After last week’s 20% dive in the FTSE 100, one would be forgiven for thinking the sky has fallen in. But it hasn’t. Even in the darkest moments for stockmarkets, there are opportunities for canny investors – especially for those who focus on quality firms with cash and strong competitive positions.
Tip of the week:Infosys ADRs (NASDAQ:INFY), rated a BUY by Bank of America
Right now, there are numerous businesses about that I wouldn’t touch with a bargepole. Yet at the same time, for the first time in two years it’s hard to claim, from a fundamental perspective, that many assets are dangerously overvalued. To me, that suggests that as long as you can cope with wild swings in the market, it’s time to start drip-feeding money back into the stockmarket on a selective basis.
So where would I begin? One area that looks like it offers substantial upside is the Indian IT outsourcing sector. This has robust long-term prospects, but has been indiscriminately bashed in recent months as American holders have liquidated their overseas assets in order to repatriate funds back to the US. The result has been a 50% crash since January on India’s benchmark index, the BSE Sensex, and a 20% slide in the rupee versus the dollar. Yet things really aren’t that bad in the Indian IT sector.
India is the 12th-largest economy in the world. It is currently worth some $1.2trn, is expanding at 7% a year, and is supported by a hefty $284bn in foreign-exchange reserves. Additionally, the local banking system appears to be in much better shape than those of its profligate Western cousins.
While American and European finance houses were lending to each other with minimum levels of risk control, the Reserve Bank of India was tightening its borrowing requirements, thus avoiding the worst of the subprime fallout. So India’s ratio of bank assets to GDP stands at a mere 55%. In the more overleverged nations, that figure stands at over 150%. Even the doom-mongers at the International Monetary Fund commented last Thursday that the impact from the credit crunch would be “minimal” and India “would continue to do well”.
One of the cornerstones of this benign outlook is the country’s huge IT industry. This sector provides top-notch yet cheap expertise for the rest of the world, generating exports worth some $23bn a year. Better still, the sector has been on something of a tear of late, expanding at a 30% clip, thanks to the value it offers the West and the nation’s vast pool of university-educated and English-speaking professionals. On a like-for-like basis, it typically costs three to four times less to employ a software programmer in India than it does in America – and with the rupee on the slide, this advantage is unlikely to change anytime soon.
So which stock would I suggest buying? There are several pure-play outsourcers from which to choose: Tata Consultancy, Satyam Computer Services, Wipro and Genpact, for example. My top pick is Infosys, the number-two provider in India. It employs more than 100,000 people worldwide and has a rock-solid balance sheet as well as colossal geographical reach. I was also pleased to see the board demonstrate excellent financial discipline last week when it refused to increase its £407m offer for IT consultancy Axon plc, having been trumped by a £441m bid from rival HCL Technologies.
Infosys’s core services include designing, writing, testing and operating computer systems for 586 clients based in North America (61.5% of revenues), Europe (28.1%) and the rest of the world (9.1%) – with only 1.3% coming from the domestic market. The work is carried out at its 53 development centres, of which 27 are located domestically, 11 in North America, nine in the Asia/Pacific region and six in Europe. That makes one of its great strengths the fact that it can offer its international clients a round-the clock turnaround. Indeed, computer programs can be written by expert teams dispersed across all three major time zones. This substantially shortens development time, improves service and has led to excellent customer retention levels of more than 95%.
So far so good, but how is the business performing? Recently, despite reporting that it saw some softness in its businesses in the three months to the end of September, the board still forecast that dollar turnover for the year would grow between 13.1% and 15.2% to $4.72bn to $4.81bn. The softness came from the weak financial services sector (representing 33% of sales), some lower billable rates and the dollar’s appreciation. But the CEO said Infosys would deal with all this by continuing to diversify outside of America (boosting its presence in Europe and the rest of the world) and by applying good cost discipline.
However, Infosys ‘body-shop’ type services are only part of its story. Ten years ago Infosys set up a software innovation laboratory (SETLabs) aimed at developing proprietary technologies and positioning the group as an ‘idea shop’ as well as a service provider. Since then it has filed hundreds of patents and come up with numerous innovations that are now just starting to gain traction. For instance, it recently launched ShoppingTrip360 for retailers and consumer goods companies. This is an application that offers real-time visibility into shopper buying habits through a network of in-store wireless sensors. This strategic shift into intellectual property ownership is very encouraging: it creates barriers to entry and should help protect the company from tough conditions ahead.
Infosys has suggested that underlying earnings per share will come in at $2.23 for the year ending March 2009. That would represent a growth rate of 12.6% and put the shares on a forward p/e of 11 times, which looks far too cheap for such a consistent performer. The stock also pays a 2% dividend yield and has a $1.9bn war-chest that not only underpins the balance sheet, but also provides sufficient fire-power to make strategic acquisitions as opportunities arise.
There are risks. Firstly, the carnage in the banking sector will undoubtedly hit demand from American clients. On the the other hand, we can expect more companies to look to Infosys to reduce their overheads by off-shoring their in-house IT resource. Meanwhile, greater regulatory scrutiny and changing laws should also create a flurry of new compliance work. Secondly, competitive price pressures, wage inflation and employee turnover (13%) could crimp Infosys’s healthy 28% operating profit margins. Finally, there are normal risks associated with emerging markets, such as foreign-exchange fluctuations, geopolitical concerns and the unwinding of favourable domestic tax laws for exporters. All that said, with the shares near four-year lows, they look good value.
Recommendation: LONG-TERM BUY at $26.40 each (market capitalisation $15bn)
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.