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June 23, 2000

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Devangshu Datta

It's momentum again!

The infotech industry took a cold shower after the Budget and lost over 60 per cent off its peak values. But then, at the very peak of the market in the latter part of February, IT had been so overbought that one was not sure that the reaction would end at those levels in these reverse momentum stocks.

The big money in the market started flowing back into IT within a couple of days of hitting bottom at May 22. It's just a month down the line and IT stocks have rebounded 50 per cent from their lows. Scrips like Infosys and Wipro were looking distinctly exciting at Rs 5,600 and Rs 1,800. At Rs 8,700 and Rs 3,000 respectively, the value equation is not quite so clear.

One big inflection point has passed for the industry. The Y2K problem is over. Many Indian companies have done well to come out of that with relationships they can leverage in the search for new avenues. Some of them such as Trigyn Technologies (earlier Leading Edge Systems) and reportedly TCS, are still scrambling for alternate sources of income but most show signs of adapting to the post-Y2K scenario.

The new growth areas are all web-based or WAP-based (wireless application protocol) and heavily dependent on a global e-commerce take off. Almost implicit here is the assumption that Internet penetration will maintain the same pace as before or even accelerate. Delivery/reception systems for the Net may change to cable or wireless but more and more people will get on to the Web.

The basic infrastructure is being taken for granted - so much so that Arun Netravali predicts bandwidth will become free. That may be so across the globe but India will be one of those pockets where bandwidth remains an issue in the medium term. It is tough to quantify the bandwidth shortfall here - so many numbers have been bandied around.

But latent demand would probably be enough to absorb a ten-fold increase in bandwidth in this fiscal. Pretty obviously, that level of expansion is not going to happen though China has pulled off even bigger bandwidth expansions in the last six months. The legislative and security problems that hinder domestic e-commerce could be lived with if the bandwidth existed. Obviously better infrastructure would boost growth. However the domestic IT industry is still growing at a healthy clip of better than 35 per cent compounded despite all the constraints.

Externally software export growth seems to remain pretty strong. The key here in the medium term would be to boost value-addition. A lot of Indian IT services are delivered at the semi-clerical level with less than 25 per cent of US productivity in per hour terms. Moving up the value chain is going to be fairly critical for most Indian firms and this fiscal will be crucial.

Is it worth investing in IT at these somewhat reduced prices? Let's look at blue chips like Infosys, Wipro and Hughes Software. All three companies have permanent "buy" status in most domestic and foreign brokerage reports. Infy has a likely growth rate of between 80-100 per cent in FY 2000-01. Wipro has a 75-80 per cent growth rate and Hughes has around 100 per cent. Let's be optimistic and assume all-round 100 per cent growth for the sake of convenience.

At the current price-earnings (P/E) ratios of Infosys around 200, Wipro at 230 and Hughes around 150, the PE to growth ratio still appears excessive except perhaps in Hughes. So the value equation again says "No" to buying. There was that short window of opportunity when the prices dipped but even then the Infy and Wipro P/Es never dropped below the century mark.

From the long term investor's point of view, you would have to assume a triple digit growth rate that lasted until 2003 at least before stocks looked reasonably priced at current price levels. There are too many uncertainties about projecting over such a long time frame and even industry body Nasscom assumes far lower compounded growth rates of around 60 per cent.

So out-performers like these three appear expensive. In fact, there doesn't appear to be a decent value equation for any of the IT big guns.

So once again after a month or so of opportunity, the industry has been reduced to a momentum play. To make sense of momentum plays, one must look at technical factors. Here one thing is clear. The industry is in the midst of a sequence of declining price-tops and bottoms. Trading volumes are also lower than four months ago. This is in line with the entire stock market and it is the classic definition of a bearish period. When buying a momentum stock in a bearish phase, you must assume a downside risk to at least the level of the previous bottom. Which means that late May prices could be seen again.

On the other hand, on price charts, most IT stocks also look to have formed positive bottoming formations. Infosys for example, is within inches of completing an inverted head and shoulders. Global Tele has gone through a classic breakout and so has Himachal Futuristic.

Wipro and Digital have formed reliable-looking bottoms. So there could well be trading gains to be made here even if the range of movement declines.

There are a few other factors that could influence investment decisions. One is that telecom-software specific stocks like Global, Himachal and Hughes are outperforming the industry as a whole. There may be more momentum in that specific segment. Especially if the government does come through with a sensible divestment plan for MTNL, VSNL, Department of Telecom Services today.

Another factor is that the industry is high beta but it is probably not negative beta. At least it hasn't been for the last two years. So a surge in IT ought to be mirrored in broader movements. Do we see signs of that happening? Or is the recent move towards pharma and FMCG a defensive posture from investors who have accepted the possibility of a continued bear market?

Devangshu Datta

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