Mid-cap IT is growing faster, but what about risks?
With valuations having risen so high, risks for investors have just compounded
Earlier this month, this column had pointed out that investors are looking to mid-cap IT stocks as a safe haven in the current market correction. Since then, some of these stocks have corrected by around 4-8%. But note that the benchmark for the sector—shares of Tata Consultancy Services Ltd—has also corrected by around 6% during the same period. As such, valuations relative to large-sized companies remain high.
While it’s true that some of these companies are growing revenue and profit at a faster pace, what shouldn’t be ignored is that some of the risks associated with mid-sized companies haven’t really disappeared. And with valuations having risen so high, risks for investors have just compounded.
“Investors seem to be focused only on near-term growth and ignore quality of the business and its riskiness. Tier-1 companies are better quality businesses because of their lower customer concentration, a broader set of capabilities, ability to hold on to their clients and the ability to absorb shocks in the event of an economic downturn in future,” analysts at Nirmal Bang Institutional Equities said in a 17 March note to clients.
While large-sized companies get around 20-22% of revenues from their top 10 clients, in the case of mid-caps, the contribution is more than double those levels. In Mindtree Ltd’s case, the top 10 customers accounted for 44% of revenues in the December quarter, down from 46% two years ago. For Larsen & Toubro Infotech Ltd, contribution from the largest 10 customers has remained more or less steady in the past two years at 51%. In the case of Mphasis Ltd, it has risen from 48% two years ago to 55% in Q3, according to data collated by Nirmal Bang.
For Persistent Systems, just one customer accounted for 28% of revenues last quarter, where for large-caps, this ratio is typically in the region of 3%.
In the past, growth rates at some of these companies have been volatile, simply because the loss of a large project or a client can have a large impact on overall performance. Investors seem to be disregarding these risks. As Nirmal Bang’s analysts put it, “We would advise investors to focus on sustainability and not overpay for a riskier business model. Current valuations of mid-cap stocks factor in strong growth over a two- to three-year time frame, which we believe is unlikely.”
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