Will Indian IT continue to outperform? Balancing the evaluation of incremental developments globally versus locally:: JPMorgan,

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 What is Indian IT’s P/E valuation premium today relative to Nifty’s versus
2008? Figures 1-3 show how the valuation premium of Indian IT relative to the
Nifty has moved. There was a time during 2H 2007/early 2008 when
Infosys/TCS were trading to a discount to Nifty on valuations. We believe that
this might have been the combined result of (a) sustained INR appreciation
versus the USD through 07 and early 08 and the gradual development of the
2008 credit crisis and (b) Indian economy then being on a solid footing (FY08
India GDP growth at 9.3%). In 2007, these factors positioned domestic sectors
in the economy far more attractive than Indian IT which resulted in underperformance
of Indian IT versus the broader market.
 Entering 2008, Indian IT was already so attractively placed relative to the Nifty
on valuations that it outperformed during the first 6 months of 2008 (Jan 08 –
Jun 08). Soon after, the tremors of the intensification of the credit crisis started
to be felt culminating in the Lehman crisis in Sep 08. Its aftershocks were felt
for about 6 months after the event till Feb/Mar 09. During this 9-month period
2HCY08-1QCY09 (Jul 08-Mar 09), Indian IT underperformed the broader
Indian market. The important point to note is that while the global environment
was uncertain but not yet reached an acute “state of shock”, Indian IT
outperformed. It was only when the markets sensed that the world was entering
the zone of state of acute shock that Indian IT started underperforming.
 However, given the currently elevated valuation P/E premium of ~ 30-35%
that TCS/Infosys trade to the Nifty (unlike in 2008), it would be surprising
to expect Indian IT to continue to outperform. But this might well still
happen near term as long as policy actions on the domestic front are perceived to
be lackluster and expectation of inflation/interest rates peaking out to reverse
domestic growth moderation does not materialize as intended. In other words,
the question of outperformance or otherwise of Indian IT rests equally on (1)
global growth prospects stabilizing/not worsening and Indian IT’s defensiveness
therein and (2) much greater domestic execution/policy action needed to revive
the declining trend of domestic growth expectations. As our prior notes on the
sector have argued, we believe that Indian IT will likely gain market share in an
accelerated manner with no meaningful detriment to margins beyond FY13.
 Investment view. Bharat Iyer, JPM India strategist, weights Indian IT neutral
in his market portfolio. He believes current valuation premium of Tier-1 Indian
IT stocks of 30-35% adequately captures some oft-cited advantages in favor of
Tier-1 Indian IT stocks (strong cash-flow generating capacity, defensiveness of
cash flows in difficult environment, attractive ROEs, superior balance sheets,
quality management). These advantages, in his view, have to be balanced
against global risks. Bharat relatively overweights TCS (OW) and HCLT (OW)
in the portfolio with TCS with maximum overweight vs. benchmark (MSCI);
INFY (UW). We believe the current rally in INFY (N) taking the stock
towards/beyond our Mar-12 PT of Rs2,700 presents an opportunity to book
profits. We expect a replay of what happened this time last year, when
INFY rallied ahead of 2QFY11 results and subsequently fell.