Mid-cap IT stocks: the safe haven that is beginning to look unsafe

Mid-sized IT services companies have never received so much love from investors. While they have enjoyed a preference over large-sized IT stocks for some time now, the recent correction in the markets has created a new fan following—those seeking a safe haven.

An index of nine mid-cap IT companies weighted by market capitalization has risen nearly 10% since the markets started correcting in end January. Stocks of large IT companies, the traditional safe haven, fell 3% and have indeed done better than the broad market, which has fallen around 10%.

But mid-cap IT stocks have really stood out, and things are getting a bit awkward on the valuation front. Companies such as Larsen & Toubro Infotech Ltd, Mphasis Ltd and Mindtree Ltd are trading between 19.6 and 22.4 times one-year forward earnings, based on estimates of Kotak Institutional Equities. In comparison, top-tier companies such as Tata Consultancy Services Ltd and Infosys are trading at 20.8 times and 16.4 times earnings respectively.

According to an analyst at a domestic institutional brokerage, investors are rewarding companies that have been able to articulate as well as demonstrate confidence about growth, something that’s lacking among large-sized IT companies. Each of the above-mentioned mid-sized companies is expected to grow revenues at double the industry growth rate in the coming year. What’s more, since smaller companies were at a relatively low base with respect to margins, investors expect earnings growth to remain high as well.

Kotak’s analysts attributed the following factors to the higher growth at mid-sized companies, “a) The deals that have ramped up over the last few quarters are in the US$20-50 million range, small for tier 1 companies but large enough to make a difference for mid-tier companies; b) the advantage of a lesser drag of legacy portfolios; c) benefit from disaggregation of deals to smaller sizes; and d) the fact that the traditional disadvantage which these companies suffered on attracting managerial and engineering talent does not hold true anymore, thanks to a revamp in their management.”

While it is true that mid-sized IT companies are growing at a faster pace and also that this is worth getting excited about in a growth-starved industry, the fact remains that investors have gotten ahead of themselves valuing some of these stocks. Mphasis and Hexaware shares, for instance, trade 20-30% higher than the target price set by Kotak’s analysts and their valuations of around 19-20 times forward earnings defies the single-digit growth in earnings estimated for the next two years.

And even with the companies that are doing better and where earnings are estimated to grow in double-digits, valuations of over 20 times forward earnings assume earnings growth to remain strong for some years to come. In the backdrop of high valuations, it’s a bit odd that some of these stocks are being viewed as safe havens in a risk-off environment.livemint

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