Mar 16, 2006|
BSE IT: Has it tracked fundamentals?
The flood of 'foreign liquidity' that has driven the Indian stock markets to new highs is showing no signs of slowing down. The psychological '10K' mark was crossed amidst much fanfare and the Sensex is close to the 11,000-mark now! While 'experts' expect the rally to continue, many market participants have also been sounding 'cautious signals' for almost six months now. But the momentum has sustained.
Amidst this broader euphoria, believe it or not, there have been under-performers! Take the case of the software sector. To put things in perspective, we analyse the performance of the BSE IT index and compare the same with the underlying fundamentals i.e. earnings growth of the top five software companies over the past few years. The combined weightage of these companies viz. Infosys, TCS, Wipro, Satyam and HCL Technologies in the BSE IT index is nearly 90% and therefore, is representative of the sector.
Strong fundamental performance...Top 5 software companies: Impressive growth*
As we can see from the table below, the 'Top 5' software companies combined have registered impressive growth in sales, operating profits as well as net profits (FY02 to FY05). While net sales have grown at a compounded annual growth rate (CAGR) of over 30%, operating and net profits have grown at a little under 30% respectively. It should be noted that the performances of the individual companies has differed over the years. While Infosys and TCS have been consistent, Satyam and HCL Technologies have been volatile.
* Companies include TCS, Infosys, Wipro, Satyam and HCL Technologies
||CAGR till FY06E (%)
...but is not reflected in returns!
Given the fact that these five companies have maintained an average bottomline growth of nearly 30%, the index returns (we are referring to the BSE IT here), ideally, should have mirrored fundamentals. But it has not been the case. Index returns on a CAGR basis have trailed bottomline growth by nearly 10% over the past 5 years (FY02 to FY06). If we consider the performance of the BSE IT index from FY02 to FY05, the picture is even worse (CAGR returns less than 15%).
What could this mean? Is it that software stocks are undervalued relative to the market? Will they outperform going forward? In our view, the risk-return matrix of investing in software stocks currently is equally poised.
On a relative basis, assuming a 15% CAGR growth in earnings of the BSE-Sensex companies, the benchmark index is trading at a price to earnings multiple of around 14 times FY08 earnings. As compared to the same, the top five software majors, on an average, are trading at 19 times our estimated FY08 earnings. This is a 28% premium to the benchmark index. Considering the fact that earnings growth of the top three software companies i.e. Infosys, Wipro and TCS is likely to around 25% CAGR in the next three years (66% higher than Sensex earnings growth), we believe that the premium is justified. That said, stock selection is a critical factor to success because competition is global in nature and there are penalties for any delay in project execution. Perhaps this is one of the major risk factors that will differentiate the wheat from the chaff going forward.
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