Are IT stocks a good contrarian bet from a one-year perspective?

The Nifty IT has been one of the worst-performing indices on the bourses this calendar year.

Rising concerns of a potential global recession, which investors fear can dampen demand for export-facing domestic information technology (IT) giants, have sent the index down over 30 per cent on a year-to-date basis.

By comparison, the Nifty50 Index has shed 2.8 per cent during the period, reveals data by ACE Equity.

Top losers from the index include Wipro, Tech Mahindra (TechM), Coforge, and Mphasis, which have corrected 38-44 per cent so far during this period.

Analysts now view the pack as a good contrarian bet amid ongoing market uncertainty as the sector’s sharp correction, along with depreciation of the rupee against the US dollar, may provide it the necessary fillip.

“Rupee-denominated costs (wages, etc) are about 40-50 per cent of total costs. Hence, exchange rates remain an important margin driver for Indian IT services business.

"A 1 per cent depreciation of the rupee versus the dollar adds 30-35 basis points (bps) to margins and 1.5-2 per cent to earnings,” says global brokerage Bernstein.

In the first quarter (Q1) of 2022-23 (FY23), the IT industry’s performance was largely below expectations, with shrinking profit margins and all-time high attrition levels.

However, the IT industry has begun rationalising high employee costs to defend operating profit margins.

Infosys and Wipro, for instance, had recently withheld staff bonuses, while HCL Technologies (HCL Tech) laid off 300 employees at its Microsoft project.

“The variable payout cuts hold the potential to lend material margin support.

"According to our analysis, these can translate into operating margin support of 220-400 bps for Infosys and Wipro,” say analysts at Elara Capital.

Further, their consensus estimates average earnings before interest and tax margin improvement of around 80 bps in 2023-24 for large-cap IT firms.

Sharing this view, Apurva Prasad, sector analyst at HDFC Securities, also believes the sector’s margins have bottomed out in Q1FY23, with the worst on this front behind it due to improvement in supply-side factors such as moderation in attrition.

“Easing subcontracting costs, increment in utilisation, and pricing will be key levers for margin improvement.

"Our positive view on the sector is also premised on some core verticals that are actually looking strong, such as banking, financial services and insurance.

"Cross-currency tailwinds and indicators from large Cloud platform partners also remain firm, hinting at resilient demand forward,” he observes.

From a long-term perspective, analysts suggest investors start increasing exposure to IT stocks in a staggered manner as equity markets currently remain in consolidation phase.

“Looking at 12-18 months, we remain positive on the IT sector as the correction is healthy, which has made valuations attractive.

"Besides, there may be some pressure on financials in the next two quarters, but in the long term, demand will stay intact as we don’t think there will be any significant reduction in global IT budgets,” says Gaurang Shah, head-investment strategist at Geojit Financial Services.

He further recommends investors avoid putting all their money at once, but buy around 30-40 per cent now and add the balance on dips.

Tata Consultancy Services, Infosys, HCL Tech, and TechM remain top picks of Shah from the large-cap segment, while he prefers L&T Technology Services, Mindtree, Persistent Systems, KPIT Technologies, and Tata Elxsi from the mid-cap segment.

HDFC Securities sees a higher margin of safety in tier 1 companies as valuations of these firms are almost close to their 10-year average.

But the brokerage observes mid-tier firms commanding a growth premium over the former and expects their relative outperformance to continue.