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May 5, 2000

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Devangshu Datta

Time to buy?

As we saw this week, it took the market just about 35 minutes to start hitting the new 12 per cent circuit filters. That was actually five minutes trading and a 30-minute enforced break. No amount of fiddling with circuit filters and other market mechanisms is going to suddenly reverse the southward trend.

The real problems that led to this bear market don't lie with trading mechanisms. They are imbedded in the fundamentals. Economic expectations simply got worse after the Budget. After the market expressed its disapproval in no uncertain fashion by hammering prices down, some sops have been announced.

It is interesting that a 57 per cent retraction in infotech, communication and entertainment (ICE) market values has finally led to the clearance of rational tax treatment of employee stock option plans (ESOPs). This is something that has been hanging fire for several years despite the desperate pleadings of both the IT and pharma industries.

Obviously while market values were up, the Income Tax authorities were loath to let go of cash in hand. With values down, options look less attractive. So fine, let's rationalise the whole tax treatment, the thinking goes. Similarly the crash in market values of the pharma industry suddenly led to a compassionate review of tax write-offs and tax holidays for research and development expenditure.

Those announcements came out of the blue with no trigger except the market crash. They must have been conceived and cleared after the Budget. Which means that government can change its mind remarkably quickly when it sees the need. The recent review of foreign institutional investors (FIIs), that are eligible for the Mauritius double taxation treaty, and the clarification within 48 hours of a sharp market decline reinforces my conviction that the market is now a powerful force for reform.

The government needs the market to stay buoyant. Without that, there is no chance of wholesale public sector divestment. If the FIIs fled, with a run on reserves, the current account deficit would suddenly start looming large. Tax collections, consumption patterns, corporate investments, everything would be affected by another long bear market which ruined a hard-won "wealth effect". In some dim sense, the government has figured this out. India isn't as leveraged to market values as the US but it is leveraged enough to influence a government that burns borrowed money quickly.

The rationalisation of ESOPs and extension of tax holidays for projects located in software technology parks and export promotion zones prompts a rethink about IT. IT is the one industry that stayed out of the bear's hug in the 1994-98 bear market. Indian IT valuations are dependent on US conditions. The venture capital (VC) comes from there, the IT revenues come from there, so do the FIIs who invest so heavily in Indian IT. The plunge in valuations has been induced by sharp reactions on the NASDAQ and the NYSE. With VC funding and FII confidence drying up, ICE valuations had to drop.

In the past quarter, the industry has maintained high revenue and earnings growth rates. The better companies have found new revenue sources after the end of Y2K projects. At the same time, share prices have retraced around 60 per cent. A halving in share price has been combined with a rough doubling of earnings per share in some instances. So the price-earning multiples have effectively been chopped to a quarter of February 2000 levels in some IT stocks.

Does this make it a good time to buy IT stocks for the long-term? Factoring in the growth rates and assuming they are maintained, IT now looks like a reasonable option. I would, however, prefer to wait a bit longer. There are several reasons for hoping these stocks will get cheaper.

The first and foremost reason is reflexivity. In bear markets, prices tend to drop to irrationally low levels. Right now, IT share prices have merely eroded to rationally low levels. Let's wait for them to become really absurdly cheap. The bearishness probably hasn't ended yet.

The second reason is that I think that there are safer bargains available. Both pharma and entertainment are growth plays that have taken even bigger hammerings than IT. Pharma stocks will see renewed buying interest after the newly announced R&D tax write-offs and tax holidays. Growth rates aren't bad and valuations are far lower than in IT. Entertainment stocks have similar growth rates to IT and somewhat lower P/Es after the recent correction. Fast moving consumer goods also haven't really participated in the rally since November - they are worth a look as defensive holdings in case the bear market continues.

The last reason for waiting for further decline is most potent. The US expansion is likely to see a hiccup this year. The US economy seems to be overheating. The Fed will raise interest rates for certain as it has done in the past five quarters. But this could turn into a big recession if the Fed misjudges the level to which it should raise rates. A recession in the US will mean that Indian IT revenues take big hits. The entire valuation game changes if we cannot depend on a stable growth rate of 60 per cent plus. Even a single quarter pullback in the US will affect IT revenues substantially since close to $4 billion of IT revenues (out of a total $5.8 billion) are earned in the US. That could provoke another big tumble for IT stocks.

Devangshu Datta

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