Gunning for Glory: Can defence stocks armour-plate your portfolio?

Since its launch in 2022, the Nifty India Defence Index has shot up nearly 400%, far outpacing benchmark Nifty. While public sector stocks like HAL & BEL are trading at PE multiples of around 50, the ratio has exceeded 100 for some firms. The bubble-territory valuations have some investors worried.

New Delhi: —Morgan Housel The end of the Second World War marked the beginning of an over two-decade-long bull run on Wall Street. As is the case with all bull markets, this one too had its blue-eyed sector—airlines. ‘Air-transport stocks’ were all the rage back then, with investors scrambling to scoop up as many shares as possible. Aeronautical Securities and the Missiles-Rockets-Jets and Automation Fund were among the hottest mutual funds of the late 1940s and early 1950s. Aviation ticked all the boxes of what fund managers considered the ‘ideal’ sector—a scorching pace of growth, extraordinary technological advancements and seemingly inexhaustible demand. What could go wrong? As it turned out, a lot. Thanks to factors like heightened competitive intensity, overcapacity and rapid technological obsolescence, which in turn necessitated steadily rising capital expenditure, airlines soon started haemorrhaging money. Despite burgeoning air traffic volumes, airlines found the path to profitability riddled with turbulence, leading to a string of bankruptcies. Such was its predicament that in 1970, this once ‘sunrise sector’ delivered a cumulative loss of some $200 million for its shareholders—a mind-numbing figure those days. It is now a commonly accepted truism that the airline industry, over its entire history, has lost more money than it made. But this was not so evident back then. The easiest job in finance is to be right in retrospect, but even at the height of the aviation mania, there were some courageous voices of dissent. Chief among them was Benjamin Graham, the father of security analysis. In his masterpiece , which practically gave birth to value investing, Graham pointed out that just because a sector looks promising doesn’t mean investors will make money. “Obvious prospects for physical growth in a business do not translate into obvious profits for investors," he wrote. For good measure, he also said experts do not have any sure-shot way of identifying the most promising companies in the most promising industries. The lesson he was trying to drive home was not that you should never buy airline stocks, but that investors cannot afford to be lulled into complacency after investing in ‘can’t-miss’ sectors. More than seven decades later, is it time to revisit these maxims? Forward March Defence stocks have been one of the star performers of the Indian equity market’s current bull run. Since its launch on 19 January 2022, the Nifty India Defence Index has shot up nearly 400%, far outpacing not only the benchmark Nifty (up 31%) but also other current market darlings like realty (up 125%), auto (110%) as well as small- and mid-cap indices, which have gained up to 75% during the period. Some individual defence counters have simply gone ballistic, delivering 5x and even 10x returns, leaving their investors almost airborne with delight. What explains this boundless optimism? Purely from a market size perspective, the opportunity is undoubtedly immense. With over 1.4 million active personnel, India has the second-largest military force in the world, as well as the largest volunteer army. It is also the world’s fourth biggest military spender. As per data by global security think-tank Stockholm International Peace Research Institute (SIPRI), the largest military spenders in 2023 were the US ($916 billion), China ($296 billion), Russia ($109 billion) and India ($84 billion). For the period 2019-23, India was the world’s top arms importer, accounting for almost 10% of global arms imports. Not just that, India also exports defence equipment to over 85 countries. India’s defence exports reached an all-time high of 21,000 crore (about $2.63 billion) in 2023-24, up 32.5% year-on-year and a whopping 31 times as compared to 2013-14. In the interim budget presented in February, India’s defence budget stood at 6.21 trillion for 2024-25, accounting for 13% of the overall budget expenditure of the government. Out of this, the capital allocation for new procurements was 1.72 trillion, 5.78% higher than the Budget Estimates of last year. The government in 2021 announced its target to spend $130 billion for the modernization of the armed forces in the next seven to eight years, with a focus on majority procurement from domestic industry. Concurrently, it has rolled out multiple initiatives to give a fillip to the sector, including the ‘Make in India’ policy which seeks to reduce import dependence and promote domestic manufacturing. It also encourages participation from Indian companies including public sector undertakings (PSUs), private firms, and micro, small and medium enterprises (MSMEs). India’s defence offset policy requires foreign vendors to source at least 30% of the contract value (above 2,000 crore) domestically, which spurs investment as well as technology transfer in defence. The government has also set up two industrial corridors to attract investments of 20,000 crore by 2024-25. That apart, in 2020, the foreign direct investment (FDI) limit in the defence sector was increased from 49% to 74% through the automatic route and 100% through government approval. “India is not only striving to become self-reliant in meeting its defence needs but is also exploring substantial export opportunities in the sector. India is already exporting defence equipment to countries like Vietnam, Afghanistan, Sri Lanka, Philippines, United Arab Emirates (UAE) and many others," Prashant Rao, director and head of equity capital markets, Anand Rathi Investment Banking, told . “Investors believe that the sector will be a key focus area for the government, driving further growth and development," he added. The skyrocketing stock prices, in turn, have led to some pretty frothy valuations. Anirudh Garg, partner and fund manager at Invasset, a portfolio management service provider, said while the defence sector has seen remarkable growth, it is important to acknowledge the high valuations many companies are currently trading at. “However, we believe that these valuations reflect strong future growth potential supported by robust government policies and ongoing modernization projects," he said. “Companies with significant order books and strategic partnerships are well-positioned to maintain their growth trajectory. Therefore, rather than viewing the space as overheated, we