There was mayhem in India's stock markets during the two trading weeks ending April 18. The turmoil began with what in normal circumstances should have given no cause for concern. Infosys, the showcase firm ranked number two in India's information technology industry, announced its annual results for 2002-03 that appeared more than reasonable. Revenues over the financial year ending March 2003 had risen by 39 per cent to touch Rs. 3,623 crore. Profits after tax had risen by an impressive 19 per cent to touch a remarkable Rs. 958 crore. And the earnings per share had risen by 18 per cent to touch Rs. 145 on a share with face value of Rs. 5. Further, despite the sluggishness of the world economy, the Iraq war and the SARS epidemic, a guidance note issued by the company forecast that profits would rise by 11 per cent in 2003-04.

This in other areas would have been cause for celebration. Not so for IT. Over a single day, April 10^th, when the results were announced, the price of Infosys shares fell by 27 per cent from Rs. 4,158 to Rs. 3,045. The company's "audacity" in issuing a prior guidance that current year profits would grow "only" by 11 per cent, was also rewarded with a 40 per cent fall in the value of its ADRs, which fell by $17.3 per unit to touch $42.0.

The battering was not restricted to just the shares of Infosys but was inflicted on all leading "technology" stocks. Technology shares as a group reportedly saw their market capitalisation fall by Rs. 16,000 crore and Mastek which had revised its earnings outlook downwards saw a near-50 per cent decline in its share value. As a result the 30-share BSE Sensex fell 3.4 per cent or 106 points to touch 3035, its lowest since November 2002. The decline continued the next day, with the Infosys share falling by a further 15 per cent, or a cumulative 41 per cent, and the Sensex moving below the 3000 mark to 2998 at closing time. Even though there were signs of some reversal of the decline in the days that followed, matters once again came to a head on April 17, when Wipro Ltd announced its results, which showed that while revenues in 2002-03 were up 24 per cent to touch Rs. 4,338.3 crore, net profit had fallen by seven per cent. Wipro stocks fell further, and dragged those of its competitors down as well.

Clearly, the market had been betting on both high growth and high profit margins from the IT sector as a whole for a relatively long period of time. Unsatisfied with the reasonable performance of IT firms in 2002-03 and jolted by forecasts of still lower, even if positive, growth in 2003-04, investors in IT stocks appeared to be dumping their holdings. The volume of transactions rose and prices fell, generating a surprising level of instability when judged in terms of actual growth and profit performance.

High growth of revenues and profits matter to investors in IT stocks because of the nature of the bets they have made. High growth, at rates far exceeding the prevailing interest rate, implies for the financial analyst that the discounted current value of future incomes is also high. That is, the implicit current value of an asset that is expected to yield those kinds of future returns is extremely high. If that be the case, the current market value of the share of the company expected to yield those kinds of returns in future can be far in excess of the currently observed earnings per share, since the price is computed based on expected future earning and not current earnings. It is for this reason that the price earnings (P/E) ratio, or the ratio of price per share to earnings per share, especially in high growth technology sectors tends to be extremely high.

The difficulty, however, is the manner in which "the market" estimates these expected future earnings. Two factors play a role here. First, available evidence on current growth rates, which provide some kind of a benchmark on the basis of which future rates are ‘guesstimated'. Second, speculative hype generated by some market players aiming to push up the prices of these shares by exploiting the herd instinct typical of investors. In the event, whenever growth is high in the technology sector, both here and abroad, technology shares tend to be characterised by high price earnings ratios. Moreover, whenever growth is high, the danger of a speculative boom that takes the ratio of price to earnings per share to unwarranted levels is great.

Both these problems have characterised the Indian industry. Thus, there have been episodes of speculation when the price earning ratios of some IT firms have touched ridiculously high levels. Consider the much-publicised Wipro story. On the 3rd of January 2000, Wipro's share price ruled at Rs. 2,809. In a bull run that began around the middle of the month, the share price climbed almost continuously to touch Rs. 8929 by February 18th. In a world where stock values were increasingly being used to value individual wealth, this close to 220 per cent increase in the course of a month had placed Azim Premji, who owned 75 per cent of Wipro stock, among the world's richest people.

