What Does the Recent Rally in IT Stocks Indicate
Why IT stocks are going up? What does the recent rally in IT Sector indicate? Lets do a 3 point analysis of IT sector in this article. It consists of 3 key points – performance of IT sector, sub-segments and reasons behind the recent rally in IT stocks.
Why IT Stocks Are Going Up – 3 Point Analysis
- Shares of IT companies jumped up to 12.5% on Thursday, July 16, 2020 after sector majors Infosys and Wipro reported better-than-expected results for the quarter Q1 FY21.
- The Nifty IT index advanced over 5.5% to 17,373 levels with 9 out of 10 constituents trading in the green.
- Lets do a 3 point analysis of IT sector.
Performance of IT Sector
- This shows that Nifty IT index has almost recovered. And it is back to pre-COVID levels, although the index is still a bit behind its 52-week high.
- However, it is most likely that IT sector index will soon cross the 52- week high. Looking at the reasons for the rally in IT sector which are discussed in the later part of this article.
Segmentation of IT Sector
- As seen, Indian IT sector is divided into two segments :
- Top 5 Big IT players
- Small IT Players
- Here, the big IT players account for 80% of the total IT sector revenue. It clearly shows how dominating are these 5 big IT companies in the overall IT sector revenue generation.
- The key strength of the big IT companies is their operating profit margin %. Lets have a look at the margins of Top 5 big IT players.
- TCS has one of the highest operating profit margins in IT sector at 27.5%. It is mainly due to the stickiness of its key clients.
- Infosys has second highest operating profit margins followed by HCL Tech, which is a dark horse of Indian IT sector. Overall analysts’ coverage of HCL Tech is quite low. However we are quite bullish on this stock and it is a part of our model portfolios.
- Wipro and L&T Infotech have comparatively lower margins ~20%.
- Small IT players have quite lower operating profit margins (15-17%) as compared to the big players.
- The main reasons for these are:
- Small players usually acquire new clients by reducing costs and thus offering their services at discount.
- These players do not have product differentiation like big IT players. Thus, they have to price their services modestly to get new contracts.
So, we have now seen the structure of Indian IT sector and its recent stock rally. Let us now discuss the reasons behind the soaring high prices of IT stocks.
Reasons Behind the Recent Rally in IT Stocks
1. Companies’ Q1 FY21 Results better than Analysts Projections – Operating Profit Margins Improved
- Usually the regular market participants like analysts, speculators, traders, etc estimate results for the companies depending upon various macro-economic as well as company specific factors prior to quarterly results.
- If the quarterly results reported by the companies are higher than that of street estimates, stock prices start increasing.
- The recent rally in IT sector is mainly a result of major IT companies like Wipro, Infosys, HCL Tech reporting results above analyst’s estimates. This is also called as Index Catch-up Rally. In the past as well, we have witnessed such rally in IT sector after positive quarterly results.
- Another inference that can be taken out from this is that insider information is not leaked by promoters and hence the rally is seen only after results are declared.
- This shows the good corporate governance of IT sector, mainly the top players which are major contributors to the index catch-up.
2. Rally in Small IT Companies may indicate the upcoming Consolidation
- Sometimes the rally is also a result of leveraging the merger arbitrage by traders as the small IT firms are taken over by larger players.
- For Example : Hostile Takeover of Mindtree by L&T Infotech
- Taking advantage of mergers/ acquisitions by timing the trades involves higher risks and we do not advise retail investors to take part in such arbitrage trades.
3. Optimism in Management’s Commentary – Positive Outlook
- Another reason for the rally is management commentary of bigger IT players which is quite positive.
- It is indicating the sector getting back to the normalcy from the downturn due to pandemic.
4. Fast Adoption of Work from Home Culture in IT Companies – Least Affected Revenues
- IT sector is one of the least affected sectors in current times in terms of operations due to faster adoption of work from home culture and other business continuity practices in place.
- Employee efficiencies are also not much hampered due to easier transition to work from home policies. This positive impact is reflected in the revenues of IT companies in Q1 FY21.
5. Companies’ Increased Focus on Cost Saving Measures
- As we know due to the pandemic, most of the companies are focusing on controlling overhead costs like Marketing Expenses.
- Also, one of the benefits of work from home culture and reduced travel has resulted in lower operating expenses like travel costs, office costs etc.
- Many IT companies have realised the cost benefits of Work from home culture. Thus they are devising policies wherein most of the staff will be working from home and very few employees will be working from office.
- For Example – 25/25 strategy devised by TCS wherein by 2025, only 25% of its total workforce will be required to come to office for work, as company now opts work from home policy.
- The remaining 75% will be working from home. There will be rotations between the employees working from home and those working from office every week.
- This move will be majorly margin accretive for IT sector due to lower operating costs which will eventually create value in longer term.
- Looking at the new structural changes that came with this pandemic in IT sector and its cost benefits, this sector will be worth watching.
- As compared to the other sectors, the negative implications of the COVID pandemic and the nationwide lockdown seems to be at limited extent for IT sector.