• Chesapeake Group

Valuation tumbles in the Technology Sector


Overview:


Over the past few weeks, US technology stocks have fallen significantly on rising inflation coupled with monetary tightening policies from the US Fed. A day after the Federal Reserve raised its benchmark interest rate by 0.5%, a sell-off in technology stocks pushed the NASDAQ to its worst one-day plunge since June 2020. Knock on effects were felt in the Indian IT services segment as well, with brokers downgrading the Indian IT sector within their respective investment thesis.


Monetary policy tightening triggers sell-off:


The US Fed, along with a number of central banks around the world, are preparing to raise interest rates to combat rising inflation. This has caused most technology stocks, or so-called “growth stocks”, to decline over the last 2 months.

On 4 May 2022, The Federal Reserve increased it benchmark interest rate by 0.5%, the largest rate move since 2000. It is the most aggressive step yet in the watchdog’s fight against a 40-year high inflation. What followed was a massive sell-off in the tech sector on concerns that the economy is in for some dark times ahead. The tech heavy index Nasdaq fell 9.1% in the first quarter of the year. Halfway through the second quarter, the index is now down 17.0% for the year.


The rotation out of tech began in late 2021 as increasing inflation and the threat of rising rates led investors to areas of economy deemed safer like energy and financial services. A further blow came from the Russia-Ukraine conflict in Feb-22 which sent energy prices higher and heightened concerns about supply chain constraints and weakening business conditions in many parts of the world.


The impact on Indian IT sector:


Outflows from foreign portfolio investors (FPIs) have continued to weigh on the Indian markets. Since the beginning of the year, FPIs have sold Indian equities worth $21.6bn. Investors have started questioning the high-level revenue growth story due to an anticipated slowdown in the US economy amidst a spike in interest rates. In addition, inflation may take longer to taper so the high EBITDA margins may also be tough to sustain. Global brokerage houses are targeting 10-20% downsides in valuation for leading IT companies like TCS, Wipro and HCL Tech.

Along with the macroeconomic headwinds, the brokers feel that the growth assumptions are too rich and steep. They believe that the market valuations are still building in growth of 6-13% for large cap and 14-33% for mid-cap IT names. Reports add that such steep valuation expectations may be hard to sustain if the global IT spending and digital spending were to taper of in the next few quarters. They expect things to worsen in 2023.


For YTD-22, Nifty IT is down c.26% while Nifty is down by c.8%. IT has been the worst performing sector amongst key sectors highlighting that current valuations may be too rich and unsustainable.

Indian tier-2 IT companies are more likely to suffer because of vendor consolidation under the pressured profit picture for customers, a less diversified revenue mix, and a larger exposure to non-global 1000 clientele whose profits are more vulnerable in the current macro environment.