Home / Markets / Mark To Market /  Mid-cap IT stocks feel the heat as investors do a reality check

Among the once high-flying stocks that sold off in the downturn this past six months are mid-cap IT stocks. The perception that second-rung IT companies could deliver higher growth rates than big IT is no longer taken as a given.

A look at the accompanying chart shows that shares of mid-tier IT companies have underperformed the Nifty IT index by about 19% in the past six months. Barring Larsen and Toubro Infotech Ltd, which has displayed rare consistency for a mid-tier firm, and NIIT Technologies Ltd, an acquisition candidate, most other mid-tier IT stocks have fallen between 20% and 37% from their highs in mid-2018.

Only a few mid-tier IT companies have been consistent in performance, leaving investors in the lurch. “We recommend careful exposure to mid-tier companies and simply back names that have business model strength to be consistently in the top quartile on growth," analysts at Kotak Institutional Equities wrote in a recent note to clients.

“Scale attributes are important for investments in mid-tier companies. Key scale attributes are—pockets of differentiation and ability to win consistently against established players in core areas of competence, quality of employee base, profile of clients and breadth of offerings demonstrated through number of accounts that have accepted multiple services," Kotak’s analysts had said in an earlier note.

A key weakness mid-sized companies struggle with is diversification of the client base. Mid-tier companies derive about 45-65% of their revenues from the top 10 clients. Incidentally, some have even seen client concentration worsen. In large-sized IT companies, the proportion is much smaller at less than 20%.

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“A few companies have seen an increase in client concentration. This is dangerous because it requires just one or two clients to pull back or postpone spending, to materially impact financial performance," says an analyst at a domestic brokerage firm.

The other niggling worry for mid-cap IT in particular has been talent acquisition and project execution. While this problem is widespread across the IT space, it is more acute in mid-cap companies. That said, the Trump administration’s new rules on visas are hitting where it hurts the most. Smaller firms are not easily able to attract on-site talent in the US and train them like the bigger companies. This is obviously increasing operating costs.

Then there is the issue of business headwinds emanating from a slowdown in the US, trade wars and uncertainty concerning Brexit. That has led to a rise in concerns that companies in the US could either postpone IT spends or cut IT budgets. Slowing IT spends and higher operating costs make a double whammy for mid-tier IT.

Further, as the IT arena turns even more competitive, analysts see earnings decelerating. In such conditions, will mid-tier IT be able to deliver market-beating results? “The market will need to see a better-than-average performance in coming quarters in many mid-tier IT companies to once again instil confidence in these stocks," says the analyst.

With time, investors are increasingly focusing their bets on a select few mid-tier names, compared to the euphoria between mid-2017 and mid-2018 when investors piled on stocks of all mid-sized companies, regardless of performance.

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