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Analysts expect earnings growth for IT companies to be in the range of 10% over the next several quarters, which is normal.
Analysts expect earnings growth for IT companies to be in the range of 10% over the next several quarters, which is normal.

Mid-cap IT stocks  outpace  large peers in 2020 but valuations are worrisome

The growth in mid-cap IT basket may taper off going ahead, as earnings are expected to normalize

The IT sector’s rise has been good so far but bears the risk of running ahead of itself, particularly in the case of mid-cap IT stocks.

Gains in mid-cap IT shares have been greater than those of large-caps in 2020. Returns of the top five IT stocks ranged between 24% and 57% year-to-date. Mid-tier IT stocks gained between 19% and 108% among the top eight companies in market value. On average, these companies surpassed the Nifty IT index returns of 42% considerably.

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While that is good, the rise may taper off as earnings are expected to normalize, going ahead.

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The pandemic has shone a light on the resilience of the IT sector, barring a supply-side blip during the virus outbreak when deliveries were affected. Overall, the sector delivered earnings growth in the second quarter. Investors also increased the premium on IT stocks on resilience, particularly for mid-caps.

“Mid-caps have outperformed large-caps since the March lows and are now trading at two standard deviations (average from the mean value) above its 10-year average," wrote analysts at Antique Stock Broking Pvt. Ltd in a client note.

Lower travel costs also meant that the sector got the benefit of margin tailwinds. An improvement in the onsite-offshore mix and higher realizations also aided margins.

“Operating margins for mid-cap IT services firms are hovering around mid-teens in Q2FY20. IT mid-cap margins were the highest since FY15 at 16% and have expanded by 300-400 basis points in the last 14 quarters," noted analysts at Antique Stock Broking. One basis point is one-hundredth of a percentage.

However, earnings growth is not going to be any faster now. Analysts expect earnings growth to be in the range of 10% over the next several quarters, which is normal. However, rising valuations of the mid-cap IT sector should worry investors, suggesting the need for a cautious stance.

Larsen and Toubro Infotech Ltd trades at a price-earnings multiple of 28 times FY22 earnings, while Coforge Ltd trades at 25 times, according to data from Bloomberg. Tata Consultancy Services Ltd’s valuations are about 27 times, while Infosys Ltd’s are at 23 times.

Analysts point out that global IT spends have to grow dramatically next year to support valuations. Even so, it may not improve the prospects of mid-tier companies over the large-caps.

“The IT sector proved its resilience during the pandemic when there was a huge disruption in other sectors. But now that the companies are valued at a higher multiple than the market, it is difficult to say whether it will prevail for much longer. We are expecting 9-14% growth in the mid-cap IT sector and nothing exceptional beyond this," said Rahul Jain, vice-president, research, Dolat Capital Markets.

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