Midcaps or largecaps? Where should you invest in IT now that the report cards are in

Along with banking, the IT sector has seen a major selloff by foreign investors in the last one year amid concerns over valuations. A possible decline in margins also did not help.

Now most IT stocks are available at close to their multi-year average valuations, prompting some analysts to go bullish on the sector. This is despite recessionary pressure on their key markets.

There are two key segments in the IT sector: midcaps and largecaps. Each has their own growth trajectories and prospects. The question is what should you buy into? Analysts say recent earnings hold the key to a part of the question.

Earnings
Most largecap IT stocks, which have come out with their June quarter numbers, have lagged in terms of growth compared to their midcap peers. Smaller size and having a niche worked in their favour.

For instance, TCS first quarter profits were up five percent year-on-year (YoY) while revenue grew 16 percent. Similarly, HCL Tech reported flat growth in profits and 17 percent jump in revenue. Mindtree saw 37 and 36 percent jump in profits and revenue, respectively. Tata Elxsi’s profits and revenue grew 62 and 30 percent, respectively.

“Despite steeper corrections in most midcap IT companies, they are likely to perform better than largecap companies as their contract sizes are lower and growth is on a lower base,” said Deepak Jasani, head of retail research at HDFC Securities.

He highlighted that midcap companies like L&T Infotech, Mindtree, and Tata Elxsi have reported stable revenue growth and their profitability was above expectations. Jasani has a positive view on L&T Infotech and Mphasis, thanks to strong deal wins, record of retaining key customers, and healthy balance sheets.

Though, some see red flags pop up in the midcap space.

YES Securities highlighted that though midcap companies that have reported results so far have performed better than largecaps on both revenue and margins, a few clients have become cautious on global macros as indicated by their managements.

It said L&T Infotech and Coforge are its picks in this space.

Recession fears
Some analysts like those at YES Securities favour largecaps over midcap IT names as any potential recession or slowdown in the US would lead to vendor consolidation favouring largecaps.

Many economists have raised fears that Europe and the US may plunge into recession as central banks raise interest rates to fight inflation. Turmoil in the energy market due to Russian invasion of Ukraine also adds to concerns.

“The demand environment remains strong as indicated by deal booking and a healthy deal pipeline. The companies which have reported results have not seen any deal deferment/ cancellation due to evolving macroeconomic concerns. Also with wage hike behind, they should see sequential improvement in EBIT margin over next three quarters,” said YES Securities, adding it believes valuation has corrected to comfortable levels.

The brokerage house prefers Infosys and TCS in the space.

Jasani of HDFC also has a positive view on these two stocks due to stronger demand environment in North America versus Europe, strong order bookings, and wider bouquet of services and specialisations.

Though he remarked that if the fears of recession in the US and other developed economies keep rising, then IT spending could get impacted, diluting the revenue visibility of IT companies.