For a while, it seemed that mine was the lone voice questioning the increasingly heady valuations assigned to shares of Indian IT outsourcers. Recently, however, a heavy hitter joined the chorus.
Earlier in the month, Barron's wrote of Infosys (NYSE: INFY), Wipro (NYSE: WIT), and Tata Consultancy: "Valuations of the stocks far exceed the companies' growth rates, and include a premium to the Indian market, which itself carries a historically high price/earnings ratio of 25 -- even though India is expected to tighten credit."
Barron's proceeded to note the potential for margin erosion from ongoing wage inflation -- a point I raised at the start of the year -- along with the threat posed by such global players as Accenture (NYSE: ACN) and IBM (NYSE: IBM).
On the latter point, a survey cited by Barron's revealed that IT decisionmakers more or less prefer these larger, integrated companies, which offer one-stop shopping for consulting and application development services.
Current valuations, however, arguably ignore such risks. Just take a look at the table below.
|
Company |
P/E (TTM) |
5-Year Average P/E |
2011 P/E |
2011 PEG Ratio |
|---|---|---|---|---|
|
Infosys |
27.0 |
30.1 |
22.4 * |
3.1 * |
|
Wipro |
39.3 |
31.0 |
31.1 * |
3.5 * |
|
Tata Consultancy |
25.8 |
N/A |
21.0 * |
1.5 * |
|
Cognizant Technology Solutions (Nasdaq: CTSH) |
29.1 |
32.4 |
22.5 |
1.9 |
|
Accenture |
17.9 |
16.9 |
14.1 * |
1.22 * |
|
IBM |
12.8 |
14.0 |
10.6 |
1.2 |
|
Hewlett-Packard (NYSE: HPQ) |
16.0 |
19.6 |
10.8 * |
1.0 * |
Data from Capital IQ (a division of Standard & Poor's), Reuters.com, and Forbes.com on March 22.
PEG ratio is for 2011 growth only.
TTM = trailing 12 months.
*Company's fiscal year differs from calendar year.
There are several relevant points to take from the above data. Foremost, compared to the global players, Indian companies are clearly trading at a huge premium to expected 2011 growth. Normally, wide price-to-growth premiums can be linked to the potential for upside surprise, greater historical earnings consistency, and above-industry growth in general.
While I'll certainly grant that the Indian names have posted earnings-per-share growth beyond that of their larger competitors in recent years, such outperformance may well narrow. Consider, for instance, that 2011 -- and even 2012 -- estimates see Infosys, Wipro, and Cognizant all growing well below their three- and five-year averages.
Sure, except Wipro, forward P/Es are below each companies' respective five-year average multiple. But on a 2011 basis, investors are still paying up to 3.5 times earnings growth that is forecast to grossly undershoot the torrid EPS expansion of the mid-aughts.
And as for earnings consistency and upside surprise, I'd say the global companies have a far better shot at outperforming. The reasoning here is simple -- company scale and sober stock valuations.
Yet not everything about the data at hand fails to reflect good sense. Cognizant Technology Solutions, which is based in the U.S. but counts the Asia-Pacific region as home to the majority of its workforce, may in fact be trading close to fair value. The company posted EPS growth of 23.6% in 2009, and its 2012 P/E is in line with expected growth.
Furthermore, I believe the market has made the right call in relegating Hewlett-Packard to the PEG basement, given the company's direct consumer exposure.
Ultimately, the Indian IT industry isn't the only area of the market vulnerable to a revision in investor expectations. My colleague Robert Steyer recently described the don't-look, just-jump approach that investors have eagerly applied to such casino stocks as Las Vegas Sands (NYSE: LVS).
But instead of getting caught up in market momentum, Foolish investors should instead sit back and make a wish list. On a broad pullback in the Indian IT group, investors may find Wipro to be the best buy of the bunch.
