What to expect from defense stocks going forward? Pratik Oswal answers

“Larger stocks will get more weightage. We believe that defense is one area where stock picking becomes extremely difficult as there are limited number of stocks,” says Prateek Oswal, Motilal Oswal AMC.

Talk to us a bit about the logic of defense funding because as I told you opinion is divided. Some say most of the price orders or all of these positives are already priced in, others say the story is structural. The data shows that stocks have indeed risen. You have created a defense fund. Talk to us about the rationale for that and how do you differentiate between undervalued and overvalued stocks in defense now?
Pratik Oswal: So, essentially we started a defense passive fund. It is called Motilal Oswal Nifty India Defense Index Fund. Hence, it is a passively managed fund. Essentially, you are looking at a stock portfolio of 15 stocks and that is market cap weighted.

Therefore, larger stocks will get more weightage. We believe that conservation is one area where stock picking becomes extremely difficult as there are very limited number of stocks.

A passive fund makes more sense because you only have 15 stocks that qualify for this index and we expect many more stocks to qualify for this index in the future.

But essentially, we believe, this is obviously a great long-term opportunity for many investors. As the house of Motilal Oswal, we are long on most of these stocks. We also have some in our active portfolio. And we believe that conservation as a theme has a very low percentage allocation to something like Nifty 50 or Nifty 500.

Many of our investors who want to take long-term bets on the sector can now do so through passively managed funds. In terms of what we see as AMC in the long term, I think there are a lot of growth levers in this space.

We believe that is a very big theme as India is becoming more export oriented. Today, only IT and Pharma are major exports. But in the next decade, we believe that manufacturing can also happen and defense is also a part of it.

We already export to 75 different countries, exports have increased 3.5 times and we believe that the government’s mandate is to reduce imports by about 70% in the next five to six years, so we believe that exports are a big opportunity, import substitution. A great opportunity.

And even our defense budget itself, while the world grows at 3%, our defense budget is growing at about 10% per year and that’s 13% of our overall budget for the year. So, it’s a very hard-hitting, very big item, and we believe a lot of that will come into our own companies as we move forward from here.

What we are actually seeing in terms of global spending is that India may be the fourth largest when it comes to defense spending, but we are still far behind the US and China, where the average defense spending per year is over $900 billion for the US.
Pratik Oswal: Overall, I think if we look at global spending on defense it is currently about $2.4 trillion. It is growing at a rate of about 3%. What we have seen is because of the recent wars that are currently going on in the Middle East, tensions between Russia and Ukraine and also in other parts of the world, defense spending, defense budgets have increased globally.

I talked about the 3% move. Last year, the overall budget increased by around 20% globally in the 2023 calendar year. So, what we are seeing is that even globally many countries are now spending increasing amounts on defence, I think this is largely due to geopolitical alliances and I think this will also be good for Indian companies who Going there and also getting these orders to the manufacturer.

You make a very interesting point. Let’s scratch a little further. You’re saying that so far, yes, stocks may have gone up, some of them, a clutch of them, half a dozen of them, but you see the opportunity for protection getting wider and bigger and more obvious. Names, new categories are also being created as they are long term. Can you talk to us a bit more about that? Are there some companies that you expect to become index constituents over the next few years?
Pratik Oswal: Yes, so the way the index is structured, it’s actually a few largecap names and a lot of smallcap names. I think 60-65% of the index will be large and midcap and around 35% will be smallcap.

So, the opportunity is on both sides. You obviously have smallcap names that are getting a very healthy order book. You also have many more companies that will be eligible for this index in the next few years.

So, if you look at the criteria for screening, what really qualifies a company in this index are two things. They are basically companies that are part of SIDM, which is the Society of Indian Defense Manufacturers, so they should be a part of that.

And about 10% of the revenue has to come from defence. So, that means you can only allow serious, I would say manufacturers who are serious, who have the majority of revenue from the space to qualify, and we believe a lot of companies are already in the space, but maybe their revenue component. Not meeting the criteria we hope to see in the next few years.

I think a few weeks ago a minister announced that we want our defense exports to be above 50,000 crore by the end of the decade in about five years, so I think that is also a big driver for this index.
I also agree with the fact that order books are very strong. And order books, obviously, don’t affect your P&L and balance sheet.

The only way you are able to make the order book a reality, which is the P&L and the balance sheet, is to expand capacity. So, I think the ability for these companies to really go out there and make sure that their production capabilities are expanded to meet this order book will really drive their stock prices in the future.

If you just look at the profit numbers, yes, I agree that the cash flow numbers may not be that high, but if you look at the overall profitability, I think most of these companies have doubled or tripled their profits in the last three years. Four years time.

So, I think there’s a lot of growth in the index that’s being priced in and that’s why you’re seeing valuations where they are right now. But we believe that this may not really be a short-term thing, but a much larger structural type of long-term growth story.

But a lot of credit goes to the government as well, because you have also mentioned the kind of emphasis that you have seen on the entire defense sector. The question is, now, with a coalition government, do you think we could see the compulsions change, the decision-making capacity change, maybe even the priorities in the defense sector change and that could change the dynamics of the whole sector?
Pratik Oswal: So, that was a risk factor and that was one of the reasons why we delayed the launch, because honestly the customers in this area are just one person. It is the Government of India and we believe that there needs to be a lot of clarity before we go there and start such a fund.

And what was very, I would say, encouraging is that the communication and what we heard from different departments and different kinds of ministries is that it will continue to I think have the same amount of pressure that we’ve seen in defense. The last three years will continue in the future as well.

So, what we have seen is that the landscape has changed in this sector as well, where there was a lot of bureaucracy and red tape, a lot of hurdles when it comes to local procurement, which has also eased under this government.

Second is obviously more self-reliance in this index and third is forex, which most people don’t talk about is this sector, actually we were net importers of defense equipment.

We have a very large import bill, perhaps one of the highest among all categories, and there is an opportunity if these imports can actually become net exports in the next decade.

As you know forex is also a big part of the government’s agenda when it comes to currency stabilization.
They have done very well in the last two-three years. So, we believe that the communication has been very consistent and if you just look at the share prices of these companies, it shows that the government is moving in the same way.