see it as an opportunity of the decade, underpinned by solid fundamentals and extensive growth prospects," he added. However, he was quick to point out that investors should focus on companies with a proven track record, strong fundamentals and substantial government contracts. “Key players like Bharat Electronics Limited (BEL) and Hindustan Aeronautics Limited (HAL) stand out due to their significant involvement in crucial defence projects and strategic international partnerships. Companies that are investing heavily in R&D and those that are part of government-supported initiatives like Innovations for Defence Excellence (iDEX) are also poised for long-term success," he pointed out. These factors might account for the rally, but what explains the euphoria? How’s the Josh? To say that the defence segment has become overheated would be flirting dangerously with understatement. Public sector stocks like Hindustan Aeronautics Limited (HAL) and Bharat Electronics Ltd (BEL) are trading at price-to-earnings (PE) multiples—the ratio of the share price of a stock to its earnings per share—of around 50. Cochin Shipyard commands a PE of 72. Some private sector players have escaped the Earth’s gravitational pull altogether. Explosives manufacturer Solar Industries is trading at a PE ratio of above 100, while that of Paras Defence is at a head-spinning 185. “The market is seeing the continuity in government and expects it to keep defence expenditure at elevated levels. But our sense is that we cannot assume the budgetary allocation to grow at substantially higher rates than the nominal GDP," George Thomas, fund manager—equity at Quantum AMC, told . “The other feature of this sector is that the government itself is the single largest buyer in many cases. In such sectors, there is a high chance of regulatory interventions, which can limit the return on equity (RoE) of companies to 14-15% at best. At some point, the RoEs of some of these companies could normalise. The current valuations do not offer any margin of safety," he further said. “The sector as a whole looks quite expensive to us. At some point, the reality could kick in and investors can see large drawdowns," he added. Thomas acknowledged that India’s geopolitical situation necessitates continued investments in defence modernization, so in that sense the sector has a long runway for growth. “But when companies are trading at PE multiples of 90 and 100, even under the most optimistic assumptions, further upside looks limited." Contrapoint However, some experts suggest taking a granular look at the numbers rather than being intimidated by the PE ratios. “We must look at company-specific reasons for the increase (in PE) but generally, the stock prices are reflecting the strong order book these companies are having. For example, HAL is sitting on an order book of 96,000 crore, Bharat Electronics has an order book of 76,000 crore, Bharat Dynamics is at 20,000 crore (as of 31 March 2024). These are very impressive numbers," Anand Rathi’s Prashant Rao said. Furthermore, the Indian manufacturing sector has shown high development in the last few years and is showing tremendous growth potential for the coming years. Similarly, defence companies are also benefiting from the government’s goal to increase manufacturing in the country. “Some of the companies in defence might be trading at a P/E of more than 100 but you will find majority trading at valuations which are reasonable. This is because the defence industry has a large variety of segments in which some companies manufacture critical value-added products requiring multiple approvals and expensive technology. Also, not only are these companies showing strong order books right now but are also poised to grow and are presenting revenue visibility for the next three-five years," he added. Hope vs Experience Few investors can resist the temptation to be macroeconomic experts while evaluating the investment landscape. When it comes to the defence sector, there’s the added thrill of dishing out geopolitical hot-takes. While discussing the Russia-Ukraine war or China’s belligerence might make for interesting dinner table conversations, they are tangential to the primary objective of stock selection. Discerning investors can identify strong contenders by focusing on several key metrics. Firstly, prioritize companies with a diversified product portfolio encompassing various defence segments. This diversification mitigates risk by reducing dependence on the performance of a single product category, said Sonam Srivastava, founder and fund manager at Wright Research, an investment services firm. “Secondly, a proven track record of innovation and technological advancements is crucial. Companies consistently at the forefront of defence technology development are well-positioned for future contracts," Srivastava added. Thirdly, prioritize companies demonstrating sound financial health, focusing on profitability and maintaining manageable debt levels. “Finally, seek out companies with a clear competitive advantage and a strong position within their specific niche of the defence market," she further said. However, as market veterans know too well, it is very difficult to separate the wheat from the chaff, that too at the peak of a hype cycle. “P/E ratios exceeding 100 for some companies suggest that the market anticipates significant future earnings, but sustaining current order book growth at these elevated levels for extended periods might be challenging. It’s important to consider the cyclical nature of defence spending, which can fluctuate based on geopolitical situations. Therefore, a cautious approach is warranted, as future growth might not always match current market expectations," she noted. While the consensus view is that the defence industry has considerable headroom for growth, the bubble-territory valuations have left the Street divided. The optimists (as well as momentum investors) see no harm in chasing the uptrend, but many others advise caution. “For those who missed the initial rally, entering the market now may not guarantee similar returns. A more measured approach, such as investing a fixed amount at regular intervals, can be beneficial as this will allow investors to acquire shares at various price points, potentially mitigating the risk of buying at a peak. Diversification across different defence companies and even exploring defence ETFs (Exchange-Traded Funds) can further manage risk and provide broader exposure to the sector’s growth," Srivastava added. Overall, a long-term investment horizon can be the most potent weapon in an investor’s arsenal. After all, that’s what Ben Graham advocated as well.