IT sector funds are down but not out. Is it a time to invest in them?

The information technology (IT) sector has turned out to be one of the worst affected by the recent volatility in the stock market. In CY2022, technology sector funds as a category have lost 24.7 percent, compared to a 5.86 percent loss reported by flexicap funds, as per Value Research. The sector was the darling of many investors last year. Does the recent fall call for a look at these funds?

Valuations matter

The IT sector houses some of the best names in corporate India. Many of these companies have good balance sheets and healthy earnings growth. They are seen as cash-generating machines. However, valuations surged dramatically when investors the world over started chasing tech stocks in the aftermath of the COVID-19 pandemic. Work from home meant that software and hardware technology that enabled remote access and communication from anywhere at any time were in high demand, as were companies that enabled this. The Nifty IT Index quoted at a price to earnings multiple at 39.58 times on January 4, 2022.

Indian IT stocks were riding on the global positive sentiment. But things changed earlier in 2022.

Some of the companies in this sector that were listed overseas, especially in the new-age tech segment, were not profitable. And when interest rates started to rise, these stocks were dumped by investors. The rub-off effect spread across highly valued tech stocks both overseas and at home. The Nifty IT Index now quotes at 27,418 from a high of 39,370 registered on January 4, 2022. The price to earnings multiple now quotes at 24.88 times.

Earnings to stay strong

The fears of a possible recession in the US—the biggest export market for Indian tech companies—on the back of sustained interest rate hikes by the US Federal Reserve may adversely affect the valuations these tech firms enjoy. While traders and speculators may be looking to capitalise on the next move, investors however are taking a more long-term view.

Meeta Shetty, fund manager, Tata Mutual Fund says, “The valuations for the sector are at reasonable levels now compared to the peak we saw at the beginning of the calendar year. IT spending, too, continues to remain strong globally, which is visible in cloud providers’ growth. The growth in cloud services is likely to continue at this accelerated pace for the next few years.”

Indian IT players play a significant role in cloud migration and have gained market share from global IT services companies. Themes like autonomous vehicles, automation in manufacturing, customer experience, mobility, artificial intelligence, etc., are the other core areas that continue to drive growth in digital revenues of Indian IT companies, she adds.

Though the earnings growth is expected to remain strong, the ride may be bumpy. “Overall, the valuations still factor in more optimism than they ought to. The drivers of earnings will be sales growth, order gains, margins, attrition and payout. Each factor has to contribute favourably,” says Shyam Sekhar, chief ideator, ithought Advisory. If the US economy slows too much, it remains to be seen how tech spends get recalibrated, he adds.

Investors should not ignore the risk the sector faces. “The key sector-specific risk would either be a slowdown in IT spends and/or a significant adverse currency movement. But technology is core to every company today and even if there is a slowdown in the interim, we expect it to be more transient in nature. Therefore, the outlook for the sector from a medium to long term remains positive,” says Shetty.

How are MF positioned?

Indian investors gain exposure to technology stocks when they invest in diversified equity funds. For example, flexicap funds as a category had allocated 11 percent of their corpus to technology stocks as on June 30, 2022 compared to 13 percent a year ago, according to ACE MF data.

Though the numbers have not changed much, value investors have begun to hunt for bargains. For example, ICICI Prudential Passive Strategy Fund of Fund, managed by Sankaran Naren and Dharmesh Kakkad, invests in units of domestic exchange-traded funds (ETFs). The fund has ICICI Prudential Nifty IT ETF as its top holding with 22.92 percent as on June 30, 2022. The scheme had no exposure to IT ETFs on January 31, 2022.

Increased allocation to IT ETFs speaks volumes about the relative attractiveness of the sector. ICICI Prudential Thematic Advantage Fund of Fund also saw exposure to ICICI Prudential Technology Fund growing to 18.46 percent from 3.82 percent over the same period.

What should you do?

You have three key investment avenues if you are keen to allocate more to the IT sector. You can buy ETFs tracking the Nifty IT Index offered by Axis, Aditya Birla SunLife, ICICI Prudential, Kotak, Nippon and SBI mutual funds. This option works for all those who do not want to take fund manager risk.

You can also invest in actively managed sector funds offered by Aditya Birla SunLife, ICICI Prudential, Tata and SBI mutual funds. These allocate some money to stocks listed overseas. The third option is an actively managed fund of fund schemes and ETFs that invest in stocks listed overseas.

Choose your investments depending on your financial goals and risk profile. Deepak Chhabria, founder and managing director of Axiom Financial Services, says, “Investors must take into account their existing allocation to technology sector through diversified equity funds before allocating incremental money to tech sector through sectoral funds. Only those investors with a conviction view on the tech sector should consider investments in this sectoral theme through actively managed schemes focusing on Indian tech stocks and also actively managed schemes investing on tech stocks listed overseas.”

When you are allocating money to a sector fund including those buying technology stocks, you should be careful of the elevated risk you are taking. You have to get both entry and exit right in these bets. Though the prices are down, do not chase the theme just because it did well in 2021.

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