Will defence stocks fire up or fizzle out?

Is there enough merit in placing your bet on this theme? By all counts, the government seems to be putting its money where its mouth is. The Centre put its plan in motion last year when it hiked the FDI limit in defence to 49% from 26%. The sector got a huge boost when the Department of Industrial Policy & Promotion (DIPP) granted industrial licence proposals to several companies which were stuck since 2012. Large corporate houses including Tata, Reliance and Mahindra bagged licences for defence manufacturing. Pipavav Defence is said to have applied for the manufacture of tanks, warships, frigates and submarine missiles while Punj Lloyd applied for manufacturing aircraft, unmanned aerial vehicles and aero engines. Another positive for the sector came much earlier under the previous regime with the introduction of the ‘offset clause’ in defence. Under the clause, companies receiving a defence-related contract will have to source nearly 30% of the contract in India. With the government inviting foreign players to participate in the Make in India initiative, large contracts are expected to come to domestic manufacturers. Dipen Shah, Head, Private Client Group Research, Kotak Securities, says, “We are definitely positive on this segment not just because of the rhetoric but also owing to visible traction in defence orders.”

Pick wisely

While the opportunity exists, investors must keep in mind that it is still an evolving segment. Pankaj Pandey, Head, Research, ICICI Direct, says, “The opportunity could play out over the next 5-7 years. But it is too early to pass a verdict as the dynamics are not clear yet.” Which stocks can investors consider? Pandey believes that the listed companies in this space are still not completely representative of the opportunities in the sector and not all of the companies are likely to benefit from the expected growth. This implies that investors will have to pick carefully, and not place blind bets in the belief that the rising tide will lift all boats. Shah makes a case for investing in firms with proven capabilities. “Investors will need to take stock of each company’s capabilities. Established companies in this space are likely to be at an advantage due to existing capabilities and ability to scale up faster.” Investors should note that the current optimism around these stocks has taken valuations to lofty heights. Ashok Leyland, Bharat Forge and Dynamatic Technologies are trading between 40-50 times trailing 12 month earnings. Stretched valuations provide little comfort. For those of you looking to ride the expected wave, be ready to remain invested for the long haul.