Software: Bigger, the better!

In the rise of Indian equity markets over the past six months, stocks from the software sector have hogged the limelight. However, rise in stocks from the sector this time seems to be different story from what has been experienced in the past.

This time around, market participants have concentrated only on the leading players from the industry rather than practicing an all-out approach of picking 'whatever was there to be picked'!

In such times, Indian software stocks have outperformed their global peers (read, the US), especially if one were to consider their relative performances over the past six months (see chart below).

As seen in the adjoining chart, for comparison purposes, we have taken CNX IT for India and NASDAQ for the US. Increasing investor optimism towards the Indian offshoring story has fueled the faster rise in CNX IT vis-à-vis the NASDAQ.

While there were concerns raised during the earlier part of 2004 with regards to the ire that offshoring had attracted in the US presidential debates, the same were calmed through pronouncements made by the managements of Indian software companies while announcing their respective 1QFY05 results.

It was indicated that the Indian offshoring story was here to stay and consequently, Indian companies likely to benefit from the same.

The buoyancy that followed even shirked fears of a slowdown in technology spending, as cited by earning downgrades from some prominent technology majors, including Intel and Cisco.

We have been optimistic about the Indian offshoring story gathering pace as outsourcing becomes mainstream. This optimism is fueled by the belief that, as more and more global corporations vie to improve profitability through offshoring their non-core operations, Indian software companies would be key beneficiaries.

But this is not to say that all companies will benefit from this opportunity. Companies with proven execution capabilities and scalable business models will lead the pack.

Moreover, innovative offshoring models, like 'modular outsourcing' as followed by Infosys, are likely to help Indian companies in widening the gap between them and the global technology MNCs that are trying to replicate the Indian offshoring model.

Now, despite the high growth prospects of the leading Indian technology players, valuations that are accorded to them have reached high levels (see adjoining chart).

While the rapid rise in stock prices in the past six months can be assigned the responsibility of these high valuations, there is no gainsaying the fact long-term investors can still benefit from a selective approach to stock picking from among the software stocks.

At the same time, if stocks like Silverline and DSQ Software are gaining sharply day after day, probably it is time to look back at the tech bubble of 2000 that caught investors napping. In the case of software sector, the bigger the better!