years, and healthy balance sheet.

The Nifty IT index shot up 29 percent in last three months against 21 percent upside seen in Nifty50, while from March 23's closing (low) point, the former surged 62 percent and the latter gained 53 percent, backed largely by FII money and hope of strong economic recovery in next calendar year.

Experts remained positive on the sector as a whole given the expected growth in coming years, but in the short term, they see limited room for upside in stock prices especially after stellar run seen since lockdown.

"During last three-month period most institutions increased their weightage in the sector by around 180bps on average basis in last three months. Weightage on IT stocks is now just below 150bps compared with BSE500 (12 percent) as against Underweight of about around 300bps as of May 31," Dolat Capital said.

"However, with IT Index now at 20 percent higher than pre-COVID levels despite average earnings compression of about 7 percent (for FY22) for our coverage universe implies expansion in earnings multiple by around 35 percent during this period. This re-rating has taken the valuations of stocks closer/higher than its +2SD of its 3-year Median PER," it added.

Hence, at these valuations, the brokerage sees limited room for further material upsides. Rather, it believes that the elevated valuations make them vulnerable to the potential risks of second order impact on the earnings and thus would prefer to wait for better entry points in these names.

At this point, Dolat Capital just sees a few names that have some more room for re-rating led by improved financial performance (across growth/OPM/FCF/Pay-out yield basis) expectations over next FY20-22E such as HCL Technologies (improving free cash flow-FCF to drive re rating – target Rs 795), Oracle Financial Services Software (acceleration in demand in Post COVID environment – DCF based target Rs 4,000) and Firstsource Solutions (US Mortgage revival led growth opportunities – target Rs 85).

HDFC Securities' top picks are Infosys (Buy, Target Rs 1,075), HCL Technologies (Buy, Target Rs 770), L&T Infotech (Add, Target Rs 2,750), Mphasis (Buy, Target Rs 1,450) and Sonata Software (Buy, Target Rs 370).

"Despite the recent re-rating in the sector (one-year fwd reached +2SD), reverse DCF based on current price implies: (1) TCS/Infosys growth at 6.9/6.7 percent over FY23-30 and HCL Technologies/Wipro/Tech Mahindra growth at a modest 5.1/4.4/5.8 percent and (2) Mphasis appears most attractive with implied growth of -0.6 percent over FY23-30," said the brokerage.

"Persistent Systems and Tata Elxsi are candidates for a higher payout, based on the disconnect between current efficiencies and high cash. Upgrades include TCS (Add), Persistent Systems (Add) and Cyient (Add)," it added.

HDFC Securities maintained its positive outlook on IT sector despite the sector recently re-rating to +2-standard deviations (SD) valuations, as the centre of gravity is expanding beyond just the tier-1s, as mid-tiers are showing symmetry in balance sheet metrics (and reverting to growth premium).

The brokerage believes that the sector is poised for higher multiples, led by (1) the longevity of high-growth period (current valuations imply around 5 percent 10-year CAGR) with 'multi-year’ growth tailwind from the economic crisis, (2) the continuity of high (increasing) payouts, and (3) global ‘best in class metrics’ across growth, free cash generation, and balance sheet strength.

As per HDFC Securities' assessment of management discussion and analysis (MD&A), (1) the demand is expected to increase for services around digital channels, collaboration and workplace transformation; (2) pipeline is expanding in areas of cloud, workplace transformation, cost efficiency and automation; (3) companies have adopted remote management of upstream processes such as solutioning, requirements workshop and service transitions are done virtually without impact on productivity, leading to on track contractual commitments and go-live dates.