Prime Fund Recommendation: A sector that disrupts to grow

Even as sectors such as auto, manufacturing and lending businesses have been firing on all cylinders and consumer and pharma sectors are showing signs of a sound comeback, IT is one sector where the fog hasn’t cleared. But then equity returns are not made when everything is certain. Even as it is evident that the listed IT stocks are still largely in consolidation mode in the stock market, we think it may be a good time to start taking exposure to the sector (if you are a high-risk investor of course). 

The consolidation and recovery

Macro slowdown and a sharp rise in inflation in the US and Europe (which account for 85-90% of revenues for Indian IT companies), unwieldy cost structures since Covid and concerns over negative disruption from Generative AI are among the many factors that have led to Indian IT stocks decline from their January 2022 peak. 

The Nifty IT fell 33% between January and July 2022 and has since undergone a consolidation. It is now 19% higher than its July 2022 lows. One could say that the index has been resilient despite the slowing demand environment. We think it is so for the following reasons:

#1 Slump and recovery

In one of our 2022 reports on an IT stock we mentioned this:

First, the recovery of global IT spending, post a slowdown, has been quite sharp. According to a report by Bernstein, during the global financial crisis, IT spending reduced by 7% in 2009 but recovered to 9.4% by 2010. Similarly, during Covid, IT spend declined by 1.6% but bounced back to a strong 7.5% in 2021. This is not only suggestive of a quick recovery in IT spends but also indicates that much of the spending has become necessary rather than just discretionary. 

It is also important to understand the quantum of growth of IT companies even from a marginal increase in IT spends. After the global financial crisis, for instance, global IT spend (according to the report) was at an average 2-3% between 2010-15 but Indian IT companies managed an average 13.2% growth (worst being 10.2%). This points to low spending still spurring double digit growth during periods of slowdown.

We think the above scenario will be valid through 2022-25 (slump followed by a likely recovery) even though we are likely to see single digit growth for a year or so. 

What also needs to be kept in mind is that while the Y-o-Y order book growth may have slowed, the order book has remained strong. Yes, you can argue that the order book hasn’t entirely translated into revenue as companies hold back on execution. But the good news is that the orders are there (also as an increasing proportion of new orders are to do with cost optimization, their likelihood of execution remains high), and a delayed execution can cause a quick spurt in revenue.

This is one of the reasons why we feel you cannot wait to time the entry in the sector. We will not know the status of these orders translating into revenue until we see the earnings.

#2 Margin bites the dust, valuation beaten

The chart below will clearly tell you that the average EBITDA margins for the Nifty IT companies have hit a low in almost 10 years. We would attribute this to the imprudent cost structure that companies led themselves into during Covid, especially with manpower costs. The impact of this was not visible in a robust demand environment and came to light only as the slowdown hit. 

We think this will reverse. Improvement in demand, likely from 2024 (as consensus emerges that US is not headed for a recession and vendor consolidation happens), improvement in utilization, sub-contracting costs and offshore costs can together lift the margins a year from now.

While the price earnings ratio of the large IT players may still be higher than their 10-year averages, they have certainly come off their highs by a significant margin. Players such as TCS and Infosys are over 30% below their respective peak valuations in late 2021 and January 2022. TCS currently trades at 28 times (from 41 times in October 2022), Infosys at 24 times (from 38 times in January 2022) and LTIMindtree at 28 times (from 60 times in January 2022). 

And this, when the top line growth was an average 19% for the Nifty IT index stocks in FY23. 

That the stock prices have held up post July 2022 is suggestive of the fact that the market sees more resilience in the sector, the demand weakness notwithstanding. It is also likely pricing in benefits from future disruptions (see point below). That the large IT companies kept their dividend payouts attractive (TCS was a whopping near-100% in FY23) also kept the markets happy.

#3 Concern over Generative AI

There have been concerns over the impact of Generative AI (read all about it in this paper) on Indian IT companies. We think Indian companies have thus far successfully navigated tech disruptions by building services and products to participate in such disruption. 

Generative AI is being actively considered by companies across sectors to improve productivity and optimize costs. From the reports that we read, large Indian IT companies have already been running pilot projects for their clients in the areas of software coding, customer services and marketing, and in documentation intense work like legal or HR etc. besides fraud detection. This article will tell you about the strides by Indian companies in Gen AI.

While most global reports are unanimous in their view that Gen AI can negatively impact lower end jobs like BPOs (a Gartner report places Wipro as being among the ones exposed higher to this segment) that are more commoditized, the Gen AI market opportunity may be too attractive for IT companies to miss the bus. Of course, in the short term, pricing pressure and market share losses as AI models like ChatGPT dominate may be inevitable, if it hasn’t already impacted. 

Even so, according to reports, growth in the near term in this segment can be driven by shift to the cloud by clients (a step needed before adoption of Gen AI), even as they decide how they will use it. Sectors such as BFSI (where IT companies have maximum exposure), retail, auto, media are touted as being early adopters. 

Fund recommendation in the IT space

We have two fund recommendations to play the sector now. 

ICICI Prudential Technology Fund

This fund is already part of our Prime Funds recommendation. This fund will help take exposure to the large IT stocks, and does not take much active risk compared with the Nifty IT index. The fund has over 50 stocks but with a long tail made up of several stocks with very small exposure. It uses this tail to play other tech and digital companies such as Siemens or Zomato outside the top-tier IT heavyweights. 

The July portfolio (see table below) will tell you that the company’s exposure to the top-tier IT stocks is high. We prefer this to play the recovery with limited downside. 

If you hold any of the other IT funds, you need not switch to this as their portfolios all have high overlap. The choice we made stems from the ICICI fund showcasing less volatility and superior consistency when returns are rolled. Keep exposure to 3-7% of your equity portfolio and not more.

Franklin India Technology

After a long hiatus, we picked a Franklin fund for a recommendation. This fund is only for high-risk investors who want to play a tactical call within the sector. This fund can be rated the riskiest in the entire IT sector fund category. 

The fund overhauled its portfolio in April 2023, significantly cutting down exposure to TCS, Infosys, HCL Technologies and Bharti Airtel and instead upping stakes in Birlasoft, PB Fintech, Zomato, C.E Info Systems and a host of other smaller IT plays. It has steadily kept exposure to its international IT fund to about 9%.

Franklin India Technology therefore sports just a 25-30% overlap with any of the other IT funds. This fund will essentially help play the smaller e-commerce, fintech and mid and small tier IT for now. As e-commerce and fintech plays have staged a recovery, this fund is expected to benefit from the same. 

But it can also take a hit if the IT slump lasts longer than expected. The fund does not have a good performance consistency record - our call now is tactical based on its portfolio and strategy (we may give an exit in the short to medium term) than for the long term. Keep this in mind if you decide to add this fund. We have included this fund in Prime Funds, with this call.

Suitability

As always, sector funds are meant for high-risk investors and those that have already built a strong diversified portfolio. You can skip this sector call if you are a recent investor. You will get some IT exposure in diversified funds as well; you can use Portfolio Review Pro to know the top 10 sector allocations in your full mutual fund portfolio. 

If you have some risk appetite, the ICICI Pru fund will be a safer choice. For others with deeper pockets, blending both based on your risk appetite will help participate across the IT market cap segment. Investments are best made in lumpsum with additions on deep corrections of 10% or more in the sector.