This Article was originally published in The Global Analyst

Information Technology (IT) stocks have been having bad days in the stock market during the last one year. While the overall Nifty 50 index is up 1.3%, the Nifty IT index is down nearly 18% with steep losses noted for its star constituents TCS (-11%), Infosys (-24%), & Tech Mahindra (-21.5%) with few exceptions like Persistent system (up 7.2%). This has led to some fundamental questions being asked about the long-term outlook for the Indian IT stocks.

Indian IT stocks have a spectacular record of stock market returns measured during the last 3,5 and 10 years and that too by a good measure (see table). In such a scenario, the present weakness can at best signal a great opportunity to buy some of them for long-term perspective.

Source: Refinitiv

Indian Information Technology companies enjoy some good long-term moats that are worth explaining  at this stage:

1.     Service industry with export focus: The long growth of Indian IT sector is purely a home grown case study that went outside India and captured global attention for its IT attributes. Many of the clients of Indian IT companies are global organisations (banks and non-banks) that depend on Indian IT companies to a very large extent. Many of these multinational companies have set-up their back-end units in India and has been seamlessly working with Indian IT companies for many years now. The industry is also viewed positively by the government given the foreign exchange that they bring in good measure, a thing that is highly needed for an emerging market like India.

2.     Evolving Business Model: While initially the Indian IT story started at the lowest end of the value chain (read body shopping and coding), they quickly evolved in the value chain and now aggressively compete in the middle segment of the value chain with immense potential to move up to the higher end. The increasing size, scale and profitability also enables them to do this. Today, many Indian IT companies are highly focused on the global digital story and provide detailed consulting to global clients. It can easily be observed that they constantly adapt their business model to maximise opportunities and profits.

3.     Good Governance: While the biggest risk for emerging market stocks stem from shoddy/suspect governance with family domination, the names in the Indian IT sector have set some good examples for ethics based governance structure primarily started by Infosys. The big names in the IT sector including TCS, Infosys, HCL, L&T, & Tech Mahindra enjoy good investor backing primarily on the back of good governance. Due to this factor, these names qualify as blue chips in the index.

4.     Superb Long-term returns: As they say, the proof the pudding is in eating, Indian IT companies have delivered excellent long-term performance beating the broad Nifty 50 by a significant measure.  A look at the risk-return chart for the last five years places the sector in a sweet spot compared to other sectors like Auto, Realty, Metals, Private Banks, Financial services and Pharmaceuticals. During the last 5 years, the sector has delivered an annualised return of 15% compared to 10% for Nifty 50 by only taking marginally higher risk as measured by the Standard Deviation.

Of course, the sector is not without its risks. Some of the key risks faced by investors in stocks in the sector are:

1.     Exchange rates: Being predominantly export oriented in its nature, the industry’s fortunes swing widely with the performance of Indian rupee vis-à-vis global currencies mainly USD. A strong rupee will hurt while a weak rupee will benefit. Currency hedging will be key to manage this risk. However, the performance of Indian rupee against the USD has been surprisingly stable given the astute management by RBI.

2.     Macro risks: Indian IT companies mainly have global companies as clients, mainly from USA. Presently a inflation triggered global economic recession is mostly feared and if this materialises, it might slow down global IT spending as it has a discretionary bias. At the same time, companies also use IT solutions to optimise cost and manage the economic downturn. Macro risks is the primary reason for the poor performance of the Indian IT sector during the last a one year. Global IT companies have been in bad news for massive layoffs as they overstretched themselves during the Covid-19 pandemic. This further adds to the risk

3.     Skill based sector: As a knowledge industry, IT sector’s reliance on people more than machines may result in higher margins but also brings other problems to the fore including intense competition, attrition and wage growth pressure. The industry has to constantly be ahead of the curve to beat these risks and they get only tougher. Availability of superior talent is always a challenge given our patchy education structure that still emphasises on rote learning (memorising). While IT companies are significant recruiters in University campuses, they spend significant amount to train/re skill the recruits in order to make them industry ready.

4.     Moving up the Value Chain: While Indian IT companies work for the global giants, they are yet to turn themselves into global giants. While the industry has successfully forayed from the low end to the medium part of the value chain, the travel to the higher end will prove very difficult given global pressures especially from USA/Europe and talent constraints. Companies that successfully navigate this travel will defiantly reap great benefits.

Future Perfect!

 Notwithstanding the current tough phase, it can be said that the Indian IT industry is well-placed to reap the benefits of an upcoming global IT spending boom estimated to be worth $4.6 tn, an increase of 5.5% from 2022, according to the latest forecast by Gartner, Inc., besides new growth opportunities in areas like Cyber Security, AI, Automation, and Cloud Computing. While these are significant trends, many of them are interconnected (like Cloud and cyber security). Indian companies are taking some interesting steps to get there, including in the now-emerging Metaverse space.

Companies that focus on these emerging digital areas will continue to provide great shareholder returns as opposed to others that are content with being service providers. Given only a handful of blue-chip IT stocks, it may well be worth pouring over their annual reports and other filings to see who all gets there!