“Unfortunately, however, stocks can’t outperform businesses indefinitely.”
That was the sound investment advice from Warren Buffett in his annual shareholder letter nearly four decades back in 1986. This investment logic has largely held firm across decades and market cycles, although it does get tested pretty often. The rally in IT services stocks over the last year is one such example and the results from Accenture on Thursday are a wake-up call for investors riding this rally wherein stock prices and fundamentals have got decoupled.
In our bl.portfolio edition dated January 15, 2024 (IT stocks rally may be on wobbly legs), we had explained risks to their elevated valuations. The rally, which had been in play for nearly a year, gained further steam post Q3 results of IT majors in early January. The confounding thing, though, was that there was hardly anything positive fundamentally in those results that warranted that rerating. Modestly better than expected margins and lower attrition, both of which actually play out during IT downturns as managements cut costs and employees are more careful in shifting jobs, was in some twisted way deemed to be a sign of improving underlying fundamentals or at least that’s what the rallying share prices indicated.
We had highlighted why this was misleading and that one of the key indicators of underlying fundamentals was headcount trend. Q3 results of major IT companies indicated decreasing headcount. The decoupling that was worth taking note of then was that while Y-o-Y change in headcount was at its lowest ebb in last 15-16 years, the valuation levels were close to historical highs.
Something has to give!
While the stock of Accenture declined nearly 10 per cent on Thursday in what was its worst single-day performance in recent years, the top 5 Indian IT stocks too corrected on Friday, but by a lesser extent in the range of 1.5 to 3 per cent. Deeper cuts at the start of the day were followed by some recovery in the second half.
Will these valuations hold? Appears unlikely. Accenture management’s commentary in the post earning conference call appears to indicate that sluggishness in the IT services space may last well through the whole of 2024, implying FY25 may not be the year in which Indian IT companies’ business rebounds. The negative revision in Accenture’s FY24 revenue guidance, from 3-5 per cent given in December 2023 to 1-3 per cent now, reflects increased clarity that the management got from January onwards on clients’ 2024 IT spending budgets. Accenture CEO event notes how a banker remarked that ‘corporates have put themselves on a diet, given the macro (uncertainty)’.
Amidst such uncertainty, one question that investors need to mull on is what explains the valuation premium that they are awarding to IT companies today as compared to pre-Covid valuations? Is growth accelerating? No. Is AI going to boost their growth rate in the long term? Plausible, but there is no evidence of that for now. It would be worth noting that technological waves have played out in the last few decades, including the digital/cloud revolution in the last 10 years, but the growth in last 10 years was, in fact, lower than the previous 10 years for major IT companies. As investors answer these questions, IT stocks will settle down at their fundamental valuation levels.