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Is there more upside in store for technology stocks?

Software stocks have seen a steep run-up in the recent market rally  

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Published a month ago on Oct 23, 2020 Read

Deepak Jasani
Head- retail research, HDFC Securities

The market is currently in a mood to reward performers, and IT companies results and reaction of their stocks prices are reflecting that. Overall, revenue and profit margin visibility are quite good, so IT stocks will remain in demand. As a result, the price band of IT stocks will be 10-20% higher from the earlier range prior to Q2 results and that could continue for the next few quarters. The commentaries of managements indicate visible confidence in each of them. There is huge demand for digital transformation across the globe from clients who want IT companies to deliver solutions fast so that they can withstand competition and meet the compliance norms in their respective businesses. So, this is a big trigger for IT stocks. On the cost front, too, travel costs have reduced and may remain low till December end. Typically, the IT sector has a cycle of growth coming every few years that lasts for four to six quarters or maximum for eight quarters. We have already seen two quarters of good growth and expect the momentum to last for another three-odd quarters. Further from a portfolio perspective, too, investors need to have IT stocks as they are defensive plays. Hence, even if there is a correction in the overall market, these stocks may not fall as much as other stocks.

 
Ajay Bodke
CEO & chief portfolio manager (PMS), Prabhudas Lilladher
 
There is huge euphoria building up in technology stocks. Looking at the mean for the past decade, most IT stocks are trading at a substantial premium, anywhere around 1.5-2 standard deviation. Other than salaries, the highest cost for IT companies is travel and visa costs. In addition to that expenditure, companies have cut down their marketing spends. In the absence of such costs, IT companies’ operating margins are looking outlandish. Once the pandemic eases, travel costs will come back, and so will marketing spends. Since most companies follow a calendar year for salary increments, you will see the impact of that as well. So, what we are looking at are peak margins and from here it is going to be only downhill as far as margins are concerned. We have to see if the so-called supercycle of digital spend is going to play out. While these companies have debt free balance sheets and their cash conversion ratios are high, growth is still not a given. In the US, IBM and Accenture have refused to give next quarter guidance because of the uncertainty related to the pandemic. Investors are also neglecting the resurgence of the virus in Europe and America, which are the main markets for these companies. Whenever valuations are significantly higher compared with the mean, and are not accompanied by strong earnings growth, it is matter of when, and not whether a valuation collapse will happen.