Are Defense Stocks Overhyped? The Risk Behind 50x Gains 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

A friend sent me a message on WhatsApp on how Mazagon Dock Shipbuilders Ltd has multiplied investor wealth by almost 50x over the last 5 years. Yes, that's right. A 59-bagger from a humble shipbuilding company.

I am sure Mazagon Dock is not the only defense stock that has sent the cash registers ringing. There are others as well that have earned the famous 'multibagger' tag.

However, is this hype around defense stock for real? What if this hype is hiding some serious risks?

Now, please don't get me wrong. I am also quite bullish on defense. There are strong factors like the government support, explosive growth in exports and modernisation plans that support the defense story.

However, while everyone's chasing defense stocks, here's why you might want to think twice before jumping in.

First though, let's get the bullish case out of the way.

There's no doubt that irrespective of the Government at the centre, defense has always been a top priority.

This time though, initiatives like Make in India and allocation of defense budget to R&D companies and startups have also been thrown into the mix.

More than 30,000 crores have been specifically allocated for R&D and the creation of infrastructural assets related to defense.

Then there is the explosive export growth the sector has seen in recent years.

Just to put things in perspective, defense exports surged from Rs 4,600 crores in FY18 to Rs 23,600 crores in FY25, a surge of more than 5x in 7 years.

At this rate, it won't be difficult to reach our target of Rs 50,000 crore worth of exports by FY30.

Another proof that defense is indeed hot, comes from the bulging order books of some of the big defense PSUs.

Sample this. Hindustan Aeronautics is sitting on an order book of more than 90,000 crores. This is almost 3 times its current revenues.

Bharat Electronics Ltd has orderbook to revenues of more than 4x.

Mazagon Dock Shipbuilders similar. An order book to revenue of more than 4x.

Bharat Dynamics, the manufacturer of missiles and defense systems has an orderbook to revenue of almost 9x.

Well, there are other players as well where the order book is bulging with orders and a lot more could be in the offing.

Hence, it is quite evident that the defense companies could see their earnings grow at a good rate going forward.

However, investing in these stocks merely on the expectations of good earnings growth could mean taking a very shallow view. You don't invest in a stock just because it has good growth potential.

Yes, earnings growth is important. But what is perhaps more important is whether the growth is already reflecting in the current share prices of these companies.

One good way of finding this out is comparing their current valuations with the valuations they have historically commanded over a 5-year to 10-year period.

You see, historically, most defense PSUs traded at a PE between 15x-25x on average. And good quality private companies commanded a PE of 25x-35x.

It won't be wrong to say that valuations for almost all the defense stocks are running almost 2x higher than in the past.

In other words, if investors were willing to pay Rs 25 for every rupee of profits earned by defense companies, they are now willing to pay Rs 50, a jump of 100%.

In some cases, the valuation multiples are as high as 3x the historical multiples.

What do these high PE multiples tell you? Well, they tell you two things.

One, investors have realised that the growth trajectory of defense companies has changed. They are no longer the slow, boring stocks of yesterday. Defense is now a high growth and an exciting industry and hence Mr Market is rewarding these stocks with higher PE multiples.

The other thing that these high PE multiples tell us is that high PE multiples bring high expectations with them. And if those expectations are not met then there could be a serious correction in the stock price.

We all got a taste of this when most defense stocks corrected significantly from the 2024 highs before the recent pullback. Data reveals that in the recent correction, defense stocks fell 30% on average from their 2024 peak prices. In fact, some stocks even fell as much as 50% from their 2024 highs, in effect, losing half their market capitalisation in just a few months.

High valuations, execution delays, profit book and concerns over Government order timelines, were the key reasons behind the fall.

Hence, in conclusion, there's no doubt that the Indian defense story is here to stay and can only get stronger from here.

However, buying defense stocks blindly before considering the business model and valuations, may not be the right way to play this highly promising theme.

Waiting for corrections of 20%-30% from the top could allow you to enter at reasonable valuations and ensure downside protection.

Besides, I also recommend diversifying across sub-sectors like aerospace, electronics and shipbuilding and continuous monitoring of financial health.

Summing it all together, the defense space is no doubt exciting. However, instead of chasing the hype blindly, it will be a good idea to wait for better entry points, focus on fundamentally strong companies and ensure sufficient diversification for better risk management.

I will see you again in the next session, good bye and happy investing.