More recently too, despite the post-scam correction, the expectations that high growth and high profit margins would continue to prevail have resulted in high P/E ratios. Any sensible observer would have realised that these expectations would be belied. The initial years of the IT boom of the 1990s saw rates of revenue growth even exceeding 100 per cent in the case of some companies. This was not surprising, since the base revenues on which these growth rates were being calculated were extremely low in the case of both companies and the industry.

Further, the evidence did indicate that competition between firms within India and between Indian firms and those located abroad was reducing revenues per employee, even when the demand-driven headhunt for good software professional was raising employee costs. With revenues per employee falling and employee costs rising, it was to be expected that profit margins would be squeezed. Even if growth remained high profit margins would not.

Finally, industry observers were pointing to the fact that, while industry revenues were being driven by exports, outsourcing to India was predominantly of lower end software generation and of low-tech IT-enabled services. Since the extent of such outsourcing and the choice of outsourcing locations in these areas were far more sensitive to economic and political conditions in India and elsewhere, revenues from outsourcing were likely to be volatile. Expectations that growth would remain stable at even creditable let alone high rates were likely to be challenged.

This is precisely what has happened in recent times. While India's performance has been creditable, given world and domestic conditions, it has been lower than what was ‘anticipated' by speculative investors. Given the fact that the high price earnings ratios that prevailed in the market were driven by such expectations, a collapse was inevitable. Hence the paradoxical situation where growth performance is good, even if not excellent, but share market performance is dismal. Faced with the battering Wipro shares suffered on declaration of lower growth and lower margins vice-chairman Vivek Paul declared: "It maybe difficult for some to figure out how when we were one-third our current size our share price was above Rs. 10,000 and now it is below Rs. 1,000."

What explains the fact that in today's markets, both in India and abroad, IT stocks are characterised by such volatility to a far greater extent than the stocks of many other ‘old economy' industries? To start with, the fact that the industry is relatively new implies that it can, even if for short periods, record rates of growth of revenues and profits far higher than the economy's average. Investments made in the industry can yield far higher returns and sooner. Such investments are the staple of speculative investors.

Second, being an "entrepreneurial", knowledge- rather than capital-intensive industry, small players, including academics and technocrats, can set up firms that grow to relatively large sizes. Small promoters cannot rely on own capital to finance growth, making venture capitalists and financial firms a major presence in the industry. This ensures that it is not just promoters who hold shares, but a number of "outsiders" especially financial ones. The interest of the latter is to trade in their shares as and when they are listed and are ruling high. Thus even from the outset the industry is characterised by a higher level of trading in its shares than is normal.

Finally, these features of the industry have ensured that growth in the industry is substantially through mergers and acquisitions. That is, the demand for shares does not come only from financial investors with an eye on the speculative buck, but industry majors looking to diversify or integrate by buying into successful smaller ventures. There is a source of demand than can prolong the speculative boom.

Needless to say, these features are less true in the Indian context than in the US. But there are other features in India which add to the volatility that factors like the above ensure. Principally, the huge fluctuations in the share prices of leading IT firms operating in a relatively healthy industry, speaks volumes about the nature of India's stock markets. Lacking width and depth, it is clear that those markets are being currently driven by the foreign institutional investors (FIIs), especially since domestic financial institutions, which ruled the market in the past, are facing difficulties of the kind observed, in exaggerated form, in an institution like the UTI.

FII investments in India's markets are indeed miniscule relative to their own global exposure and small relative to total market capitalisation in India. But these investments are large relative to annual turnover and are devoted to active trading in stocks rather than to investments made to hold particular scrips for long terms. Looking for stocks where returns could be high, it is not surprising that the FIIs honed into the stocks of India's IT firms during the long boom of the 1990s. Given the impact this had on prices, they were soon joined in large measure by domestic investors as well. The result has been excessively high price earnings ratios and a high degree of volatility. Since it is unlikely that in the near future strong domestic players would displace the FIIs and begin to influence the market, the expectations of the FIIs are the ones that matter. Those expectations are influenced by a logic crafted in western markets, where high-tech hype is crucial to the periodic highs markets witness. With the practices of these firms determining trends in India's immature markets, volatile movements of leading stocks in the IT business seem inevitable.