Home / Markets / Mark To Market /  Why IT stocks are out of favour

Not too long ago, the shares of information technology (IT) services providers were ruling the charts. But now, amid fears of a recession in the US, which can potentially weigh on demand, IT stocks have lost their charm.

The weightage of IT stocks in the benchmark index Nifty50 has reduced to 15.1% in July. In CY22, the sector’s weightage has declined by 400 basis points from 19.1% in December, an analysis by Motilal Oswal Financial Services Ltd said. One basis point is 0.01%. Note that the Nifty50 index is re-balanced semi-annually, and the cut-off dates are 31 January and 31 July.

Out of favour
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Out of favour

The drastic fall, as shown in the alongside chart, is not surprising. IT stocks had an impressive run during the pandemic as the sector got a boost as clients rushed to digitize their operations amid lockdowns and remote work.

However, the risk of a US-led recession that could hamper revenue growth and the deal pipeline of IT companies is playing spoilsport.

“As of now, the worry is not about what happens to revenue growth in the next few quarters, the worry is on visibility for FY24 revenues amid recession fears. The latest management commentaries provide no input in that direction," said Amit Chandra, institutional research analyst, IT, HDFC Securities. He further added that while the overall sector outlook is positive, weakness is emerging in some pockets, like the manufacturing and retail sectors.

Apart from that, the operating margins of IT companies were also under pressure in the June quarter due to salary revisions, higher sub-contracting costs and travel expenses. Also, barring some midcap IT companies, the attrition rate remained elevated for most companies in Q1. Even though IT companies are on a hiring spree, the sector’s attrition rate is seen coming down gradually.

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In CY22, so far, the sectoral Nifty IT index has corrected by 23%, significantly underperforming the Nifty50 index, which is marginally up.

Accordingly, the sector’s valuations have also come off.

“IT services stocks in our coverage have seen a correction of 22-48% in their price-to-earnings valuation multiple from their peak. We feel that from hereon, the risk of earnings cut is higher than a further valuation moderation," said Kumar Rakesh, an analyst at BNP Paribas Securities India.

Kumar added that the FY24 consensus earnings estimates for IT services stocks were cut by 0-6%, barring a few mid-caps that saw earnings upgrades, after their June quarter earnings.

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