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In times of heightened economic concerns, there are few industries that are able to weather the choppy waters and remain relatively intact. The difficult conditions of the latest recession led many businesses to reevaluate their spending and create leaner cost structures. The world’s largest offshore outsourcers were able to capitalize on this trend, and when the profits of many businesses were becoming constrained, companies like Cognizant Technology Solutions (CTSH), Infosys Technologies (INFY), Tata Consultancy Services, and Wipro (WIT) posted record results.

Historically, offshore outsourcing’s greatest appeal was in its ability to provide companies with greater access to the cheap labor and lower operating costs in developing nations.  In particular, India’s educated, technologically skilled, and English-speaking workforce made the country an ideal location for many U.S. and European companies to turn to, especially for call center, programming, and back office operations. Over time, many of the top outsourcing firms began to offer high-margined services in the areas of consulting, accounting, marketing and financial services, among others. We believe that over the coming years, there will be a rise in services related to cloud computing, social computing, and the mobile services. 

Although India remains the top spot for offshore outsourcing, many other countries have been closing the gap. For instance, the government in China has been increasing its investment in the nation’s technology outsourcing sector, and these efforts are bearing fruit. Some experts in the field predict that China may well surpass India as the world’s largest provider of outsourcing services over the next decade. And Eastern Europe, Russia, Southeast Asia, Africa, and Central and South America have made great strides over the past few years, too, and may take some of India’s market share going forward.

Offshore outsourcing, as with any industry, is not without its risks. Currency volatility, especially that of the Indian rupee of late, has become a growing issue as it threatens to squeeze the margins of the outsourcers. Wage inflation would also cut into the profits of many outsourcing firms.  Meanwhile, the United States has raised the fees on H-1B visas (highly-skilled professionals) and L-1 visas (multinational transferees) in an effort to curtail outsourcing and protect American jobs. In response to this, some outsourcers have indicated that they will likely hire more employees from the United States and possibly set up call centers here. A clouded outlook for a full recovery in telecommunications outsourcing spending by U.S. and European firms is a lingering concern, too. Finally, the competitive landscape is fierce, not only among the companies previously mentioned, but also from players like IBM (IBM) and Accenture (ACN).  We believe that the environment will continue to heat up, especially as the global economic climate improves.

The stock prices of some of India’s top outsourcing firms have recently hit all-time highs. As a result, they offer limited appreciation potential over the 3- to 5-year horizon. What’s more, given either minimal or no dividend payouts, there is not much appeal for most investors at this juncture. In the event of a pullback, though, the names that would likely stand out are Cognizant Technology Solutions and Infosys Technologies. Cognizant’s growth prospects are solid and the company has historically surpassed its top- and bottom-line guidance. If it continues to do so, it may well prove our estimates conservative.  Meanwhile, Infosys is steadily diversifying its offerings and is poised for another banner year in 2011. The stock’s above-average Safety rank makes it a suitable pick for income-oriented portfolios. Both companies are flush with cash and have no debt, giving them a solid foundation to pursue their growth objectives. At a more reasonable valuation, both equities are worth consideration as long-term investments.

 

At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.