The recovery in demand for information technology (IT) services has been rather strong and has been picking up steam in recent months. But all this and perhaps more is priced into top-tier IT stocks, which are trading at rich valuations of 23-24 times FY10 earnings.
Could mid-cap (medium market capitalization) IT stocks, which trade at valuations of 11-14 times FY10 earnings, help investors play the IT story?
A recent report by Credit Suisse says, “History shows that mid-cap IT stocks outperform large-caps during high growth periods. As we set out on a phase of revival in demand for the sector, select mid-cap investments could outperform the overall Indian IT sector.”
The report does caution that the choice of mid-cap IT stocks should be made carefully given that growth rates are volatile, margins are relatively weak and smaller companies are increasingly getting marginalized in the market.
But the key question from an investor’s perspective is if it’s time to play the valuation-convergence trade, and assume that mid-cap valuations will narrow in the near future. According to analysts at IIFL Capital, smaller vendors are worse off in the current environment for two reasons. One, they are likely to face relatively higher pressure on account of higher wages and increased attrition. Second, their revenue growth should continue to lag that of larger vendors since order wins are still dominated by cost-rationalization/multi-service deals, in which larger firms have a clear advantage.
In terms of their financial performance, therefore, mid-cap companies are likely to underperform in the near/medium term.
Of course, as Credit Suisse points out, all mid-cap companies needn’t be painted with the same pessimistic brush. “The previous growth cycle showed that select mid-cap names outperformed the industry by 6 percentage points on annual growth and by 700 basis points on margin improvement. In particular, mid-caps have higher operating leverage and could benefit from growth in sub-markets where they have strengths.”
One basis point is one-hundredth of a percentage point.
MindTree Ltd, Infotech Enterprises Ltd and Polaris Software Ltd are its preferred picks in this space.
In summary, it would be imprudent to play the valuation convergence game unless one is convinced about the growth story of a particular mid-cap firm. A rerating from current levels will happen only when results are visible.