Correction stabilises valuation of IT stocks before a rate hike injects more volatility in markets

The ongoing correction in global equity markets have put cogs in the bull run seen across sectors with some sectoral indices losing up to 25 percent.

Due to a surge in inflation, central banks world over have set out on aggressive interest rate hikes. Higher interest rates do anchor inflation but impact the pace of growth in the economy. “The valuation multiples adjust for higher cost of capital and a possible slower pace of growth in the economy and corporate earnings as a response to aggressive policy rate hikes by central banks,” said Gaurav Dua, Senior VP and Head of Capital Market Strategy, Sharekhan, by BNP Paribas.

“Our experience of interest rate hikes shows that the equity market tends to turn volatile for a period of four to eight months after the first interest rate hike. The situation stabilises by the end of 12 months and the equity market begins to do well again,” Dua said.

This has been evident in the US equity markets for the past four decades and also in India during the interest rate hike cycles through the last two decades. A similar trend is expected this time too.

The Nifty IT index is among the top losers of the year 2022 till date. The valuations of Indian IT companies, which were soaring high till recently and had become unjustifiable, got the does needed to bring them to reasonable levels. The IT index has lost 24.2 percent since the start of this calendar year and there could be more pain in store for the sector.

“I think there is going to be quite a fall before we see a bottom by tech stocks,” said Suman Bannerjee, CIO of Hedonova (an AIF firm). “As PE contracts and these stocks revert to more reasonable valuations, the indices will fall.”

The broader markets are impacted moderately and it's only inflated tech stocks that are falling. This is evident from a 23 percent drop in NASDAQ, compared to 12 percent in the much broader benchmark S&P500.

“The IT index is up 40 percent over the past year, driven by the boost in earnings on the back of increased digitisation globally after Covid disruptions,” said Ram Kalyan Medury, Founder and CEO, Jama Wealth.

While the industry saw a massive jump in demand, very soon the costs of retaining and acquiring talent escalated, resulting in a dip in margins. The inflationary pressures only added to these costs. In the expectations of a multi-year investment cycle, IT companies increased their hiring activities which significantly expanded their employee base.

The large number of freshers hired by the companies only added to the costs before they become productive, billable and start reflecting in the reduction in employee costs. This can be seen in the dip in operating margins by nearly 200 basis points.

“Some of India’s leading IT companies have witnessed a 50 percent jump in their employee headcounts between FY19 and FY22. The companies went on a hiring spree chiefly in FY22 to capitalise on a decadal growth opportunity,” said Vinit Bolinjkar, Head of Research at Ventura Securities Ltd.

However, Bolinjkar expect the order flows to improve gradually over a period of time and may not be in line with the increase in employee cost of the company. This may create a mismatch between revenue and employee cost, which may impact the profitability of IT companies in FY23 and FY24.

Other experts, however, are positive about the sector from the medium to long term perspective. “There has been substantial de-rating in Indian IT stocks but medium to long term demand-side forecast remain strong and valuations have started to look reasonable for the services based companies in IT domain,” said Anil Rego, Founder and fund manager -Right Horizons PMS.

Mohit Nigam, Head - PMS, Hem Securities concurred as he also holds a positive view about the sector and sees limited downside at these levels. He is of the opinion that the current valuations are in reasonable band and long term growth drivers of the sector are intact.

“The industry is seeing continued demand and is likely to deliver good growth, while the rupee-dollar exchange rate also could be favourable over the next year, thereby aiding operating margins,” Medury said.

IT fails to beat estimates on supply-side challenges but strong demand may help rebound

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