Outlook on Defence Stocks: Too expensive or a strategic investment? Rohit Sarin of Client Associates answers

In a recent note, Rohit Sarin, Co-Founder of Client Associates, highlighted the notable momentum gained by India’s defence sector over the past five years. Supported by government initiatives like “Make in India” and a growing emphasis on self-reliance, the sector has experienced a significant rise in stock prices. The critical question arises: Are these defence stocks now too expensive, or do they still offer promise as a strategic investment?

Sectoral Overview

India’s defence sector, while increasingly vital, continues to rely significantly on international partners such as the USA, Russia, Israel, and France. This sector includes aerospace, land systems, and naval systems, with companies like Hindustan Aeronautics Limited (HAL), Bharat Electronics Limited (BEL), Bharat Dynamics Limited (BDL), Cochin Shipyard, and Mazagon Dock Shipbuilders having a notable market presence. Their performance has been bolstered by government initiatives and policies aimed at improving the domestic defence sector, stated the expert.

Just in the last 1 year, Cochin Shipyard zoomed 625 percent and Mazagon Dock surged 148 percent. HAL also soared 150 percent while BEL and BDL rallied 138 percent and 135 percent, respectively.

For instance, Sarin noted that the Institute for Defence Studies and Analyses (IDSA) highlighted a substantial increase in capital allocations for modernising and developing infrastructure for the defence services in the fiscal year 2023-24. The allocation rose to ₹1,62,600 crore, a 6.7 percent increase from the previous year’s ₹1,52,369.61 crore. This budgetary support underscores the government’s commitment to strengthening the defence sector, which in turn has buoyed investor sentiment.

Additionally, government initiatives like “Make in India” and “Atmanirbhar Bharat” have been crucial in supporting the defence sector, noted the expert. These initiatives aim to boost domestic manufacturing and reduce dependency on imports. For instance, the Defence Procurement Procedure (DPP) 2020 emphasises indigenisation and encourages procurement from domestic vendors. The creation of defence corridors in Uttar Pradesh and Tamil Nadu is another significant step towards building a robust domestic defence manufacturing base, he added.

Investment Strategy

Despite the budgetary support, Sarin advises investors to adopt a balanced approach. Compared to historical performance, the current price-to-earnings (P/E) ratios of defence stocks appear elevated, raising concerns about whether these stocks are overpriced. High valuations often come with the risk of market corrections, particularly if companies fail to meet the high expectations set by investors. While reliance on government contracts provides long-term revenue streams and stability, any adverse changes in government policy can significantly impact these stocks’ performance, he cautioned.

Sarin recommends a balanced investment strategy known as Growth at Reasonable Price (GARP). This approach involves identifying stocks that offer growth potential without being overpriced. Applying GARP to the defence sector means looking for companies that balance growth prospects with reasonable valuations. The strategic importance placed on the defence sector by the government suggests that there are growth opportunities that are not excessively priced.

The long-term growth potential of defence companies is underscored by their pivotal role in national security and the increasing demand for advanced defence equipment, said Sarin. Technological advancements in missile systems, fighter jets, submarines, and unmanned aerial vehicles position these companies at the forefront of innovation. For instance, Bharat Dynamics has emerged as a leading manufacturer of guided missile systems, while HAL continues to innovate in aerospace technologies with products like the Light Combat Aircraft (LCA) and various helicopters, he stated.

The geopolitical landscape also necessitates a robust defence sector. Border tensions and the need for modern defence capabilities require a steady demand for defence equipment, making these stocks less susceptible to economic downturns. Furthermore, international defence agreements and partnerships open new markets and opportunities for Indian defence manufacturers, further mentioned the expert.

In conclusion, Sarin advised that investors must consider economic factors such as inflation, currency fluctuations, and global economic conditions, as these can impact defence budgets and spending. While the high valuations of defence stocks may raise concerns about them being overpriced, the sector’s strategic importance and long-term growth potential warrant careful consideration, he said.

Adopting a balanced approach like Growth at Reasonable Price (GARP), which seeks growth at a reasonable price, ensures that investments are made in companies offering sustainable growth potential without being overpriced. By staying informed and vigilant, investors can navigate the complexities of the defence sector and make well-considered decisions that align with their financial goals and risk appetite, suggested the market expert.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.