Defence sector rally may persist. But not for the reasons you expect

Is the party over for defence stocks? There are signs that suggest this. The one-way rally of these shares recently came to a stuttering halt, with stocks like Mazagon Dock, Garden Reach Shipbuilders and Paras Defence correcting almost 20 to 30 per cent from their July highs. Then, there is the HDFC Defence Fund, India's first defence-only fund, pulling brakes on accepting fresh investments amid growing concerns of overheated valuations.

The major culprit, though, is the slowdown in India's defence expenditure that has always been the backbone of the sector's gains. The FY25 budget allocation to defence rose by a small 4.7 per cent. To put this in context, it had jumped 13 per cent in 2023. Clearly, the fact that India's defence spending is probably hitting the wall has cooled off market enthusiasm. After all, it was the government support for indigenisation that had spurred the Nifty Defence Index over 2 times in the last one year alone (as of July 31, 2024).

So, should this mean that the sector be discounted so easily? Not quite. While the sector's fortunes have long been tied with government support, this also paves way for the next opportunity, which is exports. As domestic spending wanes, business from overseas is expected to be the new growth trigger for Indian defence players. Here's how:

• Global conflicts: The many global conflicts, from Russia-Ukraine, Israel-Palestine to China-Taiwan near home, have pushed countries to step up their military muscle. For instance, Europe is looking to increase its defence expenditure from 1.2-1.3 per cent of its GDP during 2013-22 to around 2 per cent in coming years. Notably, about 78 per cent of Europe's defence procurements in 2023 were imported, presenting a large opportunity.
  This is already playing out with Indian companies exporting defence equipment to Armenia, which is in a conflict with Azerbaijan. During 2022-23, India accounted for around 10 per cent of Armenia's total defence imports.
  
• Weaning off the domestic focus: Many Indian defence players such as Hindustan Aeronautics (HAL) and Bharat Electronics (BEL) are increasingly focusing on fulfilling their export orders. With a combined FY24 revenue of Rs 50,000 crore on a total order book of Rs 1.7 lakh crore, the duo has solid revenue visibility. Moreover, HAL is prioritising domestic orders to clear the way for more export opportunities. BEL's order book includes export orders from international giants like Airbus and Thales. BEL recently secured another large export order worth €25.75 million. Another company Bharat Forge reported that over 80 per cent of its defence orders are now from overseas. This demonstrates India's growing appeal in the global defence market.

Investors' corner

The recent breather in shares of defence companies is a reminder that good times don't always last. In fact, this might be the time for investors to take a more measured and selective investment approach. As global defence spending remains buoyant, investors should look for companies that are actively looking into exports, and those with lower reliance on domestic government contracts. This is where the next big opportunity is.

Also read: Nvidia's Midas touch has turned this Indian stock to gold