Valuation comfort, higher free cash flows give IT an edge over pharma
IT and pharma stocks have weights of 10.4% and 5.8%, respectively, in the BSE 200 index.
By Ashutosh Shyam, ET Bureau | Updated:
ET Intelligence Group: Export-oriented sectors including information technology (IT) and pharmaceuticals are facing structural headwinds over the past few quarters affecting their profits and profitability.
However, between these two sectors, portfolio managers continue to prefer IT stocks, while weights of pharma stocks in their portfolios have been continuously pared. The preference for IT over pharma is due to better valuation comfort, higher free cash yield and higher propensity to distribute cash.
Long-term investors, such as foreign portfolio investors ( FPI), are overweight on IT by 120 basis points and underweight on pharma stocks by 40 basis points. IT and pharma stocks have weights of 10.4% and 5.8%, respectively, in the BSE 200 index. Stocks from these two sectors have been major underperformers following sombre expectation of 10% annualised earnings growth in the next two fiscals. The earnings of the Nifty 50 index companies are expected to grow by more than 18% at the aggregate level.
Despite this, investors prefer IT stocks over the pharma basket for several reasons. First, top IT companies are available at valuations which are lower than their historical averages. They trade at up to 20% discount to their 10-year average price-earnings (PE) ratio. Pharma stocks, on the other hand, still trade at up to 25% premium to the Nifty. Barring Lupin and Glenmark, most of the pharma pack is trading substantially above the lower end of their PE ratios.
Second, the free cash flow of the IT companies has been consistently higher than pharma companies. Also, IT companies tend to distribute cash to investors through buybacks and dividends. Indian IT companies have distributed 40-60% of profit in dividends in the past five years. Since 2016, IT companies have offered to buy back shares worth Rs 48,000 crore. For pharma companies, the dividend payout ratio is 10-20%.
Third, the incremental return on capital employed (RoCE) of IT companies is better than pharma. The skepticism around incremental ROCE always remains in case of pharma companies owing to a spate of non-remunerative acquisitions, long gestation period of paybacks from such acquisitions, and risky product pipeline.
However, between these two sectors, portfolio managers continue to prefer IT stocks, while weights of pharma stocks in their portfolios have been continuously pared. The preference for IT over pharma is due to better valuation comfort, higher free cash yield and higher propensity to distribute cash.
Long-term investors, such as foreign portfolio investors ( FPI), are overweight on IT by 120 basis points and underweight on pharma stocks by 40 basis points. IT and pharma stocks have weights of 10.4% and 5.8%, respectively, in the BSE 200 index. Stocks from these two sectors have been major underperformers following sombre expectation of 10% annualised earnings growth in the next two fiscals. The earnings of the Nifty 50 index companies are expected to grow by more than 18% at the aggregate level.
Despite this, investors prefer IT stocks over the pharma basket for several reasons. First, top IT companies are available at valuations which are lower than their historical averages. They trade at up to 20% discount to their 10-year average price-earnings (PE) ratio. Pharma stocks, on the other hand, still trade at up to 25% premium to the Nifty. Barring Lupin and Glenmark, most of the pharma pack is trading substantially above the lower end of their PE ratios.
Second, the free cash flow of the IT companies has been consistently higher than pharma companies. Also, IT companies tend to distribute cash to investors through buybacks and dividends. Indian IT companies have distributed 40-60% of profit in dividends in the past five years. Since 2016, IT companies have offered to buy back shares worth Rs 48,000 crore. For pharma companies, the dividend payout ratio is 10-20%.
Third, the incremental return on capital employed (RoCE) of IT companies is better than pharma. The skepticism around incremental ROCE always remains in case of pharma companies owing to a spate of non-remunerative acquisitions, long gestation period of paybacks from such acquisitions, and risky product pipeline.
Too busy to trade in stocks? Invest in Mutual Funds with ET Money!
Bookmark or read stories offline -
Download ET Markets APP
Download ET Markets APP
ADVERTISEMENT
