At a time when the street is focused on “what’s going to move next?” we discover value in the most unexpected places.

The past week saw the big boys of banking on a tear, playing catch-up with the market, after being the under-dogs for more than a while due to asset quality concerns. What also nudged the financial behemoths out of their slumber was the “privatization” word mentioned in the budget. This spells several things. For one, a few could get a chance at fulfilling their banking growth ambitions—like the Prem Vatsa group for one, which has been eyeing inorganic opportunities. Two, it could mean a freer marketplace—state-owned entities tend to cobble together and toe the government’s line, and if there are fewer of them, it would tilt the scales. Three, with fewer government-backstopped entities, it could spell bigger gains for the fittest.

So, is there more steam left in bank stocks? Perhaps. A look at the performance of the Nifty compared to the Nifty Bank reveals a stark under-performance of the latter. While the Nifty has returned near 23% since December 2019, the Nifty Bank has delivered a paltry 11%. That does provide room for some catch-up.

BEYOND THE CATCH-UP TRADE

At a time when getting caught on the wrong side of the market, with high equity exposure at steep valuations, is a big concern, we decided to look for value and safety. Here’s what we did. We sifted through the BSE-500 stocks for companies that have delivered an ROE of >12 percent in each of the past 3 years. These companies should also have generated free cash flows in each of the 3 years. We further filtered the lot for companies that had grown quarter-on-quarter in the quarter ended December 2020 and in the 9 months to December, year-on-year. We then evaluated the companies on a free cash flow to market capitalization metric to assess the attractiveness from a valuation perspective. For this, we used their last financial year’s free cash flow (FY20). So, if they have grown in the current fiscal, the number should only look better.

Very interestingly, we discovered a number of companies that were offering free cash flow yields of 2 percent or more. Throw in the anticipated growth, all experts seem so gung-ho about, and the numbers could start looking much better a year-or-two down the road. What stands out clearly is the dominance of the IT pack. Surprised? We were too. But there’s clearly great value still to be had in this sector that has seen some underperformance in the recent past—important to note here that the Nifty IT index has delivered a 62 percent return since December 2019 in comparison to the Nifty’s 23 percent.

THERE’S VALUE IN TECH

What might have gone unnoticed, though, in the recent past is that while the Nifty IT index has corrected from a high of over 27,000 to about 25,000, some stocks have seen a fairly sharp sell-off. Notable among them being HCL Technologies and Tech Mahindra, both of which are available at free cash flow yields of over 4 percent. The other startler is lesser-known KPO player, eClerx, which offers a yield of over 8 percent. However, the company has its share of troubles: profits and profitability have been on a downward trend the past few years. So, it could be either a value buy or a value trap, to discern requires closer study. But more on specifics at another time.

What’s comforting about being invested in technology services is the near-unanimous outlook guidance from most managements about strong growth ahead (double-digits in many cases), not just for a year but maybe three. And this is the outcome of an unprecedented development, and hence an opportunity. Microsoft’s Satya Nadella summed-up the essence of it in a line when he said: “We’ve seen two years’ worth of digital transformation in two months”.

So, even as there are big bets on India’s economic growth revival and the return of the cyclicals, select IT services stocks offer a relatively safe haven with good earnings visibility and attractive valuations. That said, equities have had a strong run since March last year and this is a time to be cautious, not foolhardy. So do your homework well, and keep that margin of safety.