The IT sector is a crucial sector of the Indian economy as well as one of the most significant drivers of export revenue for the country. However, it has faced multiple headwinds at macro and micro levels, including global slowdown, high attrition rates and margin pressure impacting the companies, resulting in a stock slump.
We had predicted in April 2022 that the sector would continue to underperform or, at best, be a market performer until September 2022. Instead, since mid-April, the Nifty IT index underperformed the Nifty.
Nifty IT versus other indices' performance has been down by -27%, which clearly shows the underperformance level. But is the pain finally through? Will the IT sector pick up from here on?
We find out.
Factors plaguing the IT sector
The IT sector is an important sector for the stock market. In October 2021, the IT sector weightage in Nifty 50 enjoyed almost 18% and accounted for 13% of India Inc's net profit and market cap. However, despite underperformance, the weightage has come down in terms of net profit and market cap percentage to 15.91%. But despite its reduction, it stilsesl holds a significant portion of India Inc's net profit and market cap.
But it has been struggling to get investors' attention. This has been due to high attrition rates, increased travelling expenses, rising retention costs, global uncertainties, and world economies slowing down. Besides, given competitive pressure, IT companies cannot pass on the cost to end customers.
In addition, slower GDP growth in the US and Europe could further push demand down and cut IT spending.
Against this backdrop, the underperformance of large IT stocks is likely to continue. The fall in IT stocks has also been in line with the slide in tech-heavy NASDAQ. We believe the US Fed's tightening monetary policy weighs heavily on tech companies yet to show revenue and profit growth. Due to these reasons, the IT sector has been struggling to vie for investors' attention.
Elevated Attrition Rates
Typically, the IT sector is an excellent paymaster. So across the industry, IT companies hiked salaries. Unfortunately, that impacted margins. But despite salary hikes, retaining employees has been the biggest challenge.
A critical trigger for the intense change in the workplace culture of the IT industry has been the Covid-19 pandemic. As a result, attrition rates began to rise in double digits. In addition, several factors impacted employee retention: better prospects for specialized skills in cloud, cybersecurity, AI/ML and others, a transformation in employee mindset and work dynamics etc.
However, one factor that has provided a ray of hope is the delta in the attrition rate that is slowing down, which should give a level of comfort to investors. In addition, several startups have also started slowing recruitment, which could relieve the IT sector.
Gartner forecasts
Cloud service demand could reshape the IT services industry and drive spending on servers to 16.6% growth in 2022. Gartner also opines that the global critical IT skills shortage could decrease by 2023.
How to approach investing in the IT Sector?
Given the headwinds impacting macro issues, investors are confused on how to approach investing in the IT sector.
As an investor, you may be concerned about top line growth in the IT sector due to a slowdown in the global economy, supply-side issues impacting margins and the inability of the companies to pass on wage hikes to customers. Gartner opines that the global critical IT skills shortage could decrease by 2023. However, most leading Indian corporates believe that attrition levels will stay elevated only until the next quarter - September 2022. Besides, due to the economic slowdown, it would not be easy to pass on salary hikes to the end customers.
Hence, we will likely witness another quarter of poor margins and net profits reported by IT companies. Nevertheless, we expect the IT sector to pick post-September 2022, as currently, supply-side pressures and attrition rates are still high. For a strange reason, IT companies' performance mimics Nasdaq's performance. Hence, if you are keenly eyeing investing in IT, you must maintain a close watch on the Nasdaq movement.
This is not a sector where one should go all guns blazing. Hence, adopting a stock-specific approach rather than a broader one should be the strategy for investing in the IT sector.
Sunil Damania is the Chief Investment Officer of MarketsMojo