IT midcaps outshine largecap peers, attract foreign investor attention

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Indian midcap IT companies have outperformed their large-cap counterparts in the past 1-2 years, driven by robust sales growth and profitability. Notably, Q2 FY24 saw mid-tier IT firms like Persistent Systems, Cyient, and Coforge outshining tier-1 giants such as TCS, Infosys, Wipro, HCL Tech, and Tech Mahindra, thanks to a post-pandemic surge in digitalisation and increased tech spending.

The strong performance was further enhanced by a healthy deal pipeline, increased deal wins, and reduced attrition rates, leading to improved margins. These companies also benefited from the integration of acquired firms specialising in niche sectors like engineering research and development, healthcare, and transportation. Foreign Institutional Investors (FIIs) took note of this impressive performance, increasing their stakes in these midcap IT firms during the July-September quarter.

What does FII interest mean for IT mid-caps?

This shift in FIIs' holdings has significant implications for mid-tier IT companies due to their limited free float caused by substantial promoter and Domestic Institutional Investor (DII) holdings. Consequently, changes in demand and supply dynamics result in heightened price volatility. Notably, the aggressive buying by FIIs tends to substantially elevate the stock prices, while their selling can have an equally significant downward impact. This leads to high overbought and oversold situations.

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While mid-tier continued to outperform tier-1 IT firms on year-on-year growth in Q2 FY24, the gap has reduced considerably and analysts are now cautious about the sustainability of the positive trend IT mid-caps. Going forward, they anticipate potential underperformance, primarily due to elevated valuations and an anticipated slowdown in growth in the upcoming quarters.

This deceleration is expected to result from reduced IT spending as global economic uncertainty looms. "The expectation is for elevated furloughs not just in industries such as BFSI, hi-tech, and manufacturing but in other verticals as well," Sumit Pokharna, Research Analyst Vice President, Kotak Securities told Moneycontrol.

Best time for IT Mid-caps over?

Despite their robust sales growth and improved margins, mid-tier IT companies face increasing underperformance risks in the short to medium term. This vulnerability stems from the delayed impact of negative guidance from large-cap counterparts, which may lead to a cascading effect on the mid-tier segment, currently trading at premium levels. This consolidation trend mirrors similar patterns in developed markets, emerging markets, and domestic large caps. Given the ongoing global uncertainties and the evident deceleration in IT spending, both IT large and midcaps are expected to face challenges in the near term.

Investors have become cautious about the equity asset. FIIs selling have been enlarged in the last 1-3 months, affecting the performance of Indian stocks and leading to underperformance lately. This trend is forecast to continue in the short to medium term, led by global uncertainties. Simultaneously, the visible deceleration in IT spending, as indicated by early results from the US Q3, is leading to further downgrades in the technology outlook. This will make the scenario difficult for IT large and midcaps to perform in the near term, Vinod Nair, Head of Research at Geojit Financial Services, told Moneycontrol, adding that for retail investors, it is a good time to deploy accumulation, or SIP, in the industry for long-term gains.

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Mid-cap IT space outlook

Brokerage firm Geojit Financial Services has a neutral view of the total IT sector with a constructive view on a long-term basis. "We are advising an accumulation strategy in large caps for long-term investors and a stock-specific approach in midcaps," said Vinod Nair. The upbeat performance of IT midcaps in Q2 may not sustain in 2024. High FIIs selling on mid-tiers can have a negative effect as the category is highly volatile due to changes in buy and sell scenarios and aggressive trading approaches of FIIs, he added.

How to pick midcap IT stocks for your portfolio?

Talking about what key metrics or indicators investors should watch for when evaluating midcap IT companies for potential investment, Nair said that qualitative factors are essential to identify the bright future of the stocks. "For example, IT companies that embrace renewables, transportation, communication, Gen AI, IoT, Cloud and security will have a better outlook," he told Moneycontrol.

In quantitative terms, the ability to grow above the industry in terms of revenue, PAT margin, and inexpensive valuation, like an attractive PEG ratio near 1x, are additional factors to gauge, Nair added. "Currently, we expect IT large caps to be safe and lucrative compared to midcaps due to recessionary risks and the high volatility of the global market. Generally, for the total sector development in the US recession, bond yields are highly warranted to take-out," he added.

Mid-cap IT stocks to watch

Sharing his top picks in the mid-cap IT space, Sumit Pokharna of Kotak Securities said that Cyient is their preferred stock in the mid-tier space, given its attractive deal win sizes, robust order book size, and focus on strengthening and building technology solutions across key megatrends. The fair value of Cyient is seen at Rs 2,000 per share.

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"We like Persistent as well," said Pokharna. However, the upside is limited at current valuations," he added. It is one of the strongest firms among its peers on the engineering side, and it has created a niche in carve-out deals, which will continue to drive growth for this vertical. The stock is currently trading at above Rs 6,000, while Kotak Securities has pegged its fair value at Rs 6,000 per share.

Meanwhile, FIIs increased their holding by 9.5 percent in Coforge in the July-September quarter as promoter holding (PE fund) has been reduced to zero percent. However, analysts are not bullish on the stock as they believe that its valuations are far ahead of the earnings growth trajectory.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.