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Is this the Best Time to Invest in Defence Stocks?

Apr 8, 2022

Is this the Best Time to Invest in Defence Stocks?

If you follow developments from the defence space closely, you know that the Russia-Ukraine war has accelerated the prospects of Indian defence sector.

What this means is that concerns are raised across countries like India, if and when such escalations take place.

Given the strained relationship we share with our two neighbours China and Pakistan, the defence sector plays a crucial role in handling any possible aggression.

Earlier this week on Monday, the defence ministry announced an ambitious plan which gave the defence sector another boost.

Minister of State for Defence Ajay Bhatt announced that the ministry plans to procure military equipment worth Rs 5 lakh crore from the domestic industries in the next 5-7 years.

Now, you know what this means. Defence stocks are all set for a re-rating as they get increased orders.

Just consider this example.

In August last year, shares of Zen Technologies were trading at less that Rs 80. What followed a month later was shares of the company skyrocketing to over Rs 200.

Multibagger returns in less than a month, all thanks to the company bagging multiple orders for defence technology and manufacturing.

The government's realization to have an import substitution strategy is already driving defence stocks higher.

The push for self-reliance is acting as a massive tailwind.

Things can play out pretty well for defence companies, for both public as well as private sector players, as India moves towards reducing imports and become a big exporter.

FYI, we are already exporting missiles to Philippines. Defence exports have grown by 334% in last five years. India exports to more than 75 countries. By 2025, defense exports are expected to grow almost 5 times.

Let's take a look at the factors that can possibly trigger a rally in defence stocks.

Increase in defence budget

The Indian government is likely to spend a massive US$130 bn over the next 7-8 years on the modernisation of the armed forces.

This will give a big boost to the indigenisation of defence procurement.

Increasing Budget Allocation to Defence (in US$ billion)

As can be seen from the chart above, the allocation to the defence sector is steadily rising.

In this year's budget, India announced around US$70.2 billion to the defence sector, an increase of 10% from the past year.

The budget also saw 68% of the capital procurement for domestic industry.

Here's another interesting data that has been disclosed by a Stockholm International Peace Research Institute (SIPRI) report...

India's defence spending between 2011 and 2020 rose 76% as against the global average of 9%.

Import ban

For many years, India has relied on Russia for defence supplies and technology transfers. However, Russia is facing a huge setback with global sanctions due to its invasion of Ukraine.

Thus, overreliance on the old ally could prove costly for India.

Thankfully, the Indian government has already taken proactive steps to make India Atmanirbhar in the defence sector.

Recently, several Russian weapon sub-systems were banned as part of a fresh list of 107 defence items, including warships, helicopters, tanks, infantry combat vehicles, missiles, ammunition, and radars.

These items are imported by Indian listed defence companies Hindustan Aeronautics (HAL), Bharat Electronics, BEML and other unlisted players.

Note that this ban is on top of the 2,851 sub-systems, assemblies, sub-assemblies and components notified by the ministry's department of defence production last December.

In view of the rising geopolitical tensions, it appears the import ban is accelerating the self-reliance push.

Which defence stocks to look out for?

Here's a list of defence stocks that should be on your watchlist. These are not recommendations by any stretch.

Avantel - Avantel is engaged in the business of designing, developing and maintaining wireless and satellite communication products, defense electronics, radar systems and development of network management software applications for its customers.

The company's customers are majorly from the aerospace and defence sector.

Cochin Shipyard - Cochin Shipyard is one of the largest shipyard company in India. With its Miniratna status, the company boasts of prestigious projects and other defence ship orders from its clients.

Apart from defence shipbuilding, the company focuses on inland and coastal shipping along with the fishing industry and cruise and ferry market to diversify its product line across various sectors.

Hindustan Aeronautics (HAL) - Hindustan Aeronautics is a monopoly stock which faces limited competition from the private sector due to the high capital intensity and long gestation periods for developing manufacturing capabilities.

While competition from the private sector is likely to intensify in the long-term, the company's long-standing relationship with the Indian defence forces and R&D agencies, established manufacturing facilities, and manpower base will continue to be strong mitigating factors.

