Why has JP Morgan downgraded the IT stocks and do you see a major impact?

In a sense, the move was expected but it did come as a surprise when JP Morgan downgraded the Indian IT sector to Underweight. It has expressed several concerns like tepid growth and pressure on the operating margins. JPM feels that the glorious days of high growth combined with high operating margins may not sustain in the future. There are several reasons for this argument by JP Morgan and let us look at some these views.

JP Morgan believes that the high revenue growth assumption may come into serious question due to the anticipated slowdown in the US economy. The spike in interest rates is expected to have a perverse impact of slowing down the growth levers of the US economy and consequently impact technology spending by American corporates. On the EBIT margins front, the cost of operations and manpower are likely to be tough to handle. JPM is pegging about 10-20% downside risk in these stocks.

The good news is that the impact is going to be different on different stocks. JPM remains overweight on Infosys, as it still appears to have room for growth. It is also positive on Tech Mahindra among the large caps due to its strong franchise in the 5G telecom space. In the mid-cap IT space, the brokerage house likes Mphasis and Persistent, considering that the business models are more defensive in nature. However, TCS, Wipro and HCL Tech are likely to see the most pressure on growth and margins.

However, a lot of damage has already been done. For example, even though IT looks fundamentally vulnerable, the IT sector has underperformed the Nifty with losses of 27%. This is the worst performance among key sectors. It also highlights that the current valuations may be too rich at this point of time. The reason that JPM offers is nothing new since the Indian IT sector has rediscovered itself time and again despite constraints.

According to JPM, the dichotomy is that Indian IT companies are low-end value creation do giving them steep valuations may be contradictory. For example, Indian IT stocks trade at a premium to digital peers. However, this argument may be a tad lame since the Indian IT sector has not only reinvented itself as a digital force. Also, it must be evaluated based on the importance of the business to global clients and on that there is no doubting IT.

To be fair, there is justification for pressure on IT stocks after the frenetic rally, but these are cash rich companies with stable business models. Despite the headwinds, this is a business that contributes bulk of the operating profits of the Nifty. Considering that the index has already corrected 27% in the current year, the concerns may be overdone and the Indian IT stocks may actually be providing a good time for entry for long term investors.