Why IT Companies Have Fallen Out Of Favour With Investors

Investors in IT stocks seem to be on the edge, following the sustained selloff in big IT companies over the last several weeks. On Monday, IT stocks fell for the third successive session, with HCL Tech leading the losses in the Nifty50 index. Tata Consultancy Services, Wipro and Tech Mahindra were among the top Nifty losers. The sub-index of IT stocks has fallen 12 per cent over the last three months, underperforming the Sensex, which is up 4 per cent.

Here are the reasons for the selloff in IT stocks:

1) The selloff in IT stocks was triggered by Infosys' downward revision of its annual sales guidance in July. India's second largest outsourcer, which finished FY16 on a strong note, surprised investors by downgrading its FY17 constant currency revenue growth estimate to 10.5-12 per cent from 11.5-13.5 per cent earlier.

2) Days later, New Jersey-based Cognizant also lowered its 2016 sales guidance for the second time in a row citing cautious demand from clients.

3) Last week, Infosys stuck to its cautious commentary and reiterated that it is witnessing client-specific softness across verticals and slower ramp-up of large deals. According to analysts, Infosys will have to cut its annual guidance again in light of these unanticipated developments.

"We believe Infosys will lower its revenue growth guidance by at least 150-200 basis points and possibly err on the side of conservativeness as it may not want to cut numbers for a third time in an uncertain macro and industry environment," said Girish Pai of Nirmal Bang Securities.

4) Analysts expect India's $150 billion IT sector to remain under pressure because of weak growth in the US and Europe, which together account for 70-80 per cent revenues of big IT companies. Adverse consequences of Brexit have further added to gloom around the IT sector. Earlier this month, Infosys became the first casualty of Brexit as one of its clients - Royal Bank of Scotland - cancelled a project to set up a separate bank in the UK.

5) Nearly all IT companies are banking on fast-growing, high margin Digital (automation) business to compensate for the slowdown in traditional bread and butter IT services business. But analysts say Digital business is a small part of the overall IT revenue to make any "material" difference to overall business.

What should investors do: IT stocks are likely to remain under pressure for the coming months, but some buying can emerge at lower levels, analysts say.

"We expect the near-term share price performance to remain sluggish given concerns over FY17 guidance and the impact of Brexit on decision making. These factors will add to near-term volatility in the sector but we think Infosys' valuations are inexpensive at 14 times FY18 price earnings," said Religare Securities.

Religare has a "buy" call on Infosys with a target price of Rs 1,200. Nirmal Bang Securities, which was perhaps the first brokerage to turn bearish on the IT industry last year, retained its "sell" rating on Infosys with a target of Rs 970. The brokerage continues to have a negative outlook on the entire IT sector.

"Our sell rating is based on the view that the IT sector's revenue growth and price earnings multiple are likely to contract in the base case scenario that we have assumed for US economy in 2016 and 2017... Industry commentary gives us the feeling that our target price earnings multiple could be breached on the downside," it said.