Bharat Forge - Bharat Forge is the largest forging company in India and one of the largest players in the world in terms of its installed capacity and revenues.

Bharat Forge has diversified its business model to defence and aerospace sectors as the auto sector is known for its cyclicality.

Bharat Electronics - Bharat Electronics is primarily engaged in the business of manufacturing radar, communication, and electronic warfare equipment. The company invests approximately 7.5% of its turnover in R&D, which is the highest among defence PSUs.

Paras Defence - Paras Defence is engaged in the designing, developing, manufacturing, and testing of a variety of defence and space engineering products and solutions. The company caters to segments such as defence & space optics, defence electronics, among others.

The company is also into drone manufacturing, which can be a key driver for its growth.

Mazagon Dock Shipbuilders - is primarily engaged in the business of building and repairing ships, submarines and other types of vessels.

The company's product line includes cargo ships, passenger ships, water tankers, fishing trawlers, destroyers, conventional submarines, and corvettes.

Apart from these, there's other companies such as Bharat Dynamics, Larsen & Toubro (L&T), Astra Microwave, Data Patterns, MTAR Technologies and Solar Industries, which are directly or indirectly engaged in the defence sector.

Here's a look at above companies with their crucial financials for fiscal 2021.

Company Sales growth (%) Profit growth (%) ROE (%) Debt to Equity (x) Dividend (Rs)
Avantel 49.65 42.54 26.01 0 4
Cochin Shipyard -17.64 -3.69 15.69 0.03 15.5
Hindustan Aeronautics 6.11 12.47 22.57 0 30
Bharat Forge -21.35 -124.73 -1.82 0.92 2
Bharat Electronics 8.8 15.44 19.59 0 4
Mazagon Dock -17.47 20.24 13.97 0 7.24
Bharat Dynamics -38.36 -51.81 9.82 0 7.35
Larsen & Toubro -1.81 19.26 18.2 1.76 36
Astra Microwave 37.17 -30.09 5.77 0.22 1.2
MTAR Tech 15.28 47.09 13.13 0.04 6
Solar Industries 12.44 3.37 19.47 0.5 6
Data Patterns 43.47 164.02 30.76 0.16 2
Data Source: Ace Equity

But here's the thing to keep in mind while hoping to get rich from the defense megatrend...

The business is lumpy, with the government as the key client in most cases. The receivable days are long. The orders depend on the budgetary allocations towards defense. There could be heavy debt on the balance sheet if the business is capital intensive.

The right way to play it is to look for companies working on defense technologies and IP (intellectual property) that would find applications not just in defense industry, but outside as well.

This will include the likes of communications, sensors, radars, imaging systems, advanced materials, unmanned vehicles, drones, and so on.

It also makes sense to look for companies where the market is not limited to India but are global with scalability in the business.

Why you should invest in defence stocks...

In the past decade, military spending has increased all over the world, indicating growing demand for defence equipment.

To capture this growing demand, the Indian government has opened up the defence sector to private firms.

It has also increased its spending to boost defence manufacturing, and many more efforts.

Even mutual funds have turned bullish on the sector.

India's third largest asset manager HDFC Mutual fund increased their exposure to defence stocks recently.

These stocks included Bharat Dynamics (increased holding by 2,35,800 shares), Bharat Electronics (increased holding by 2,000,000 shares), BEML, as well as HAL.

The fund house has also filed for a defence fund, that will be the first of its kind in the mutual fund industry.

All these factors indicate that the defence sector is set to grow rapidly over the next few years.

Earlier this month, lead smallcap analyst at Equitymaster Richa Agarwal recorded a video on YouTube channel discussing defence sector and the stocks to watch out from this space.

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Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

Yash Vora

Yash Vora is a financial writer with the Microcap Millionaires team at Equitymaster. He has followed the stock markets right from his early college days. So, Yash has a keen eye for the big market movers. His clear and crisp writeups offer sharp insights on market moving stocks, fund flows, economic data and IPOs. When not looking at stocks, Yash loves a game of table tennis or chess.

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