Tier II information technology (IT) stocks have risen at a much faster rate compared with top-tier firms since early March. The cumulative market capitalization of the top four firms in the sector, Tata Consultancy Services Ltd, Infosys Technologies Ltd, Wipro Ltd and HCL Technologies Ltd, has risen by about 126% from the lows in early March. The cumulative value of the five next biggest firms in terms of market capitalization has risen at nearly double that rate (251%) during the same period. This includes firms such as MphasiS Ltd, Tech Mahindra Ltd and Patni Computer Systems Ltd.
At first look, this seems odd since larger firms tend to gain at the expense of their smaller competitors during a downturn. Before reading much into this, it must be noted that smaller-sized firms had witnessed a sharp fall in valuations till early March and are now only catching up. Patni Computer Systems, for instance, was trading at less than the value of the cash on its books and Tech Mahindra’s valuations had dropped to as low as three times trailing earnings. With investor sentiment recovering in the past six months, these stocks rose at a faster rate.
Graphics: Sandeep Bhatnagar / Mint
They still trade at substantial discounts to the top three firms. Based on the trailing price-earnings multiple, MphasiS trades at a 21% discount to Infosys, while Tech Mahindra and Patni trade at an over 40% discount to the most expensive stock in the sector. Among firms that are even smaller in size such as MindTree Ltd, Core Projects and Technologies Ltd, Infotech Enterprises Ltd and Hexaware Technologies Ltd, the experience has been similar. Valuations of these firms, too, had fallen to abysmally low levels earlier this year. The cumulative value of ten such firms has risen by 183%.
As far as financial performance goes, the smaller firms have expectedly lagged in terms of revenue growth. While the big three have managed to maintain volumes or contain the drop in volumes at low single digits, some of the smaller firms such as MindTree reported a considerable drop in volumes. In a downturn, clients normally look to consolidate vendors and cut costs. The larger firms gain in this process because of their diverse service offerings and broader geographical spread.
According to analysts tracking the sector, tier II level firms will continue to underperform in the medium term. So, while the sharp rise in some of these stocks may be justified because they had fallen too low, there’s no reason for a continued outperformance. In fact, already there are a few examples such as Satyam Computer Services Ltd, whose valuations have risen above those of a larger firm such as HCL Technologies. Then there’s a firm named Avance Technology Ltd, whose valuations have risen by 3,000% since March and now trades at 136 times adjusted net profit for the past 12 months, according to data collated by Capitaline. While this is not a broad trend, investors should be careful in their enthusiasm about mid- and small-cap IT stocks.
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