Stocks from the defensive IT sector have been on a roll over the past year and mid-tier software services companies have been leading the surge. The stock prices of many mid-tier IT companies have doubled in this period, resulting in these companies now trading at a significant valuation premium over their larger players.

The price-earnings (PE) multiples of mid-tier IT companies are currently at 20-29 times, whereas large and mega-size software firms, with the exception of TCS, trade at 14-18 times their trailing earnings, according to Bloomberg data. These multiples are the highest that mid-tier IT companies have enjoyed in the last five years.

This re-rating of mid-tier IT stocks has taken place despite most of these firms reporting only single-digit revenue growth and a sedate increase in profits.

Coming from behind

According to market experts, besides the broad-based rally in mid-cap stocks over the last year helping IT players, the attractive valuations of these companies has also helped.

Says G Chokkalingam, Founder and MD, Equinomics Research & Advisory: “Last year, if you see, there was a solid valuation gap between mid- and large-cap IT companies. PE multiples were 10-12 times for mid-cap IT stocks. Not just that, enterprise value-to-sales (another key valuation multiple) was around one or less for these stocks. So, there was a definite case for re-rating.”

Operationally, too, mid-tier IT companies seem to have done well, as many have been able to tap into newer revenue generation streams, with sound execution capabilities.

Says Deepak Jasani, Head of Retail Research, HDFC Securities: “Mid-cap IT stocks have been early movers in the niche digital / SMAC (social media, analytics and cloud) space compared to their larger peers. Focussed client servicing and the ability to cater to customers of varied sizes are some other advantages of these companies.”

BL21P1FAREcol
Another reason for the expansion in valuation multiples could be due to institutional investors taking a fancy to these stocks.

“Under-ownership by institutions, compared to their larger peers, also seems to have played a role in their outperformance,” says Jasani.

He adds that larger mid-cap IT companies have started following better capital allocation strategies by distributing a higher proportion of their earnings through dividends or buybacks.

The consolidation in the mid-tier IT space with overseas firms buying domestic software players too seems to have led to better PE multiples.

Emphasising his point, Chokkalingam cites the examples of Polaris (acquired by Vitusa), Mphasis (Blackstone Group) and Hexaware (Baring Asia); all three companies witnessed significant expansion in PE multiples in the last one year.

With the re-rating in the mid-cap stocks resulting in high PE multiples, would the space be a preferred option for investors?

Not as attractive now

Chokkalingam doesn’t think so. He says that with the rally in these stocks, the enterprise value-to-sales multiple is in excess of 2.5 times. “Therefore, I do not think that mid-cap IT stocks, barring one or two, would be attractive options for investors, at least for the next 1-2 years.”

Jasani thinks that a selective approach may help. He says that some mid-cap stocks may have high PE multiples, but vis-à-vis their expected earnings growth, they may not be that expensive. “Some of them are on the verge of recording a sharp rise in earnings over the next two years.”

He, however, adds a note of caution. “From the current levels, an investor will have to be careful in checking whether the above positives are already in the price of these mid-cap IT companies.”

comment COMMENT NOW