“Large valuation differential makes select mid-cap IT companies attractive”
Moneylife Digital Team 03 October 2012

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.

Free Helpline
Legal Credit