I am hoping that tech stocks will give an opportunity for a neat trade sometime in the next 3-6 months. Currently the big-4 (Infy, TCS, Wipro and Satyam) are trading between 13x-15x P/E, one year forward. I am hoping that if/when the US recession is confirmed these stocks will get cheaper. At that time, hopefully, I will hold my nerve and buy.
Three possible scenarios
1. The US recession is short lived and growth resumes after a 2 quarter lag – This is the base case and the ideal scenario. My expectation is that tech stocks will perform will be on three counts.
Growth expectation – Once the recession is confirmed, analyst estimates will face downgrades. These will be upgraded when the economy starts emerging from the recession.
Currency ($) appreciation – The weak $ trend may be reversed once the economy gets back on the growth track, providing further fillip to revenue growth of Indian IT companies.
P/E expansion – This will be the real kicker to stock price appreciation. I hope to buy Infy around 12x. When bad news dissipates I expect P/Es to revert to 16x-22x for the big-4.
2. The US recession lasts longer – This can have a nasty effect on tech stocks. First, growth will disappear for a while; Second, the dollar will probably not recover for longer. Add to that higher importance investors will pay to things like higher tax incidence on Indian IT companies from next year. The result can be underperformance for a long time.
3. US economy does not go into a recession – If this happens Indian IT stocks (and others as well) will start rallying pretty soon. I would have missed the opportunity.
How much do I expect tech stocks to rally in my base case?
P/E expansion will probably provide 50%-80% return. Effect of volume growth on profit (i.e. difference between analyst assumptions after downgrades and subsequent upgrades) will add about 10%-15%. Currency appreciation can add a further 5%.
4 Comments:
while i am a bull on tech stocks myself, i think there is significantly more risk than you outline -
1) growth rates could taper down significantly becase of high base (infy guided 15-20% $ growth last year, before sub-prime). in Re terms this could be much lower.
2) in case this happens, multiples will contract, not expand. already you can see that ibm, cts, cap gemini etc. trade at much lower multiples than our big 4.
3) i do think that the margins our dudes operate at are unsustainable. as you get into bigger contracts, you get into cost+ models cos the other guy knows how much you make. add that to low growth and you are talking pretty much doom
4) the way out is to buy growth. these guys have the cash (and the valuations currently) to do it. but they wont do it because of the huge hit on margins that they will have to take
5) net-net while i am bullish, the market has a reason for pricing these stocks where it is. the market knows best!! it is seeking much higher returns for the highly risky trajectory of these cos.
Dada,
What you point out is possible. There are millions of scenarios of which what I have mentioned is one.
1. Growth probably will taper off if US slows down. I am betting that it will come back once US starts growing again. Hence I will wait for US to get into a recession. Gloom/doom scenarios are generally good times to buy.
BTW infy guided 20-22% EPS growth in rupee terms in April...and 28-30% revenue growth in $ terms.
2. I HOPE to buy Infy ~12x. At that valuation there is margin for error. Even if they deliver 15% growth, its still PEG<1. Moreover I am hoping growth will trend up once US recession is done with.
IBM - cannot compare this with our big-4...different growth profile...IBM grows at low/mid teens. Still trading at 14x forward.
CTSH - good comparison, though general opinion is that it is higher quality than our dudes...trades at 27x forward !!
Cap gemini - no idea
3. Net margin WILL compress next year as tax rates trend up. Market has probably factored this in. where do you think OPM will end up? I guess even if it goes down to 23-24% (from 27%+ in FY08) valuation is a support. CTSH generates about 20% OPM. Eventually OPM for our dudes may trend there. But that is some way off.
4. Take outs - there were some rumours abt Wipro taking out Cap gemini some time ago. Nothing happened. I guess rumours will again flare up when US goes into recession. At that time cash hoards of indian cos will be very powerful. Maybe they will buy out and then increase offshoring component to shore up margins.
5. True for now. I hope a tippping point comes when there is gloom all around and market underprices.
I don't think we'll see any expansion of multiples.. while the Indian market is complicated, it does tend to be simplistic in taking sectoral calls...
Multiples can only expand if the sector suddenly becomes a 'hot' one, and I don't think its likely for IT, since it is least decoupled with the US economy..
But you might see some upside due to currency appreciation..
You mean it is "coupled" with the US ecomomy?
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