Why mid-cap IT may not outperform TCS, Infosys after recent Bull Run?

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Mid-cap IT stocks have outperformed their bigger rivals such as TCS and Infosys over the last one year on the back of a sharp recovery in margins. Margins of tier-2 IT companies hit a historical high in 2013-14 led by around 33 per cent depreciation in rupee over 2011-14 fiscal years, Nomura estimates.

The brokerage categorizes Mindtree, Hexaware, Persistent, Eclerx, NIIT Tech and Infotech Enterprises under tier-2 IT stocks and Infosys, TCS, Wipro and HCL Tech as tier-1 IT stocks.

“Tier-2 IT stocks have nearly doubled (up 96 per cent) as compared to the 53 per cent gains notched by tier-1 IT stocks over a 12-month period,” Nomura says.
The outperformance in these smaller IT firms means that their valuation gap in terms of price/earnings has narrowed as compared to their larger peers, the brokerage says.

Currently, tier-1 IT on aggregate trades at 19.1 times one-year forward earnings, while tier-2 IT trades at peak valuations of 12.4 times over the past five years, Nomura estimated.

This means that mid-cap IT companies might have smaller headroom for further outperformance over their bigger rivals, though IT stocks in general are poised for more gains amid the improving demand environment in the US.

Can tier-1 IT outperform tier-2 IT? Nomura says questions on longer term sustainability of growth will be an overhang at tier-2 IT stocks, which is likely to limit further narrowing of valuation discounts.

Nomura’s Ashwin Mehta and Pinku Pappan say tier 1 IT stocks are better posed for further gains. Here’s why,
1) There is greater predictability of revenue growth and margins at tier-1 IT vs higher volatility at tier-2 IT.

2) Tier-1 IT has more diversified presence across all segments with higher exposure to faster growing and underpenetrated segments.

3) Benefits of scale can be leveraged at tier 1 IT to make necessary investments in newer opportunities without impacting margins.