I recently made a discovery – The higher the market goes, the more I get a lot of intellectual thoughts. This is exactly reverse of a lot other people who seem to be finding a lot of good ideas to invest in the market. Well I guess I may have to work a bit harder to find something good …sheesh why isn’t it easy to make money in the market 🙂 ?

All IT stocks overvalued?
I was not precise enough in my previous post. I think some of the large cap IT stocks are fairly valued, if not overvalued and hence there is no margin of safety. That is they are priced for perfection.

The same may not be true for several midcaps, though I think one cannot make a general statement. As I have written in the past, general statement such as ‘market is overvalued or undervalued’ are meaningless and the same holds true for IT stocks too. So let me be more precise – companies like Infosys, Wipro and TCS seem fairly valued.

In case of Mid –cap IT companies like NIIT tech, patni or hexaware it is not as clear, atleast to me.

I typically value stocks using 3 different approaches at the same time. The first approach is the discounted cash flow – try to estimate the future cash flow (or earnings) and then discount them to arrive at a net present value. The second approach is to look at past valuations of the company and compare with the current valuation. The third approach is to look at the relative valuation of the company with others in the same sector.

I try to evaluate a stock on all the three approaches and see if they are pointing in the same direction. A stock may appear undervalued in terms of the DCF value and with reference to other companies in the sector, but appear fairly valued compared with its past valuations.

Now such a situation, which is currently present in case of Mid-cap IT and some cement companies, definitely throws up a key question for me – Why should the market value the mid-cap IT companies at a higher level in the future than it has done in the past ?

A typical case where the market values a company at a higher levels than in the past is when the growth or return on capital of the company has increased and the market now thinks that the company has a much better future and prices it accordingly.

In case of mid-cap IT companies and various other mid-caps, I am grappling with the same question – what is it that I know which the market has not considered, that would cause it to value it more in the future. In some cases it is easy to figure that out, but I am not able to figure it out in case of IT companies.

Hence my statement – Some IT-midcaps may be undervalued depending on your point of view. My point of view is that i can’t think of any unrecognized factors which may cause the market to re-price these companies upwards.

On the contrary I can only think of negative factors, several of which are not yet priced into these stocks. You may have a better insight on factors which may cause the market to value these companies higher and so both us are correct from our respective points of view.

The problem with stock tips
Moving on the next general thought – stock tips. Regular readers to this blog know that I am totally against stock tips. Other than the reason that I think that most of the stock tips are given by the unethical to the unsuspecting, I also believe that such tips do not help in the long run.

It is easy to take stock tips and follow them in a bull market. Even a dart throwing monkey can come up with some profitable ideas (unfortunately I am not as smart as this monkey during bull runs :)) and it would not difficult to follow them. How many of us will have the courage to hold on to such stock tips when the market drops or add to such positions? I cannot speak for others, but I definitely cannot blindly follow others when the market is in a free fall.

The only way one can follow stock tips or such a person is to understand that person’s underlying approach and then have some amount of blind faith on the skills of such a person. So the next time you decide to follow someone else stock picks, remember that you are putting some amount of blind faith in that person, which will be tested when the market drops (which it will sooner or later).

How to get decent return these days?
One of the readers asked me a question on the previous post – how do I make decent return these days when a lot of stocks appear overvalued and fixed income options don’t give much returns?

I don’t have an easy answer – if I had one, don’t you think I would be using it?

The first option is to keep analyzing stocks everyday (as I am doing) and hope that you may hit a few good ideas in due course of time. If you can find a few such ideas, you will have to have the courage to buy such stocks, knowing fully well that such stocks could drop if the market were to drop suddenly.

The other option is to do nothing and sit tight. This option is not easy too as you will have to watch your friends make easy money while you sit like a dumb dodo, doing nothing.

Either of the options are not easy – in one you face the risk of losing money (atleast in the short term) if the market drops and in the other you are foregoing easy money. You have to choose your poison.

It’s not that I have always been a bear on IT companies. I have held NIIT tech, Patni computers and Infosys are various times over the last 5-6 years.

You can see my analysis of NIIT tech here and patni here.

The main reason for my bearishness is simply ‘valuations’. Mid cap companies like NIIT tech or patni and maybe a few others could be slightly undervalued (depending on your point of view), but I find it difficult to see the undervaluation in large caps such as Infosys which are selling over 30 times their current earnings.

A lot of the IT companies are priced for perfection which as we have seen never happens in reality. In the alternative universe of brokers and tipsters, the time to buy IT stocks was in 2000 and now and to sell was in 2008. We do not know how things will turn out in the future, but can clearly say from hindsight that 2000 was the time to sell and 2008 was a decent time to buy.

The advantage (or disadvantage) of having a blog for more than 5+ years is that all your past thoughts and statements are online and can be referred back at any time. In 2008, I felt that IT stocks, especially midcaps were extremely undervalued (some selling for PE of 2 or 3) and hence were a bargain. It was not a macro point of view, but based purely in valuations (you can read the post on it here)

Getting the timing wrong
My decision to start buying into some of the IT midcaps was based on valuations and a belief that the underlying economics of the IT service space was still attractive and the companies would continue to be profitable in the long run.

I had no clue that 2008 and 2009 would be such a disaster ( if I knew, I would have bought put options and retired by now 🙂 ). So clearly, in hindsight the best time to buy was 2009.

However one cannot make investment decision based on hindsight and so mere mortal like me (unlike some of the forecasting gurus ) have to base their decision on current valuations and expectations of reasonable business conditions in the future.

Still no idea of the future
As I have still do not have any special powers of knowing the future, my current view on IT stocks is centered on valuations and some of the long term headwinds faced by the industry such as
– Dollar depreciation : when and by how much …who knows, but more than likely to happen
– Increased costs : If you are an employed with an IT company, a point to remember is that everytime you get a good raise in salary, it comes from the bottom line (no there is no santaclaus paying for your salary)
– Intense competition: From other IT companies which is likely to drive down returns in the long run
– Host of other factors: regulation, slow growth in developed markets etc etc

The point is that the current valuations do not reflect these risks. Ofcourse you can make a point that current valuations for a lot of companies do not reflect the risk – but that is whole different story.

So what to do ?
Nothing much – sell if you think the stocks are overvalued and yes, be prepared to look like a fool if the stocks keep zooming up after you have sold. I have done that for most of my IT stocks and I am fully ready to look like a complete fool.