IT sector recovers in 2023 after a weak 2022: Emkay lists 6 reasons to invest in this space

The Indian IT sector has been recovering a bit in 2023, after falling 26 percent in 2022 on the back of recession concerns. However, in 2023, so far, the Nifty IT index has risen over 4 percent. In comparison, the benchmark Nifty rose over 4 percent in 2022 and has lost 4 percent in 2023 YTD.

Recently, research house Emkay Wealth Management, in a note, stated that going ahead, it expects the Indian IT companies to do well basis their experience over the past two decades in handling disruption, changing geographical presence, currency gains, attractive valuation, economic recovery in the west, and relatively unchanged tech spending. It sees digital revenues for IT companies growing in the range of 25 percent to 30 percent.

Performance and outlook

The IT sector has been facing the perfect storm at the global as well as domestic levels in the last 1 year.

"The sharp run-up in inflation globally, and the resultant aggressive monetary policy actions by central banks in the developed economies (the major market for IT companies) to contain inflation resulted in recessionary expectations gradually gaining ground. The expectations of a slowing economy transforming into lower digital spending were reflected in the price performance of domestic IT companies. The high attrition rates and cross-currency movements (while the rupee depreciated against the dollar, it appreciated against other global majors such as GBP and Euro) created margin pressures. The double whammy of risks to revenue, as well as margin, has led to valuations easing in the IT space," explained the report.

Emkay noted that the near-term headwinds offer investors an opportunity to accumulate assets from a structurally resilient and long-term growth-oriented sector.

IT spending can moderate over the near term but the maintenance of existing IT infra and digital transformation of businesses across sectors and size of businesses will keep demand for Indian IT services strong, highlighted the brokerage.

Given the near-term headwinds, investors should invest in the space in a gradual manner with a minimum horizon of 3 years, it advised.

IT Sector and The Economy

The brokerage noted that the Indian tech sector has been gaining prominence in terms of its contribution to the overall economy, employment, innovation, and resilience. It further informed that the relative share of the sector in India’s GDP is 7.4 percent and the share in service exports is 51 percent, adding that the sector employs more than 5 million people, and the trend of employment is gradually accelerating, and the sheer size of the employment is going to be of astounding proportions.

With India already being the third-largest start-up hub for tech start-ups with close to 2500 new startups and 45 unicorns, the digital revenue for the IT space to grow at 25-30 percent, predicted the brokerage.

Emkay noted that all major segments of the industry are growing at a double-digit rate, and IT services are growing at around 17 percent.

"Whether it is infrastructure management, cloud-based testing services, cloud migration, consulting, etc. all are growing at a decent pace. The other growth areas are networking services, AI and analytics, platform-based services, etc. ability to respond to customer needs, focus on creating future-ready solutions, and accent on customer centricity are some of the interesting features of the business approach," highlighted Emkay.

Why should you invest in the IT space?

The domestic tech space is fundamentally stronger today than it was at any time in the past, said the brokerage. This is due to a number of factors that have actually evolved over the last two decades. It explains:

Experience of the past to handle disruption: The tech companies have faced recessionary conditions and sluggish economic conditions at least thrice during the last two decades and have already weathered the storms and the business models are stable at present, noted Emkay. The experience of the last decade has provided these companies with enough data to plan things ahead more effectively, it added.

Geographical diversification: As per the brokerage, the geographic diversification of business was more skewed towards the US and America, and this has undergone changes with the exposure to the US coming down by almost half of what it was before as business expanded to Europe, Africa, Australia, and the Middle East too.

Currency gains: The Rupee has been weaker and those who would plan their receivables with an appropriate budgeted rate for receivables and a sound hedging policy would tend to gain in the future too, said Emkar. It further mentioned that the forex gains cannot be ignored in the overall scheme of things.

Attractive valuations: According to Emkay, the last few months have seen a significant amount of price correction in the tech stocks ranging from 25-30 percent. The price correction makes the relative valuations attractive as the mid-cap companies where the valuations were overstretched have moved down, it suggested.

It further pointed out that the Nasdaq has been declining with each passing day in the last three months and this trend may continue for a little more time as the tech platform companies could face some more rough weather due to the evolving business models, competition, and the gap between delivery and customer expectations.

Economic recovery in the West: Emkay also mentioned that the macroeconomic headwinds emanating from persistently high inflation and the resultant hike in policy rates and the rise in market yields could eventually result in a slowdown in economic activity. However, many estimate the slowdown in the US or Europe might be rather weak and transient and it may not affect economic activity too badly, it informed.

Technology spending is required even when the economy may not be too sound, stated Emkay as businesses need to run, and the experience of the pandemic is that technology gained more prominence mainly through online platforms covering a host of things like digital content, social media, gaming, and e-commerce.

The global technology spending, excluding hardware, was close to US$ 1.70 trillion in 2021, close to 10 percent growth. The global sourcing market during the same period showed a growth of 12-14 percent, that is, US$ 240 billion in 2021. This shows the resilience of the industry, it pointed out.