Red-hot defence stocks may have more legs to run, say analysts

With one-year returns for benchmark indices remaining lacklustre, investors have been scouting for individual stocks or sectors to generate superior returns. One such theme that has played out well over the past year has been defence.

The Nifty India Defence Index has not just bucked weak market trends, but crushed every major sectoral index. Data shows that the Nifty Defence (total return index) Index has jumped 50 per cent in 2021-22 (FY22) and has already risen 44 per cent so far this financial year (2022-23, or FY23).

The growth has come on the back of healthy growth in the order books of defence companies amid the government’s focus on indigenisation and surge in exports.

“Given we were largely importing all requirements until five years ago, the indigenisation move has opened up a huge market with strong growth visibility,” says market advisor Sandip Sabharwal of asksandipsabharwal.com.

India’s military spending is the third-highest in the world, with the FY23 Budget pegging it at $54 billion, excluding pensions. Given high defence needs, even a small but consistent push towards indigenisation can prove to be a major boost for domestic defence production companies.

Additionally, India’s defence exports are also on the rise, having touched a record Rs 13,000 crore in FY22.

According to ICICI Securities’ April 2022 report, the third wave of indigenisation alone is expected to bring in Rs 2 trillion worth of business for the domestic sector in the next five years.

According to OmniScience Capital’s Vikas V Gupta, who manages a defence portfolio in smallcase, defence stocks remain attractive from a valuation perspective, notwithstanding a strong rally in the past few years.

“Some of these companies are highly profitable with near-zero debt. Moreover, some of these companies have cash amounting to more than half their market capitalisation,” observes Gupta.

Strong order flow and decent valuations paint a bright future for the sector, albeit enfeebled. Given the industry is linked (most major companies being public sector undertakings) and is dependent on the government (for orders), any change in policy/government is likely to have a bearing on the industry.

“A change in government or policy may have an effect, but such a change is unlikely in the next few years. Of course, things can change in a longer time frame. One risk is that foreign companies can take away a share of orders if urgent requirements of weapons or equipment come up,” says Gupta.

No sector-specific mutual fund (MF) offering yet

Despite strong performance in recent years and high growth potential in the medium to long term, asset management companies have abstained from launching a defence sector fund.

HDFC MF had filed papers for a defence fund in March, but the launch is yet to happen.

MF executives say the defence universe is still too small for a fund manager to be able to bring out a sector-specific fund.

“The space is too narrow right now. Plus, a good number of these companies are newly listed. The sector is still not ready to have dedicated schemes,” says a senior fund executive.

“A dedicated fund can only be possible if there is enough room for diversification. Any scheme coming out now will have risk of concentration,” says Anil Ghelani, head-passive investments and products at DSP MF.

At present, the top four constituents of the NSE Nifty India Defence Index — Bharat Electronics, Hindustan Aeronautics, Solar Industries India, and Bharat Dynamics — have close to 70 per cent weighting in the index. The high weighting of select companies is due to absence of enough proven companies in the sector.