IT Sector Valuations Turn Attractive Post AI Sell-Off Amid Portfolio Reset

Indian IT Sector Valuations See Attractive Opportunity

According to Emkay Global Financial Services Ltd, the Indian IT sector valuations have become attractive following an over-reaction to the artificial intelligence (AI) threat. Seshadri Sen, Head of Research and Strategist, believes that while structural growth challenges remain, the market's most pessimistic projections of a deep, prolonged contraction are overstated.

Valuation Metrics The sector's price-to-earnings ratio is currently in the range of 14-18x, with a free cash flow yield of 4-6%. Emkay expects a potential return of 6.5-18.3% with limited downside, prompting the brokerage firm to turn marginally overweight on the sector.

The Jevons Effect Emkay cites the "Jevons effect," which suggests that efficiency gains from AI can lower costs and ultimately expand overall demand. While AI may compress individual contract values, new use-cases and broader adoption may expand the overall technology spending pie over time. Indian IT companies remain relevant in customizing, integrating, and implementing AI-based solutions, with no visible impact yet on hiring or growth trends.

Read also: Treasury Yields Experience Largest Increase in Two Weeks Following Release of Labor Market Data

Long-term Growth Projections Emkay's base case sees the sector settling at 0-3% long-term EBIT growth in dollar terms, with upside if companies adapt swiftly. The feared "destruction before recovery" phase may be mitigated if near-term revenue tailwinds from legacy modernization and AI transformation projects materialize.

Macro Risks and Implications An ultra-bearish IT scenario could have second-order effects on India's macro fundamentals, including IT exports and sectoral contributions to wages and consumption. However, Emkay views this worst-case scenario as remote, expecting tech hiring to grow modestly at 0-3%.

Portfolio Changes Emkay Global has made several changes to its model portfolio, including adding Indus Towers, SRF, Infosys, and HCL Technologies, while exiting Sun Pharmaceutical Industries, Gravita India, and Mphasis. The brokerage firm has also trimmed its positions in Maruti Suzuki India, Larsen & Toubro (L&T), and Craftsman Automation.