Technology has become the engine of modern equity returns, and its cycles ripple across borders. The INDEXDJX DJI includes several technology and technology-linked giants, so its performance can reflect enterprise spending trends. The KOSPI, meanwhile, is closely associated with semiconductors and consumer electronics, making it a useful gauge of the global hardware cycle. For Indian investors holding information technology shares or funds, understanding this cycle explains why sector earnings sometimes surprise.
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The Anatomy of a Technology Cycle
Technology demand follows cyclical trends. In periods of expansion, companies look to invest in the cloud, software, automation and devices, helping revenues of suppliers. In periods of contraction, budgets get cut, projects get deferred and inventories pile up, impacting hardware companies first and then service providers.
Semiconductors tend to lead the cycle since chips are bought months ahead of product launches. A recovery in demand for semiconductors often precedes an improvement in the overall sector, while a correction in inventory levels may point to a potential deterioration.
How the Cycle Impacts Indian Companies
Indian IT services companies derive the majority of their revenues from overseas clients, spanning banking, retail, healthcare and manufacturing. When these clients feel confident about the economy, they commit to long-dated digital transformation contracts. When they get cautious about their own profitability, they postpone discretionary spends, slowing down deal closures even as ongoing contracts continue to contribute to revenues.
Indian electronics manufacturing is witnessing a boom, driven by production-linked incentive schemes. As global companies look to diversify their supplier base away from China, India is emerging as a preferred destination for assembling mobile phones and their components. While this provides an alternate narrative around the growth of the domestic technology ecosystem, it continues to be dependent on imported components.
Metrics to Watch Out For
While revenue growth is important, it is useful to keep track of deal wins and order book sizes for visibility into future revenues, operating margins as proxy for cost management and pricing power, and attrition rates that impact ability to deliver on existing contracts and cost to hire. Client budgetary updates during quarterly earnings calls can be an important pointer.
Valuations are also an important consideration, especially for technology names which can see frothy multiples during an optimistic environment, leaving little room for error. It is useful to track how valuations (in terms of price-to-earnings multiple) compare to historical averages and growth rates.
Emerging Themes and Risks
Artificial intelligence, cloud migration, cybersecurity and data analytics are areas where demand is set to grow, and Indian companies are looking to invest in capabilities and partnerships to participate in the associated opportunities. However, the same technological advances can also be a disruptor, with automation threatening to cut down on demand for some services, while newer capabilities require fresh sets of skills and investment. Regulatory changes around data security, taxation and services can also impact profitability. Currency fluctuations, which have featured in quarterly earnings commentary for some time now, can also impact revenue growth and margins.
Portfolio Allocation for the Individual Investor
While there is no doubt about the importance of the technology sector, it is best to adopt a cautious stance around over-concentration, especially in a sector that is prone to cyclicality. It may be useful to diversify across software services, product companies and broad market funds rather than allocating a heavy chunk to a single stock. It may also be a good idea to re-evaluate the allocation after every quarter, tracking macro commentary and developments on the ground across the different segments rather than getting spooked by near-term fluctuations in share price.
While understanding the earnings cycle will not enable you to time the market, it should help you with patience. When a correction plays out, you will know that it is part of the process and when optimism returns, you will remember the importance of not getting carried away.