The defense sector has been in action for the past few days as stocks like BDL, HAL, and BEL have rallied sharply.
BDL in particular is up 120% YTD while HAL is up 43% YTD while BEL is up 23% YTD. Globally, the shares of defense and aerospace companies have rallied. Lockheed Martin is up sharply and at ATHs along with General Dynamics and the likes.
The iShares U.S. Aerospace & Defense ETF, the largest of its kind with 33 equity holdings, has risen more than 12% since Russian troops invaded Ukraine on February 24.
Let’s delve more into the Defence theme, the factors driving the stocks, and is it the right time to enter defense sector in India.
Effects Of the Russia-Ukraine war On Defense Sector
With the Russia-Ukraine war still raging, it will be prudent for world economies to reconsider the effects of the war on global defense budgets. Global defense expenditure is expected to shoot up exponentially. Recently, Germany said its defense budget would now make up over 2% of its GDP from 1.5%; Japan also plans to increase its 2022 defense budget to more than 1% of GDP for the first time since the 1960s.
So overall, the conflict is likely to encourage more spending, which will lift the valuations of these stocks. In a rising defense budget environment, defense stock multiples should typically rise.
This is going to impact Indian defense expenditure too and hence Indian government will have no choice but to increase its defense expenditure. India for its part is considered to be a geopolitical hotspot due to its border tensions with China in the north and tense relationships with Pakistan in the west.
So let’s look at some of the factors back home driving the stock in this sector.
India stands to benefit from increasing defense capital outlay as well as an emphasis on indigenisation of defense equipment, led by the ‘Make in India’ and ‘Atmanirbhar Bharat’ initiatives.
India’s military expenditure had seen a sharp rise to 2.88 percent of GDP in 2020 due to its escalating tensions with China. Before that, the military expenditure as a percentage of GDP had been on a downtrend since 2009.
With Government emphasis on defense indigenization, domestic defense equipment companies stand to gain.
To encourage domestic defense manufacturing, the Government over the last couple of years has taken multiple steps like
- Increasing the FDI limit to 74% from 49%
- Import Embargo of 209 defense items
- increasing the requirement of indigenous content by 10% and
- Exclusive reservations for Indian vendors in a few categories to protect domestic manufacturers.
So this was on the policy front, now some interesting facts-
- India is the third-largest spender on military goods globally, posting a spending CAGR of 8.5% over CY00-20 to USD 72.8 bn in CY20 (the US is No 1, followed by China).
- India, for the first time in the past two decades, has seen military expenditure CAGR rising by 8.1% over CY16-19, surpassing China’s 6.6%.
So where does the opportunity lies
- India’s Armed Forces need next-generation technology and equipment.
- There is an estimated Rs 8-10 an opportunity for PSU and private companies over the next 10-12 years.
- India is the largest importer at USD 2.8 bn in CY20 or 12% of total imports. The US is the largest exporter of defense equipment at USD 9.4bn in CY20.
- Local share at 59% and imports at 41% over FY11-21.
- Domestic procurement at 63% of the total defense capital budget in FY22BE
- The Indian government has set an ambitious defense production target of US$25 billion by 2025 (including US$5 billion from exports by 2025).
We are positive on the Defence and allied sector companies such as Aerospace, Explosives, Ship Building, industries due to
- Government focus on self-reliance on defense needs
- High imports of military goods provide a huge opportunity for local manufacturing.
- India is targeting to export USD 5 bn worth of defense goods by FY25 from the current levels of USD 1.1bn in FY21.
- Can take exposure to India’s defense sector story by buying shares of listed companies present in this sector.
- We are positive BDL, HAL, BEL, Paras Defence, Garden Reach Ship Builders
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