Markets are irrational. There have been umpteen times in the past where this has been proved and will continue to be proved till eternity. One of the most telling examples of this is 'Black Monday', May 17, 2004, a day which will definitely not be remembered with any degree of fondness by investors. On that day, the BSE Sensex fell by as much as 565 points, driven by (largely exaggerated) fears that with the UPA government in power, backed by the 'Left parties' from outside with their 'socialist agenda', reforms might take a 'back-seat'.
That day has taken its toll, with Securities and Exchange Board of India (SEBI) recently banning a prominent securities house from the market for a year for alleged involvement in manipulating certain scrips. However, since then, the UPA government has shown that there was absolutely no need to panic, as reforms have not shown any real signs of slackening (from their earlier mundane pace), major macro-economic indicators, such as inflation and GDP growth rates are healthy, corporate profits have shown strong growth despite input pressures due to rising commodity prices and the markets themselves have given a thumbs-up to the new government, rising quite substantially from the lows of 'Black Monday'.
The lesson to be learnt is that markets are irrational only in the short term. Factors like sentiment and liquidity will impact stock price movement in the short term, but over the longer term, fundamentals take over. Markets will thus, price stocks based on their fundamental strengths, growth prospects of the sector, the company's ability to exploit these prospects, management quality and consistency in maintaining growth. This is especially true of stocks in the software industry. This industry has grown at a fast clip over the years and has been the 'poster-boy' of the strong growth story of the Indian services sector over the years.
The way markets reacted after Infosys announced a 'conservative guidance' for FY06 and TCS announced below-par results for 4QFY05 was a small sign of irrationality. The way the stock prices of these two companies were hammered, one got the feeling that they would actually be wiped out in the near future! It was as though markets were re-rating the entire software sector. Any layperson would be forgiven for being completely baffled by the market behaviour on those days with regards to these stocks.
We attempt to give a macro picture of the software industry's prospects for FY06 as well as possible threats faced by it in the medium term.
Offshoring momentum to continue: Through our interactions with managements of companies like i-flex, Wipro and Satyam, as well as what other managements have been saying in post-results conference calls, the common refrain among all of them is that the momentum will continue as far as the offshoring story is concerned, though the pace might not be the same as in the previous year. Despite objections to outsourcing in various quarters in the US and a number of bills prohibiting outsourcing pending discussion, we believe that ultimately, economics will prevail over politics. Companies that hope to stay competitive have no option but to outsource non-core functions, as the cost advantages and service quality offered by top-tier Indian vendors make for a compelling proposition.
Increasing scalability: All the major software vendors Infosys, Wipro, TCS, Satyam and HCL Technologies have reported a decent increase in their client bases, particularly clients in the million dollar brackets. Infact, companies like Infosys have also had major clients worth over US$ 50 m in revenues for the first time in FY05. This shows the scalability of these vendors in being able to win and execute deals of a significantly large size and gives credence to the belief that the day when they will start to win US$ 100 m deals is not far away.
Clients' approach to outsourcing: Clients have started viewing offshore outsourcing as a strategic tool to remain competitive in their industries. Earlier, only technology personnel used to be responsible for taking decisions on this front. However, given recent attention to the outsourcing issue and how it can work for companies, clients have started giving it increasing importance, deploying not just technology but also finance personnel as well as the CIO and CEO to take such decisions. The major factor is that they have started viewing outsourcing as a strategic tool that can be aligned with their company's long-term objectives and can help to achieve them. Top-tier vendors with good managements and a strong track record of execution will continue to benefit the most from this shift of mind-set.
Political rhetoric: In the medium term, the outcry in the US against outsourcing is likely to impact revenues of software companies. The risk remains, but as mentioned above, we believe that this will be only temporary. Investors must understand that when they invest in any stock, they should do so with a long-term view of the company's business and they must be willing to ride the crests and troughs of the business. If the management has faith in the long-term sustainability of the business, the results will ultimately show.
Slip in profitability: Software is a people-intensive industry. Given the current imbalance between demand for and supply of skilled technical and managerial personnel and competition between Indian and MNC software companies for scarce talent, manpower costs could go up as a percentage of revenues, thus putting pressure on the margins of these companies.
Competition from other destinations: Given the fact that, slowly but surely, India's cost advantage is reducing, given relatively higher infrastructure and power costs in the country, as well as higher employee costs and wage inflation, there is a possibility of global corporations shifting their business to other low-cost destinations like the Philippines and Eastern Europe.
All said and done, we maintain our view that the software industry will continue to show strong growth in the medium term, given a strong macro-economic environment and country and company-specific factors, such as low cost, high skills, global delivery, strong execution skills and so on. As can be seen from the graph, over the longer term, the IT sector has shown strong returns, while in the short term, the performance has been a lot more volatile. Since the markets hammered Infosys and TCS in mid-April, these stocks have soared. Infosys has, from a low of Rs 1,887, crossed the Rs 2,200-mark, giving returns of nearly 20%! TCS, on the other hand, has, from a low of Rs 1,113, crossed Rs 1,300, giving similar returns. Investors who took advantage of the market irrationality on that day and accumulated these stocks must be laughing all the way to the bank! It is almost as if in a matter of just one month, markets suddenly decided that prospects for these companies and by extension, the software sector, were not so bad after all!
Therefore, the lesson that investors can learn from this is that one can take advantage of such market irrationality to reduce the average cost price, in the knowledge that, in the long-term, the stock price will eventually revolve around fundamentals. The view must be to maximize long-term returns on the stock. As long as one understands the business of the company, its long-term prospects and strong fundamentals, the risk-reward ratio remains favourable to the investor.