Infosys Technologies: Buy

Recommendation:Buy

Suresh Krishnamurthy

``Valuation is both an art and a science.

Why was Infosys considered a buy at Rs 13,000 and within a few months there were no takers for it at Rs 5,500 levels. There is no rational logic to it. The way we see it depends on the fund. A momentum scheme up to a certain part of its corpus would still go for a bet. While a fund... driven by valuation issues, it will not do that. Therefore, it entirely depends on the fund.''

Mr S. V. Prasad, President, Zurich India Asset Management Company in July 2000.

WITH year 2000 drawing to a close and with one of the premier technology stocks -- Infosys Technologies -- trading at close to its year-low, questions that were asked in May and June this year have come back to haunt the retail investor.

Once again, the obvious answer, to an extent, is there is no rational logic to it. And what is more, a momentum investor would not be really bothered about the price; his investment criterion would be different. An investor concerned about valuation issues, on the other hand, would probably buy it at close to its year-lows, on the assumption that the precipitous fall in stock price was not occasioned by any change in the fundamental factors.

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However, for a shareholder, this kind of rationalisation hardly offers any help and he is probably interested in knowing only whether to hold the stock or exit. Perhaps, there is no one with a clue as to what should be the right price to invest in the case of a technology stock such as Infosys. Yet, one can highlight a few factors that form the background for the stock price of Infosys right now.

Uncertainty wreaking havoc

Investments in technology stocks are indeed more risky than in a market index. In fact, this is reflected in quantitative measures of risk calculated for most technology stocks. For Infosys, the measure indicates that the risk factor is more than the market average. The higher risk measure indicates the potential for a larger loss in value compared to a market index.

The recent price movements, however, do not wholly appear to be a manifestation of the higher risk involved in investing in Infosys Technologies. These movements appear to be shaped more by the factor of uncertainty. What uncertainty does is that, it puts a question mark over the ``returns estimated'' from an investment in the company. A logical end-result of such a development is a higher degree of instability to the stock prices than the norm.

Growth stocks valuation

The other side of the equation is the risk factor. Take the trigger for the recent meltdown in valuation of Infosys -- reports that suggest that Indian software service companies may be hit by the slowdown in the US technology spending. The wisdom until now is that the revenue growth of Indian companies are not cyclical in nature and that they are growth stocks. If the slowdown in US spending affects revenue growth, it will introduce an element of cyclicality in the revenue growth of the software service companies.

Such an element of cyclicality would put a question mark over the ``estimated risk'' involved in an investment in a stock such as Infosys. If the estimated risk increases, the ruling stock price has to come down to provide a higher return for an investment. In the case of stock markets, this spectre of uncertainty over an assumed factor such as risk or return would cause a notable decline in the stock price.

Valuations caught in a bind

In fact, the relatively higher valuations commanded by Infosys reflects the larger degree of uncertainty inherent in investing in stocks of Indian software service exporters. Among all such stocks, an investment in frontline stocks -- such as Infosys, Wipro and HCL Technologies -- has been perceived by the markets to have the least degree of uncertainty.

Since March 2000 this year, this uncertainty factor has reared its head a few times, backed by a reasonable basis. Listed Indian middle- and small-sized firms were and are finding the challenge of moving up the value chain tougher than it was anticipated earlier. In addition, by March 2000, the valuations of most Indian technology stocks were at a peak. The combination of such factors has led to a flight of investment flows into quality stocks such as Infosys, where uncertainties are lower.

The flight of money ensured that while the valuations of middle- and small-sized firms plummeted, those of Infosys and Wipro continued to trade at a substantial premium. This is similar to what happens in a bear market, where defensive large cap stocks may even appreciate or experience a relatively tempered fall in stock price vis-a-vis other stocks.

There is another side to remaining invested in defensive stocks. Since the valuations are already rich in a bear market, further appreciation in stock price when the bull market arrives is likely to be limited on a relative basis. In the case of technology stocks, after the precipitous fall in stock price since March, the expected bull market has failed to arrive.

A bull market can begin only if the middle- and small-sized firms, among Indian software service exporters, are able to report growth in earnings which are at least in line with that recorded by leaders. However, the expectations in the medium-term are for the middle- and small-sized firms to continue to lag behind the growth rates expected from the majors.

This has ensured that the valuations of the frontline stocks are caught in a bind. There is not much scope for a further rise in price since the valuations are already pretty high. And since middle- and small-sized firms are continuing to languish, a decline in frontline stocks is inevitable so that their proportion of the markets or portfolios do not rise to unprecedented levels.

If one takes the portfolios of mutual funds, irrespective of whether it is a diversified or a tech sector fund, Infosys is mostly at the top and that too invariably with a weightage of around 10 per cent. The holdings in offshore funds of much larger size are not known and this is also likely to mirror the weightage in domestic funds, since some of them are managed by the same asset management companies. For the concentration not to increase beyond a point, funds would have no option but to sell, dragging down the price in the process.

Another view

When the returns of a market index are taken for a longer-term of 10 years or so, a bulk of the returns is accounted for by price movements in two or three years. The rest of the time, markets meander in an attempt to regress to the average. In other words, in the other seven to eight years, markets go up and down but never cross significantly past the highs established in the two to three years of bull run.

Since market indices are nothing but a composition of several stocks, it is reasonable to expect a similar behaviour from stocks that form part of the index. In such a context, it is possible to take the view that a bulk of the long-term returns in the case of Infosys Technologies have already been achieved during the year 1999 and early 2000. If that be the case, then the stock price of Infosys is unlikely to get past those price levels in the medium-term and is likely to remain range-bound. Overall, the combination of all three factors -- uncertainties over expected returns and estimated risks and Infosys already having a delivered a substantial portion of its long-term returns -- may be behind the recent stock price movements. This uncertainty at this point in time appears a little overplayed, although the impact of the slowdown is an unknown factor, as of now. And, if it is a case of mean regression, then the critical factor is the revenue growth rates of Infosys. If Infosys continues to notch above-normal growth rates even over a longer-term, then in the year in which such estimates fructify, there will be a substantial price increase.

Today and tomorrow

Infosys Technologies shareholders also need to consider one more factor -- the rapid changes in the stock price of Infosys. This ensures that what is true when the stock price was much above Rs 7,000 does not hold good when the price is at Rs 5,500. So, at Rs 5,500, there is a significant upside to the stock price over the medium-term, even if an element of cyclicality is introduced into the revenue streams of the company. In short, at the present stock price of Rs 5,600, the stock of Infosys Technologies is a first-rate buy among technology stocks.

The potential for upside will recede when the stock price bounces back to more than Rs 7,500. Still, at that price, Infosys will even then be the stock with the least degree of uncertainty, as things stand today. As such, it will continue to attract buying interest ensuring liquidity in the counter. Until this fundamental assumption of Infosys being the stock with relatively lower uncertainty remains unchanged, this would be the safest direct investment candidate on a relative scale for investors in the technology sphere.

Pic.: Mr Nandan Nilekani, Managing Director, Infosys... refuses to comment on the impact of the US slowdown in technology spending.