Can Infosys and TCS become Buffett's babies?

Equitymaster.com

A lot of tributes have come Warren Buffett's way, arguably the world's best investor ever. But the best one we believe will be reserved by Charlie Munger, the business partner of Buffett and a very intelligent man himself. Munger observed that the reason that Buffett is so successful is because he is a lifelong learning machine. What this means is that he has gotten enormously smarter over the years.

Yesterday, the world got a proof of what Munger was trying to say. Going against his own exemplary discipline of sticking within his circle of competence, Buffett said that he has shelled out a whopping USD 10 bn for IBM, one of the world's largest IT (Information Technology) services firms. Not surprisingly, even the closest of his followers would have been left with their mouths wide open. A man who has made his distaste for anything technological or IT related extremely clear, had in a matter of few months become the largest investor in one of the world's biggest IT firms. Perhaps Munger's contention that Buffett is a lifelong learning machine has a lot to do with this bold investment of his. It is quite possible that he has finally managed to unravel the business fundamentals of an IT services company. Or in other words, his circle of competence has acquired an even greater diameter.

Of course, IBM is the creme de la creme in the field of IT services. But we believe that our very own desi firms a la Infosys and TCS (Tata Consultancy Services) have made a mark for themselves as well. And who knows, few years from now, may start giving the IBMs and the Accentures of the world, a run for their money.

Thus, the question that begs itself is, if Buffett is around for that long, will he contemplate buying into an Infosys or a TCS? Well, to give an answer to this question, these companies will have to go past a rigorous screening test that Buffett conducts for every potential equity related investment of his. And what exactly are the criteria for the test? For starters, he wants to know whether he understands the business models of investment candidate well enough. The IBM investment shows that he finally has some idea about the nitty-gritty of an IT services company. And Infosys and TCS may well be a little lower in the IT services value chain than IBM but they do have a business model that is pretty similar to the US giant.

Mind you, these companies are not the Apples and the Microsofts of the world that come out with disruptive technologies and whose growth depends on innovating new products. But when we say 'technology' with respect to Indian software companies or say IBM, we are largely looking at an opportunity, which has not much to do with innovation. Furthermore, cost cutting is an extra element that gets added in case of say TCS or Infosys as they are also a play on low cost offshoring. The core principle that drives offshoring to India is the low cost and high quality of services that our companies can provide. If we believe in the fact that the western world will try to become more productive and profitable in the future, in good times or bad, through offshoring more of its services to countries like India, we have the 'business predictability' issue that Buffett lays so strong an emphasis on, resolved.

Thus, having acquitted themselves quite well on the business predictability parameter, the second criterion that Buffett looks at is the sustainable competitive advantage. And how do Infosys and TCS present themselves on this front? Not bad we should say. Take the case of Infosys for example.

Infosys has been consistently generating returns on equity of over 25% in the past 8 years. Over the past 5 years, the company has posted returns of over 31% on an average. It is interesting to note that this good performance on return on equity is not at all supported by any leverage. The company can boast of a rock solid strong balance sheet consisting of huge amounts of cash and no debt at all. This shows that the business of the company does have some sort of competitive advantage. While slightly different, we believe that the economics of TCS is also equally compelling if not better.

The third thing that Buffett considers very important is the quality of the management. Here too, the Indian IT behemoths do not disappoint. While TCS is a part of the legendary Tata Group, Infosys has set new standards of corporate governance over the past few years and had the charismatic NR Narayana Murthy at its helm for a good number of years and it would not be wrong to say his legacy has been fully preserved.

Having come this far, the Indian IT stocks we believe would trip up on the last criterion laid by Buffett and that is about valuations. Even though IBM has gone up a good 50% in the last on year, its P/E is still a pretty decent 14-15 times much lower than 22-23 times that Infosys and TCS command right now in the Indian market. Having said that, the growth prospects for the two Indian companies are certainly better than their US counterpart, also in part due to their much smaller size.

To conclude, we believe that not just IBM but our own TCS and Infosys lay a strong claim to become Buffett's babies i.e. one of his investments even though the Oracle of Omaha may never end up owning either as he seldom ventures out of the US. However, the investing legend's stamp of approval will certainly go a long way towards these companies coming on the radar of an even larger set of investors.

(Equitymaster is a Mumbai-based independent equity research house)