The Nifty IT index has been the worst performing sectoral index in 2022 with declines of over 25 percent. The last time the Nifty IT index fell over 25 percent in a year was back in 2008 - the year of the Global Financial Crisis.
However, one must note that the decline has come after five straight years of gains, particularly in 2020 and 2021, when the index gained over 50 percent in each year.
However, the question that everybody on the street is asking is Have IT stocks corrected enough? Should one buy into the downturn? Nobody knows how long will the downturn in IT stocks last. But are they presenting an attractive opportunity or are likely to fall some more?
Here are four reasons why IT stocks could weaken further and four reasons why you may consider buying into this downturn. Let's begin with the bear case first:
On the bear side, what could be the things that go wrong - tech budget is a key issue. Tech budgets are typically announced in January, sometimes in early February, may decline.
Two - there is a risk that tech budgets this time may be short-term and they may not be annual budgets. You may have companies saying that perhaps this time, we are going to outline a tech budget only for three months, six months, because there is too much uncertainty.
There is also a risk of spending divergence if the performance of a company deteriorates as the year goes by. If a company has allocated a certain sum for its tech budget, the actual spend could be much lower if deterioration in performance takes place.
Point two - The US economy is the big elephant in the room. There is a very big co-relation between the growth of Nifty IT companies with that of the US GDP growth. In case the US economy gets into a severe recession, there are chances of IT companies seeing cuts in their Earnings per Share (EPS) forecast.
An analysis from Credit Suisse in the table below explains this co-relation.
Premium Valuations is the third argument on the bear side. Despite the de-rating seen recently, Indian IT companies are still trading at a premium-valuation compared to the pre-Covid average.
Lastly, Midcap IT companies can be far more vulnerable due to two reasons - first being client concentration. They depend a lot on a few large clients, and if there is weakness in any of those, their revenues can get disproportionately affected.
Second is vendor consolidation, which means if a client would earlier give five companies smaller deals each, it may just opt to give away all the deals to one large company. Midcap IT companies also depend a lot of short-term deals, which have been hurt due to the uncertainty.
On the flip side, the bottom may not be formed just yet. But in the next three to six months, things may get worse before they get better, so one can buy into the downturn.
IT stocks have been consistent wealth creators. If you look at the three-year, five-year and 10-year CAGR returns of these companies, you would see that on an average, they have given returns of close to 20 percent.
Names like TCS, Infosys are not created in the day. TCS has a topline of nearly $25 billion, something that cannot be replicated in a year or two. These companies have proven themselves in the digital transformation wave that is currently ongoing.
Additionally, IT companies have gone through a time correction of almost a year as well as seen a significant de-rating in valuations and hence, we could be in the final stages of an IT downturn.
Finally, the fourth reason is cloud adoption and migration, which is a multiyear tailwind. Even if things slow down, it cannot be reversed. So this is a cycle which is expected to last over a couple of years. So it can pause, but it cannot be reversed.
We've presented you the bull case as well as the bear. The ball now lies in the court of the investors to decide which side of the fence they wish to be on.