I remember Jeffery Gundlach quoting Ernest Hemingway, ‘How did you go bankrupt? Two ways. Gradually, then suddenly’. This quote is deceivingly insightful. It shows how change takes place, small changes occur with the minimal impact until the cumulative effect reaches a critical point where the entire framework disintegrates and settles at a new equilibrium.
The quote seems apt for the world’s journey to its digital future, being accelerated by the pandemic. The groundwork for this new digital reality has been in progress ever since the mass production of computers and more so since the internet revolution. Being born in the early 90s in India, it’s truly astonishing to reflect upon how the digital world has slowly taken predominance in our lives from the time of the dial-up internet connection and computers being more of a novelty item to the smartphone-dependent world of today. The pandemic will now accelerate this trend even more with trends like work from home and e-commerce becoming the new normal, making parts of the old economy redundant. This has profound implications for sectoral returns in the coming decades, with few sectors disproportionately outperforming others.
The first IT boom in India happened in the late ’90s when the market realized the potential of Indian IT firms to capitalize on the world’s need to migrate business functions on to the computer. It has been 20 years since then and a lot has changed. The Indian IT industry has grown substantially. Just as an example, Infosys which had a revenue of less than Rs.2000cr in FY 2000 had Rs90,000cr revenue in FY 2020. Contrast this with HUL, a current market darling, which had revenue around Rs 11000cr in FY2000 and Rs.40000cr in FY 2020 barely keeping up with inflation. Both companies command similar markets caps around Rs 4.5 lakh crore, but Infosys trades 25x trailing earnings compared to HUL’s 65x.
The Indian IT sector despite its mighty financial performance through the last decades has not been a darling of the markets as it could not for obvious reasons sustain the growth rates during the early stages of the industry. Barring brief periods of outperformance as a defensive sector, it has barely been in the limelight. I remember around 3-4 years back when NASSCOM projected a 7% handle for industry revenue growth, investors were all ready to write off the industry as having limited growth potential. This dismal outlook for growth is precisely the reason for the underwhelming valuations for the IT industry compared to other sectors. The pandemic has broken this narrative and the market is slowly recognizing the fact the Indian IT industry barely into its 4th decade has plenty of gas left in the tank.
I enumerate the factors that I believe will lead to a massive re-rating for the Indian IT industry in the post COVID world
- The Indian IT industry at under $200 billion still is just a fraction of the near $3trillion global industry. There is tremendous scope for increasing market share with all factors that aided the industry’s growth thus far remaining intact.
- The pandemic has given a boost to the industry with enterprises worldwide being forced to strengthen their IT architecture and capabilities and this will be a persistent trend.
- The domestic market will grow to outpace Indian GDP growth and will be a significant contributor to revenue growth in the next decade.
- The market will realize the staunch nature of the earnings strength of quality IT firms. Customers find it difficult to switch vendors as the cost of migration outweighs any potential savings of lower pricing, hence protecting revenue and margins.
- There is no reason to believe that the total earnings of an Infosys for the next 30 years will be any less than HUL for the next 30 years and hence they should have similar valuations. The market will soon realize this fact and reprice accordingly.
- The level of Global debt means that the system cannot support ‘normal’ interest rates and global central bankers are sure to embrace dovish policy for the foreseeable future giving a great tailwind for stock valuation.
- The sector should be an outperformer just by the process of elimination with most other sectors still reeling from the impact of the pandemic and the road to recovery remaining murky for most. Some industries like Aviation and Hotels may not fully recover any time soon, as even after the pandemic ends, the behavioural change will ensure business travel is significantly scaled back denting a significant blow to revenues.
- Most Fund houses have been underweight the sector and thus once the sectors start outperforming, they will be forced to chase the sector to avoid underperforming the benchmarks. This fund rotation will be a great driver for outperformance
- More often than not, markets tend to have excesses at the later stages of secular trends and this will give outsized returns for anyone able to exit the trend in a timely fashion.
The above-detailed points and few others not mentioned will lead to a boom in the Indian IT stocks given stagnant or rising markets according to my judgment. The risk/reward for the sector seems very attractive as very little of the above narrative has been priced in. Even if the narrative fails, there will be a minimal loss since the present prices have not discounted for it. Let us wait for time to give the final verdict.
Written By – Nitin Mathew (BKFS, PGP 2)