The information technology (IT) sector has proven to be one of the hardest hit by recent stock market volatility. In fiscal 2022, technology sector funds as a category lost 24.7%, compared to a 5.86% loss reported by Flexicap funds, according to Value Research. The sector has been the favorite of many investors over the past year. Does the recent fall call for a look at these funds?
The IT sector is home to some of the best names in Indian business. Many of these companies have strong balance sheets and healthy earnings growth. They are considered cash-generating machines. However, valuations rose sharply as investors around the world began to seek out tech stocks amid the COVID-19 pandemic. Working from home meant that the software and hardware technologies that enabled remote access and communication from anywhere at any time were in high demand, as were the companies that made it possible. The Nifty IT Index will trade on January 4, 2022 at a price-earnings multiple of 39.58.
Indian TI shares benefited from positive global sentiment. But things changed in early 2022.
Some of the foreign-listed companies in this sector, particularly in the New Age Technologies segment, were not profitable. And when interest rates started to rise, investors sold these stocks. The friction effect has spread to highly regarded technology stocks both abroad and at home. The Nifty IT Index is now trading at 27,418 from a high of 39,370 on Jan 4, 2022. The P/E ratio is now 24.88 times.
Income to stay strong
Fears of a possible recession in the United States, the largest export market for Indian tech companies, following continued interest rate hikes by the US Federal Reserve, could weigh on valuations of these companies’ technology. However, as traders and speculators look to profit from the next move, investors are taking a longer-term view.
Sector valuations are now at reasonable levels compared to the peak at the start of the calendar year. IT spending also remains strong around the world, as evidenced by the growth of cloud providers. The growth of cloud services is expected to continue at this rapid pace for years to come.
Indian IT players are playing a major role in cloud migration and have gained market share from global IT services companies. Topics such as autonomous vehicles, automation in manufacturing, customer experience, mobility, artificial intelligence, etc. are other key areas that continue to drive digital revenue growth for Indian IT companies.
Although strong earnings growth is expected, the ride could be bumpy. “Overall, valuations are still more bullish than they should be. Earnings drivers will be revenue growth, order intake, margins, attrition and payments. If the US economy slows down too much, it remains to be seen how technology spending will be recalibrated.”
Investors should not ignore the risk facing the sector. “The key industry-specific risk would be a slowdown in IT spending and/or a large negative currency move. But technology is at the heart of every business today, and while there is a recession in the meantime, we hope it will be more temporary. Therefore, the outlook for the industry remains positive in the medium and long term.
How is MF positioned?
Indian investors can access technology stocks by investing in diversified equity funds. For example, as of June 30, 2022, flexicap funds as a category had invested 11% of their corpus in technology stocks, up from 13% a year ago, according to ACE MF data.
Although the numbers haven’t changed much, value investors have started looking for bargains. For example, the ICICI Prudential Passive Strategy Fund of Fund managed by Sankaran Naren and Dharmesh Kakkad invests in shares of domestic Exchange Traded Funds (ETFs). The fund has ICICI Prudential Nifty IT ETF as its main holding at 22.92% as of June 30, 2022. The program had no exposure to IT ETFs as of January 31, 2022.
The higher allocation to IT ETFs speaks volumes about the relative attractiveness of the sector. ICICI Prudential Thematic Advantage Fund of Funds exposure to ICICI Prudential Technology Fund also increased from 3.82% to 18.46% over the same period.
What should you do?
You have three main investment avenues if you want to invest more in the IT sector. You can buy ETFs that track the Nifty IT Index offered by Axis Mutual Funds, Aditya Birla SunLife, ICICI Prudential, Kotak, Nippon and SBI. This option is suitable for those who do not want to take risks as fund managers.
You can also invest in actively managed sector funds offered by Aditya Birla SunLife, ICICI Prudential, Tata and SBI Mutual Funds. These allocate money to shares listed abroad. The third option is actively managed funds of funds and ETFs that invest in foreign-listed stocks.
Choose your investments based on your financial goals and risk profile. Investors should review their current allocation to technology through diversified equity funds before allocating additional funds to technology through sector funds. Only investors with a strong view of the tech sector should consider investing in this sector theme through actively managed programs focused on Indian tech stocks and also actively managed programs investing in overseas listed tech stocks.
When allocating money to any industry fund, including those that buy technology stocks, you need to be aware of the high level of risk you are taking. You must enter and exit these bets directly. Even though prices have dropped, don’t continue to struggle just because you did well in 2021.