IT stocks down up to 32% from their 52-week high; is it time to take a contra bet on IT?

There is no doubt that IT stocks will gain in the long run when economic recovery will be clearly visible and their profitability will increase, but the pertinent question at this point is – should one bet on IT stocks at this point or wait for more correction?

Nifty IT is down almost 12 per cent from its one-year peak while the benchmark Nifty is just 3 per cent below its all-time high level. Stock such as Mphasis is down almost 32 per cent from its 52-week high. Shares of Infosys and Wipro are down more than 20 per cent from their one-year peaks.

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Why are IT stocks under pressure?

IT stocks have been under pressure primarily because of worsening economic conditions in important global markets such as the US and Europe.

The risk of a recession in the US and unstable financial markets in the West are also the key concerns that are keeping the IT sector under pressure.

The IT sector saw a boom during the coronavirus pandemic time in 2020 and 2021 as demand for IT products and IT-enabled services saw a steep rise there were no signs of an economic shock from the key markets.

However, things started to change when the Fed and other global central banks embarked on the path of aggressive monetary tightening. This hit the economy hard which was yet to recover fully from the Covid-19 effect.

IT stocks started feeling the heat of demand deterioration from North America. Clients started pausing, delaying and even cancelling discretionary programs. Higher attrition and tough competition made it worse for IT firms and they started finding it difficult to flex margin levers.

The January-March quarter earnings of the IT firms have been subpar.

Brokerage firm Kotak Institutional Equities said that the recent earnings season for IT companies showed that the slowdown in growth is broad-based across companies and is led by BFSI, communications and North America. Moreover, the guidance of the IT companies is based on quick recovery which is an aggressive assumption.

Kotak also underscored that in the hopes of quick recovery, companies are willing to carry the extra cost of people, making them vulnerable to a short-term margin correction in case demand does not recover.

Should we take a contra bet on IT?

There are expectations that the IT sector may revise its growth guidance in the second half of this fiscal year. The sector may focus on growth areas such as core tech spending, as well as in-demand sectors such as healthcare and travel to improve its performance.

Industry analysts believe that the revenue growth guidance reflects clear weaknesses, but also leaves the scope for revised growth open in the second half of the year.

Read more: IT firms may revise guidance upward in second half of FY24

But, should we take contra bets on this sector? Analysts are not very upbeat about buying IT stocks at this point. They say one needs to be cautious about the sector unless clear signs of economic revival in the US emerge.

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Deepak Jasani, Head of Retail Research at HDFC Securities believes despite a cut in valuations over the past year, one will have to look at investing in the IT sector carefully.

He underscored that the management commentaries have been cautious in the backdrop of the tough macro. Most IT companies have underperformed in Q4 either in terms of results or guidance.

However, some managements have shown optimism for the period beyond Q1FY24.

“Valuation of IT companies are still high compared to pre-pandemic levels and the macros are still not favourable. Order wins could be smaller and less recurrent; pricing pressure could continue for some more quarters,” said Jasani.

“Investors may still want to wait for a couple of quarters and hope either for improvement in growth outlook or valuations going further lower for starting to SIP into IT stocks. Traders could, however, keep getting opportunities as stocks get temporarily oversold and lead to bottom-fishing before another bout of selling happens,” Jasani said.

Milind Muchhala, Executive Director at Julius Baer India underscored that the markets had already toned down their growth expectations for the IT sector amid increasing economic uncertainties. While the IT companies have indicated that the demand environment is cautious in the near term, especially in the US, there have not been large-scale project cancellations or budget cuts.

“The companies continue to witness healthy deal wins/pipelines, especially in cost optimisation and vendor consolidation. Moreover, the companies have margin levers in the form of improving wallet share from customers, higher utilisation, and better pyramiding,” said Muchhala.

However, Muchhala added that the outlook in the near term remains a bit cautious, with the growth trajectory expected to soften further over the next couple of quarters before it starts improving as we progress ahead.

Kotak Institutional Equities has Infosys and HCL Tech as its top picks.

“We believe there are reasonable upsides in Infosys and HCL Tech. Infosys did have a bad March quarter and could have handled expectations better. Nonetheless, the fundamental underpinnings of the business, i.e., of Infosys, are extremely strong,” said Kotak Securities.

Brokerage firm JM Financial believes IT Services demand is firmly in the grip of a slowdown.

“Hyperscalers continue to point towards optimisation. Cloud companies expect things to worsen before improving as enterprises focus on must-haves over nice-to-haves,” said JM Financial.

However, the brokerage firm said the near-term appears unanimously weak. Weak growth could have a flow-through impact on margins as most operating levers are ineffective sans growth.

Jm Financial is cautious about the sector but has positive views on Infosys and Wipro.

“Though we remain cautious on the sector, a sharp correction in Infosys means it is now trading at a 12 per cent discount to the five-year median, balancing risk-reward, in our view. Wipro remains our anticonsensus buy while we see higher risk in LTIMindtree and Persistent Systems. Coforge is our preferred mid-cap pick,” said JM Financial.

Disclaimer: The views and recommendations given in this article are those of individual analysts and brokerage firms. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.