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“Large valuation differential makes select mid-cap IT companies attractive”

Valuation differential between Tier-I and Tier-II mid-cap companies has widened to 37%—the largest in four years

When the market goes up, analysts look for new investment ideas. How about a bunch of smaller software companies which the market seems to have forgotten during the two-year bear market? Companies such as Polaris Software, Persistent Systems, KPIT Cummins, Tech Mahindra, MindTree and Mphasis. Generally speaking, investing in mid-cap companies comes with inherent risks: they may lack pricing power or staying power of large-cap companies which have scale on their side. Establishing scale requires time and management quality. If these companies are still mid-cap after years of being in the business, quite possibly the management is not that capable. But that does not mean that mid-caps cannot be bought for the medium-term.
 

Espirito Santo Securities has come up with a research report on smaller software companies that are worth buying. The mid-cap IT companies, pointed out the report, have given an absolute return of 44%, outperforming the BSE IT index by 24% in the last 12 months. This is an impressive statistic given the turmoil in the global markets. But more gains could be possible, argues the report.
 

One major aspect is the valuation differential between Tier-I and Tier-II mid-cap companies which has widened to its largest in four years. This makes mid-cap more attractive to invest than large-cap. The report says that, “In the last 10 years, Tier-II IT companies have mostly traded at a discount to Tier-I IT and that discount has widened. The discount has widened from an average of 17% in the early part of the decade to 37% in the last four years.” This makes them ‘buy’ candidates. (Mid-cap IT has offered good ‘sell’ candidates whenever this discount has been close to single digits.)
 

By and large, markets are concerned about margins as well as growth. When the margins are increasing, the market likes it and the stock price goes up, and vice versa. So why not buy large-cap software companies? Espirito Santo Securities suggests mid-cap because “valuation discount is less correlated to the growth gap and more skewed towards the margin gap and inherent risks.” In other words, even though growth has caught up with valuations, there is the margin gap between Tier-I and Tier-II IT companies which the market seems to have missed, and the potential future benefits due to increased risk taking vis-a-vis acquisitions by Tier-II companies.
 

Espirito Santo believes that this gap will narrow as mid-cap companies acquire companies, scale up and become competitive over time. Their niche market also serves a reason to be able to charge premium rates through to specialised service and offerings, something that large-caps cannot do as effectively.
 

How about corporate governance?

It is very difficult to pick and rate companies on something that cannot be quantified and where opinions are bound to vary from one analyst to another. Espirito, for this purpose, has come up with a handy matrix, which includes corporate governance. However, we are confused as to how they have implemented it. Consider the two of the following companies.
 

1.    Hexaware Technologies

 

Hexaware Technologies has got a ‘SELL’ rating due to its lingering forex fiasco in 2007. The report says, “Relatively high remuneration to directors on an absolute basis and relative to peers and high year-on-year (y-o-y) growth in remuneration paid to directors gives a red light on the board, management and related parties.” In other words, shoddy corporate governance is one of the reasons the company is a ‘SELL’, despite green light Epirito Santo has given on accounting and fundamental parameters.
 

2.    Polaris Software

 

On the other hand, we are especially surprised with their inclusion of Polaris Software to their ‘BUY’ list, because the company doesn’t have a squeaky clean record on corporate governance. In fact, the report itself clearly red flags the company. Yet, Espirito Santo has green lighted the company based on numbers and fundamentals. It said, “Polaris performs fairly well on most of our accounting checks. However, a lack of proper disclosure of product revenues and margins on a consistent and quarterly basis, plus disclosure of licenses, implementation and AMC on a consistent basis, are a few of the parameters where we believe Polaris needs to improve. We give a green light on accounting and auditing and promoter background and insider trading.”
 

The report puts a ‘Buy’ on Persistent Systems, KPIT Cummins, Polaris and Infotech Enterprises and a ‘Sell’ on Hexaware. It believes that MindTree, Tech Mahindra, Rolta and Mphasis would miss the NASSCOM estimates of 11-14% growth in FY13.

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India, China consumer spending to rise to $10 trillion a year by 2020

Middle class would be the main driver of the consumer boom in India and China and are expected to spend $64 billion on goods and services during 2010 to 2020

New Delhi: Consumers in India and neighbouring China are expected to spend nearly $10 trillion on goods and services a year by 2020, which is three times the amount spent in 2010, reports PTI quoting global research and advisory firm Boston Consulting Group (BCG).

 

The middle class would be the main driver of the consumer boom in the two countries, BCG said in excerpts released from its new book titled, 'The $10 Trillion Prize: Captivating the Newly Affluent in China and India'.

 

"By the end of the decade, consumers in the two countries (China and India) are predicted to spend nearly $10 trillion annually, three times the amount they spent in 2010," BCG said.

 

It further said Chinese and Indian consumers are expected to spend a combined total of $64 trillion on goods and services between 2010 and 2020, propelling a new wave of growth in the global economy.

 

The book finds that middle class in the two countries is expected to reach one billion by 2020, with Indian middle-class is projected to grow from 28% in 2010 to 45% in 2020.

 

"We are at a turning point in history where relative wealth will shift from the West to China and India, but absolute wealth, including in the West, should increase," said Michael J Silverstein, a co-author of the book and a senior partner at BCG.

 

"It is not a zero-sum game. But Western businesses and individuals wishing to gain their share need to act now. They must choose to be contenders, and remake their dreams for a new world in which China and India play a much larger role -- but where the West can still prosper. That's the real lesson of The $10 Trillion Prize," he added.

 

The book written by BCG consultants Michael J Silverstein, Abheek Singhi, Carol Liao, David Michael noted that business leaders and politicians alike need to take urgent action to build for the long term. They should not postpone their efforts because of the current troubles facing the two emerging economies.

 

The book suggested that in order to fully Participate in the emerging $10 trillion consumer market, the Western countries should embrace China and India.

 

"...Western companies must learn to "captivate" them (consumers in India and China) by understanding their distinctive buying habits in order to capitalise on this opportunity," as per the book.

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