July 2016: IT Services – Market perception and reality?

The Nifty continues to be strong despite various concerns like the Brexit and the mounting bad debt concerns in the Indian banking sector. Globally, volatility is the norm with big swings in currencies and commodities. However, the market continues to climb the walls of worry and move higher. While most sections of the market have seen some move back to the mid end or high end of their historical valuation ranges, the one sector that remains undervalued is the Indian IT services sector.

The market has been ambivalent about the IT sector for quite some time, despite it being among the best performing sectors in terms of revenue and earnings growth. Over 3 and 5 year time frames, the Indian IT services sector has grown revenues and profits in the high teens – earnings growth for the Nifty during the same period is in the 4-5% p.a. range. Moreover, the IT services companies have enjoyed very high returns on invested capital and continuous free cash generation.

Concerns have been raised in recent years about automation impacting IT services and how that could result in a large number of jobs becoming redundant. The situation is still developing and it is difficult to make definitive predictions, but the Indian IT services sector remains at the fore front of harnessing this technological change, and continues to gain market share from its global counterparts. Moreover, there remains a large opportunity in the transition from legacy systems to the new digital world. Also, automation provides opportunities to squeeze higher margins in the medium term. We note that the Indian IT majors continue to hire at a brisk pace, and in fact, hiring has picked up over the last couple of years – this belies immediate concerns that automation will lead to big redundancies. We continue to watch this space for further developments.

What is puzzling though is the stock performance of this sector over the last 3-4 years. Despite being in a market where growth is at a huge premium, as most sectors struggle for growth, the market has paid scant attention to the robust growth rates that the Indian IT services companies have recorded. Within this sector, the stock price momentum is significantly below earnings momentum where as in, most other sectors, the situation is the opposite. It is no wonder then, that when we scan our universe, we find this sector the most undervalued in relation to the quality of the business and future prospects.

Furrowing the lonely path, where others fear to tread, is part and parcel of being a value investor. We have thought deeply about this space and are unable to find a way to justify whatever fears have been expressed about the IT services space, especially with respect to the top tier names. We are also aware that unfounded fears usually produce great investment opportunities. All one can do in such times is to exercise patience – we remain confident that the market will sooner or later come around to the view that these are great businesses – and more important, the price that Mr Market is placing on them, seems irrational. What is further comforting is that, as these businesses keep generating cash, the cash hoard builds which further adds to the intrinsic value of the business and is the price we get paid for waiting. Meanwhile, we remain comfortable with both the future prospects of the business and the prices at which the respective stocks are trading.