Smaller companies seem to be the current favorite with investors

The Big Five of Indian IT services are facing a new predicament: keeping investors’ faith.

Valuations of smaller IT firms raced ahead of what their larger peers command in the last four years, regardless of their record on revenue, profitability or leadership, aMint analysis showed.

Tata Consultancy Services Ltd, Cognizant Technology Solutions Corp. and Infosys Ltd have seen their forward price-earnings (P-E) ratios decline since January 2021, while the ratios have only marginally improved at HCL Technologies Ltd and Wipro Ltd.

P-E ratios better
At the end of 2020, the P-E ratios of relatively smaller firms, including Tech Mahindra Ltd, Persistent Systems Ltd, Coforge Ltd, and Cyient Ltd, were similar to those of their larger peers. Since then, the valuation gap has widened, with shares of Persistent and Coforge valued at over twice that of TCS and Infosys and even four times that of Cognizant.

The price-earnings ratio—calculated by dividing stock price by earnings per share—is one of several metrics to measure how expensive a stock is.

Given the current market dynamics, the shift in investor sentiment towards smaller IT firms raises the question: is this change justified?

Hardly.

However, according to three investors and two analysts, the sanguine outlook on smaller IT companies rests on the belief that the smaller IT firms are better suited to weather the uncertainty posed by the rise of generative artificial intelligence.

The great leveller
“GenAI is proving to be a great leveller,” the CEO of a Pune-headquartered IT company said on the condition of anonymity. “Scale loses its relevance because a technological change brought in by the rise of AI tools potentially makes the traditional approach of efficiently deploying thousands of people on projects irrelevant.”

Since the launch of ChatGPT in November 2022, AI has become the biggest talking point in the technology world as a potential catalyst for business disruption. GenAI, which includes technology-driving innovations such as ChatGPT, spans a broad array of capabilities, including creating new content forms such as text, audio, and video.

“I believe much of this interest in the stocks of mid-cap companies like Persistent, Coforge and Cyient can be explained by liquidity or money from passive index funds and retail and other institutional investors,” said Karan Kamdar, research analyst at Deven Choksey, a research and wealth advisory firm. “The growth by some of these smaller companies in the last few years has made them catch the interest of investors. At the same time, I don’t believe large-cap IT companies face much threat from the rise of GenAI and in two-three years, we could again see parity in terms of their valuation compared to the mid-capcompanies,” he added.

Not winning over investors
Even with their industry-leading profitability, the largest companies have not been able to win over investors.

“The belief is that smaller companies should manage to improve their profitability while the larger companies will only see their operating margin decline,” said a Singapore-based analyst at a foreign brokerage firm.

TCS’s operating margin declined from 26.1% in October-December 2020 to 24.1% at the end of October, a fall of 230 basis points. Infosys and HCL Technologies saw a 430-basis-point decline in profitability, ending with 21.1% and 18.6% operating margins, respectively, during the July-September quarter.

But smaller companies have fared no better.

Coforge’s profitability has declined 120 basis points, from 13% to 11.8%, while Tech Mahindra’s operating margin has shrunk 550 basis points, from 15.1% to 9.6%. Only Persistent improved its operating margin by 130 basis points, from 12.7% at the end of December 2020 to 14% at the end of September.

Again, a long-serving tenure for the CEO does not entirely explain a company’s outperformance. Agreed, both Persistent and Coforge, which have seen the biggest jump in PE over the last four years, have had a stable senior leadership team. Sudhir Singh, a former Infosys executive, has been at the helm at Coforge since May 2017, while Sandeep Kalara has been CEO of Persistent Systems since October 2020.

New CEOs at helm
In contrast, many larger IT firms have appointed new CEOs in the past 18 months.

Cognizant appointed S. Ravi Kumar as chief executive in January last year after the board of the Nasdaq-listed company sacked Brian Humphries. TCS entrusted K. Krithivasan as CEO in June last year after the abrupt exit of Rajesh Gopinathan. Wipro appointed Srinivas Pallia as CEO in April this year after Thierry Delaporte left without completing his five-year tenure. Even Tech Mahindra appointed Mohit Joshi as the boss in December last year.

However, C. Vijayakumar has been CEO of HCL Technologies since October 2016, making him the longest-serving boss among large IT firms. At Infosys, Salil Parekh has been at the helm since January 2018.

“It’s a reminder that during the 2000s, TCS, Infosys and Wipro enjoyed a premium to companies like IBM, Computer Science Corp and Accenture. Back then, Indian IT firms were smaller,” said an executive at a Mumbai-based IT firm. “Now, there’s a belief that some, if not all, of the smaller companies could become the next TCS. It’s a testament to the dynamism of the market. It remains to be seen which of these smaller firms can ride the next technology wave.”