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Should You Worry About Your IT Stocks? - The Cognizant Saga

Oct 4, 2016

In this issue:
» The risk that PMI data fails to capture
» RBI cuts repo rates by 25 basis points
» Market roundup
» ...and more!
00:00
Richa Agarwal, Research analyst
  • I admire that man. He has a vision for his company.

I heard that last year at a family dinner. The man in question, was Francisco 'Frank' D'souza. He's the co-founder and CEO of Cognizant Technology Solutions Corp (Cognizant). This NASDAQ-listed multinational, is the second biggest IT company in India after TCS. More than 75% of its 244,000 employees are in India.

The gentleman who told me this, was working for a leading bank in the US. He said that Cognizant had provided the bank with the highest quality software services. I have no doubt that he spoke the truth.

Many people thought the same way about Cognizant and it's forty-eight-year-old CEO. D'Souza has been in charge since 2006. He gets credit for Cognizant's spectacular growth over the last ten years. In the 2016 Fortune 500 list, the company was ranked 230.

But things are different now.

Last Friday, the company dropped a bomb. It informed the US authorities that it may have paid bribes in India for land permits and building licenses. Cognizant's president and second-in-command, Gordon Coburn, resigned the same day. The stock fell 16% when the news broke.


Here's what will happen now. Cognizant will conduct an inquiry. So will the US authorities. They will find that bribes were indeed paid to Indian babus. Cognizant's reputation will take a hit. The company will be fined. Some senior employees may even go to jail.

But will things go back to how they were? Maybe. If not and the issue escalates, Cognizant's stock will be taken to the cleaners.

This brings me to the crux of the matter.

I noticed that the BSE IT index was up 0.13% yesterday. Most IT stocks were up. None of the big ones, were down more than 1%.

Does this mean that all Indian IT firms are completely above board?

No. It just means that the market thinks so.

I believe it doesn't make sense to be so naive. It's true that Indian IT firms have set a high benchmark for ethics and corporate governance. Many of them have famously refused to pay bribes in their past. We almost take this for granted today.

But what if the market is wrong? What if the senior management of Indian IT firms are also corrupt? We don't need to be reminded of Satyam again. We know it's possible. But there is no way to know for sure. Just ask Cognizant's investors.

Cognizant may become an untouchable stock on the NASDAQ. If something like this were to happen to an Indian IT firm, what can an ordinary investor do?

There are a few things you should keep in mind.

  1. Be aware that in the IT sector, high growth can never last. The competition is fierce. There's not much differentiating one company's services from another. If a company is growing much faster than its completion, find out why. The pressure to maintain high growth rates can push the management to do unethical things.
  2. Stay away from IT firms that aggressively chase government orders. This is not a path that leads to a happy ending.
  3. Check the company's board of directors. If the board has many ex-bureaucrats, there better be a good reason.
  4. Never overpay for an IT stock. The industry faces many global risks. That should be reason enough to not buy a high PE IT stock. Buying any stock at reasonable valuations will help protect the downside risk. This is even truer in a sector like IT, where the rear view mirror is so much cleaner than the windshield.
  5. Finally, remember this Warren Buffett quote: 'Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don't have the first, the other two will kill you.'

No matter what happens to Cognizant and its dynamic CEO, be vigilant with your IT stocks. They may not be as safe as you think.


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03:10 Chart of the Day

The manufacturing Purchasing Manager's Index data is out for the month of September. While some of the Asian economies - S. Korea, Myanmar, Malaysia and Thailand suggest contraction in manufacturing with a score below 50, India bags 4th place among the key Asian economies on this metric.

India's Performance in Manufacturing Sector Growth in September


That said, on an absolute basis, India's Manufacturing PMI has slipped on a month on month basis due to softer growth in order book. It now stands at 52.1, down from 52.6 last month when the it touched 13 month high. While a score above 50 implies expansion in manufacturing, a month on month decline suggests loss in momentum.

While expansion in manufacturing bodes well for GDP, there are other parts in the equation that may disappoint. The most crucial will be investment spending aspect that does not offer reasons to cheer, as suggested by slowdown in new business orders.

Another important part of the equation is jobs in the manufacturing sector. While manufacturing remains an important part of growth, thanks to automation and lack of skilled labour, it may not offer jobs to the millions of Indians joining work force every year.

If this trend continues in the years to come, the demographic dividend can easily turn into a demographic nightmare. Irrespective of what the monthly macro-economic data suggests, this could pose a serious threat to the India growth story.

As Vivek Kaul mentions in one of the editions of Vivek Kaul's Diary:

At times it is very difficult to make sense of a country as complicated as India is. What complicates the situation further is the fact that we have very little data going around in many cases. But then there are broader trends, which one can comment on.

One such thing is the demographic dividend or to put it more precisely India's demographic dividend.

