From boys to men: What’s behind ‘eye-popping’ returns by midcap IT stocks?

The midcap IT stocks’ outperformance over their largecap peers and all other indices rests on their radical transformation from boys to men, argues Nuvama in a report. The brokerage picks LTIMindtree, Coforge and Persistent Systems as its top picks from the pack while initiating coverage on Mphasis with a ‘Reduce’ tag.

Even as the Nifty IT index has marginally underperformed the broader Nifty50 on three, six and 12-month basis, the midcap and smallcap IT stocks have outrun all indices, the report said, adding that some quality tier-2 IT firms delivered “eye-popping returns”.

While LTIMindtree has delivered 32% returns in the last 12 months, the returns by Persistent and Coforge during this time have been 60% and 50%, respectively versus a 13% upside seen in the Nifty50 and 11% in the Nifty IT index.

Nuvama calls this a remarkable dichotomy of the IT sector.

The outperformance of midcap IT companies is rooted in their attaining a critical size that passes muster on bidding for large deals. Moreover, their margin profiles have undergone a reset and businesses are much more diversified, Nuvama said, calling this factor “no less significant”.

Coforge, LTIMindtree, Persistent and Mphasis (CLAMP companies) are currently trading at significant premiums to tier-1 players and the market is ascribing a premium as these are no longer the mid-cap companies of yesteryears, the brokerage note said. The companies are expected to report superior sustainable growth over the next three–four years, in Nuvama’s view.

LTIMindtree: Buy | CMP Rs 5,640 | Target: Rs 6,800Coforge: Buy | CMP Rs 5,702 | Target: Rs 6,600

Persistent Systems: Buy | CMP Rs 6,336 | Target: Rs 7,600

Mphasis: Reduce | CMP Rs 2,384 | Target: Rs 2,100

Key Triggers
1) Valuation premiums should hold in the near-to-medium term because of their growth outperformance and business transformation.

2) Glaring similarities between LTIMindtree/Coforge and Infosys/Cognizant of yesteryears, and see these companies traverse the path of these larger peers.

3) CLAMP companies can sustain margins at levels similar to (or even higher than) during the pandemic while FY25 margins of most tier-1 IT firms are likely to wane to pre-covid levels (or even lower). The margins of CLAMP companies are expected to be at least 200 bps higher than their pre-covid levels.

4) These companies are benefitting from leadership changes with their CEOs (excluding Mphasis) coming in from tier-1 companies, bringing with them best industry practices, connecting with tier-1 clients, and calibre to build and nourish strong teams, not to mention the right vision/direction for the company.

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