Information technology (IT) stocks are scaling new heights every other day even while the broad markets have corrected from their highs in early November.

The Nifty is currently trading around 5% lower when compared with its highs in early November. In contrast, the CNX IT index has risen by around 8%.

This relatively sharp outperformance has come after months of subdued returns relative to the broad market.

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Before the recent rally, the CNX IT index had underperformed the Nifty by around 7% in the past nine months, essentially taking a breather after valuations of IT stocks had shot up in 2009.

With the recent concerns about corporate governance in Indian companies, the renewed interest in large IT stocks is understandable. But more importantly, investors are flocking to these counters because of a strong demand outlook.

In the September quarter, three of the top four IT firms in the sector expanded revenue in double digits on a sequential basis. Revenue growth may be lower in December quarter owing to a lower number of working days, but the overall growth momentum continues to be strong.

In fact, analyst interactions with top IT companies suggest that growth will remain strong in fiscal 2012. According to analysts at Motilal Oswal Securities Ltd, Tata Consultancy Services Ltd is confident of growing at more than 20% in the next three years. Also, it expects significant growth in fiscal 2012 based on the initial budget outlook from large, existing clients. Importantly, its growth outlook does not factor in any large transformational deals.

Similarly, Infosys Technologies Ltd hinted at a growth of 20% in fiscal 2012, provided there aren’t any global macro shocks. According to Motilal analysts, its near-term outlook is bullish with deal activity being robust and the deal win rate being in line with the past few quarters. The high growth of the past few quarters, it appears, is sustainable going into the next financial year.

Of course, IT stocks had already been factoring this in for some time. But with visibility on demand improving, more investors seem to be buying into the story. The only concern at this point would be sustainability of margins, considering that most top firms are running at peak operating parameters.

In that backdrop, the fact that wage inflation is likely to be high next year may affect margins.

So even if revenue grows briskly, earnings growth may not match it. In any case, earnings growth will be affected next year owing to an increase in tax rates.

But margin pressures may keep a check on operating profit growth as well.

Of course, some of this is likely to be overlooked by investors, given the strong underlying demand story. But then, it must be noted that top IT firms trade at 27 times fiscal 2011 earnings already, and for them to generate decent returns from current levels, revenue growth rates would have to reach 30% in the next few years.

Graphics by Yogesh Kumar/Mint

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