In the past one year, the rupee has appreciated by 11% from levels of over 50/dollar to under 45 currently. Every 1% of rupee appreciation has a negative impact on the net profit of software companies by roughly 1.6%. How have software stocks performed in the past year? They have risen by 135% on an average, as measured by the CNX IT index.
Why is it, then, that information technology (IT) stocks corrected by around 5% in the first three trading sessions of this week after the rupee appreciated from 45.6 last week to 44.9 this week? The accompanying chart shows that the rupee has appreciated gradually through the past year, but this is the first time IT stocks have been affected. How is this time different?
The simple answer is that valuations of IT stocks have become quite stretched. For much of the past year, the earnings of IT companies were being upgraded because of an improvement in the demand environment. Besides, valuations had fallen to rather low levels in the aftermath of the financial crisis. As a result, the rupee appreciation didn’t matter much.
Graphic: Yogesh Kumar/Mint
Large IT stocks now trade at 24-25 times fiscal 2010 earnings, and are already factoring in strong earnings growth. In this context, an appreciating rupee could play spoilsport on analysts’ earnings estimates. And it’s not just the 1.5% appreciation in the past week that investors are worried about. The concern is that the upward movement in the rupee is likely to continue, as currency strategists at Standard Chartered Plc have pointed out.
Of course, companies can increase their forex hedges and protect against the anticipated rise in the rupee. But this factor will now play on investor sentiment, especially at current valuations. According to a recent report by Kotak Institutional Equities, “Technology stocks look fairly valued and may find it hard to do well in the face of a stronger rupee.” As an example, Infosys Technologies Ltd trades at an fiscal 2011 price-earnings multiple of 21.5 times based on Kotak’s estimates, even though annual earnings growth estimate between fiscal 2011 and 2013 is lower at 18.6%.
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