Looking To Invest In Beaten-Down IT Stocks? Here's What To Watch
The demand outlook for IT companies ended up being better than many had forecast at the end of Q3. Were IT stocks oversold?
The jury is out on information technology companies. The performance of most frontline IT companies in the third quarter of the current financial year and the commentary by their managements on deal wins calmed investor nerves somewhat, but worries persist in anticipation of a slowdown in key U.S. and European markets.
Part of that pessimism is reflected in the performance of the IT index in 2022. It was the worst performer of the top 10 sectoral indices in 2022. The S&P BSE IT index lost over 24%. Of course, IT stocks have clawed back some ground in 2023, having largely beaten consensus estimates in the third quarter.
The question that investors are probably asking is, with prices of most IT stocks having declined sharply from their peaks, is this the right opportunity to make a tactical investment—either through sectoral funds or directly into individual company stocks?
Should You Buy IT Sector Funds?
“Investing in sector funds is fraught with timing risk, both on entry and exit. The nature of the market is to be cyclical, where different sectors come to the fore at different points of time,” said Kaustubh Belapurkar, director-fund research at Morningstar India.
Sector winners continue to rotate and thus, it is crucial to identify a sector early before the run-up happens as well as exiting the sector before it starts to relatively underperform, he said.
"This is by no means an easy task and even professional money managers can’t predict which sector will lead the way in the near future,” he said.
Indeed, data by Morningstar showed that the winners and losers among the top sectoral indices were constantly changing over the past decade. And what’s more, the winners in one year quite often were among the worst performers in the next.
According to him, it is also important to not buy into a sectoral fund that has done well recently.
"The past returns may look attractive, but that’s probably the worst time to get into a sector, when perhaps its best times are behind it already,” said Belapurkar.
But this timing is difficult to get right. In a recent study, Morningstar found that though technology funds had generated returns of 27.5% in the half-year to June 30, 2022, investor returns in such funds had only been 3.18%. That’s because a bulk of flows into these funds came in after the strong performance in 2020 and 2021.
Belapurkar argued in favour of diversified equity funds, where active managers express their view by taking modulated overweight or underweight calls on sectors rather than it being a binary allocation.
On the other hand, Aditya Shah, chief investment officer at JST Investments, said that investors with a high risk threshold can consider a tactical allocation to IT sector funds at this juncture.
“IT companies performed better than expected in the third quarter. The outlook for demand was not as bleak as some had feared,” he said. “Investors that can tolerate higher risk can consider investing in IT sector funds, but only via the SIP route.”
Shah highlighted the need to maintain a threshold of 10% of an equity portfolio for any sectoral allocation.
Should You Buy Individual Stocks?
In a recent interview with BQ Prime, Girish Pai, head of research at Nirmal Bang, said, “If you look at the management commentary, it’s been largely positive. But most managements indicate that the next quarter or two could be slow. But they’re indicating that things will pick up beyond that. That takes into consideration a view that things will improve on the macro front in the U.S. beyond the next six months, which I’m sceptical about.”
Despite the recent price drop in most IT companies, valuations remain expensive, he said.
“…If I buy today, even if I ignore interim volatility, and look at a five-year view, I don’t think the current valuations are enticing for me. I would buy these stocks at least 15-20% lower, because that is where I will get a material upside,” he said.
Harshvardhan Roongta, co-founder of Roongta Securities, said that investors should take a bottom-up approach to investing in IT stocks, rather than investing in a sectoral fund. Companies that are likely to be able to weather the storm of a recession in the U.S. and in Europe can be looked at, he said.
But, a better idea, according to Roongta, is to look at global tech companies in the U.S. These companies have seen a sharp fall in valuations and are looking attractive, he said.
“A retail investor looking to take a tactical exposure can look at a Nasdaq 100 exchange traded fund using an SIP approach. On the other hand, an investor with the ability and the risk profile to invest directly into these companies can do so, but should consider taking a staggered approach,” Roongta said.