He further adds:

As the 12th Five Year Plan (2012-2017) document pointed out: "One hundred and eighty-three million additional income seekers are expected to join the workforce over the next 15 years." This essentially means that a little over 12 million individuals will keep joining the workforce every year, in the years to come. This works out to around one million a month. And at this rate, the Indian workforce is expected to be larger than that of China by 2030.

And this is India's demographic dividend. As these individuals enter the workforce, find work, earn money and spend it, the Indian economy is expected to do well. When economists and politicians talk about an economic growth of close to 10 per cent per year, they are essentially hoping that India's demographic dividend will play out as it is expected.

But the question is how likely is this? How have things with other countries been in the past? Have countries which were expected to benefit from the demographic dividend benefitted from it?

There are no absolute answers, but the warning signs are there for all to see.

03:45

Amid speculations, in its fourth bi-monthly policy, RBI has cut the repo rate by 25 basis points to 6.25%.

Otherwise a regular phenomenon, this time the announcement was different in ways more than one.

First, it was Urjit Patel's maiden announcement as RBI Governor. Second, unlike in the past when the RBI Governor had final say on the rate cut decisions, this time, it was a collective decision. The decision was taken by a committee of 6 members. The committee is equally represented by RBI and the Government and the Governor has a veto power in case of a tie. There wasn't any scope to use that as the rate cut decision was unanimous, facilitated by softening inflation outlook. Further, the RBI has suggested maintaining an accommodative stance.

What does this rate cut imply?

The markets that were trading on a cautious note before the monetary policy announcement have cheered the decision. However, if you expect us to list the top picks post the rate cut, you are in for a disappointment. We don't think the rate cut will have any significant impact on the intrinsic values of the stocks. In fact, we believe it would do one's investing record a world of good if to ignore such news and focus on finding undervalued stocks trading at significant discount to intrinsic values.

04:15

One million children die in India every year due to severe acute malnutrition. What's worse - only 1% of India's malnourished children have access to services that can save them. In Palghar, Maharashtra alone there have been 18,000 child deaths between 2015-16.

Fight Hunger Foundation is setting up an emergency intervention team to detect and treat children who are severely malnourished. Over the coming year, they will work with the government and local groups to screen 5,000 children for signs of severe acute malnutrition. They expect to save the lives of 1,800 children in crisis by providing them with a supply of ready-to-use-therapeutic food.

On behalf of HelpYourNGO, we urge you to celebrate the festive spirit during this Daan Utsav, by donating to end child hunger in India!

04:30

Indian share markets continued to trade in green in the late afternoon session after the Monetary Policy Committee decided to reduce the policy repo rate by 25 basis points from 6.5% to 6.25%. The Committee expects that the strong improvement in sowing, along with supply management measures, will improve the food inflation outlook.

At the closing bell, the BSE Sensex stood higher by 91 points, while the NSE Nifty finished up by 31 points. The S&P BSE Mid Cap & the S&P BSE Small Cap finished up by 0.5% and 0.7% respectively. Gains were largely seen in oil & gas and PSU stocks.

04:50 Today's Investing Mantra

"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll so things differently. - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst).

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4 Responses to "Should You Worry About Your IT Stocks? - The Cognizant Saga"

Jose Mathew

Oct 5, 2016

In India, bribing of baby's by companies to expedite things and to get illegal favour / advantage is very common. If one start totally avoiding these companies for investment there will be no companies left for investment except one Infosys or wipro or one or two Tata companies.

Like 

carl saldanha

Oct 5, 2016

Richa,


Integrity and the paying of bribes is an issue that would affect all companies operating in India or anywhere. It is not restricted to the IT industry. There is no reason for a company like Cognizant which is very profitable and cash rich( like most IT companies) to pay bribes , they can afford to pay a higher cost. This is probably due to a few over enthusiastic local employees. Since Cognizants management sits in the US they are less familiar with local operations.


You should not single out the IT industry. Depending on the extent of this transgression, they will take their medicine and the price will bounce back to where it should be. Some people will give credit to the company for its compliance policy and disclosure.

Like (1)

MURALIDHARAN M

Oct 4, 2016

Indian Companies can get away with lax laws here. US Registered companies will have the issue due to the stricter laws. That is the reason Indian IT and other companies will also sail in the same boat - same officials in India. No one is worried as it is well known.

Like (1)

Yatin Parikh

Oct 4, 2016

Dear Richa,
Regarding your article on Cognizant, we the layman people would like to understand -
1.WHY would cognizant (or any other company) inform the US authorities (for that matter any authority) that it paid bribes ? Is the CEO running for the POPE's position ?
2.WHY do you pinpoint the IT sector and warn us specifically about Indian IT companies ? dont you think all the 5 points you highlighted in your article can apply for most other industry/sectors ?
Please explain and advise your readers.
Thank You

Like (2)
  
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