Look beyond India to partake a slice of lucrative defence sector

Representative Image

Recent events over the past couple of months again highlighted the defence and security challenges that India face. According to a report by the World Economic Forum, India has a defence spending of around $63 billion. The same report highlights that global defence spending is $1.7 trillion. According to a News18 report, India has been the top arms importer across the globe for the last eight years, except this year. It is estimated that India imports about 60-65 percent of its arms requirements.

Focusing on the Indian defence spending, the question as an investor is: What is the best way to capitalise on this large expenditure?

Since India imports a majority of its arms requirements, it is clear that it is best to look outside the Indian equity markets for taking proper exposure to the defence, aerospace and security sector.

Just focusing on the familiar developed markets of US, EU and UK, one can see 42 companies with a market cap of $1 billion or more listed in the defence and aerospace sectors. There are numerous other companies that also contribute to defence and security but are listed under some other industry categories.

One could look at Dassault Aviation SA of France, which makes the Mirage 2000 and Rafale fighter jets. Or, one could look at Lockheed Martin that manufactures F-16 and F-21 fighter jets. Similarly, there is Boeing, the makers of F/A-18E/F Super Hornets, or SAAB, the makers of Gripen. Besides, these companies make several other defence and security products.

Or one could look at Aerovironment that specialises in Unmanned Aircraft Systems (Drones), such as, Raven and Wasp. Besides, it also offers tactical missile systems. Then there is the Cubic Corporation that specialises in C4ISR (Command, Control, Communication, Computer, Intelligence, Surveillance, and Reconnaissance) systems.

The whole theme of defence and security is rich with possibilities and is an established and fast-evolving theme that has numerous companies in the global markets offering products, services and solutions.

Of course, as an “intelligent investor” (on the lines of Benjamin Graham) one cannot just jump on a theme and buy companies that look interesting. An investor will have a necessary condition that the company operates and benefits from the targeted theme.

But sufficient conditions before investing in a company will be a stable business model, strong balance sheet, and a sustainable competitive advantage. These factors would make it a supernormal company. Supernormal companies generate supernormal profits or excess returns on their capital.

However, as an intelligent investor an investment cannot be made unless these supernormal companies are available at a large discount to intrinsic value, i.e. they are available at supernormal prices.

Further, buying a handful of companies, say 3-5, with exposure to the theme will not make sense. This will become a very risky portfolio. Ideally, one should have around 20-25 companies in a portfolio with limits on the maximum allocation to a single company. If one can create such a portfolio then it is likely to not only have low risk, but also a potential for high returns.

Most people do not invest globally since they find it unfamiliar. However, once they start becoming aware of the opportunities available globally and start becoming familiar with them through research, the discomfort of the unknown will reduce, and global companies will start becoming a natural opportunity set for an equity investor.

Remember that not only are you getting exposure to different economies, countries, currencies, but also to different sectors and themes. Thus, the defense theme discussed above could just one among many themes in your international portfolio of stocks/funds. Thus your portfolio is becoming more diverse and hence more robust and anti-fragile. This means it is a lower risk portfolio.

Further, the chances of enhanced returns have increased, too, since the portfolio has exposure to fast-growing themes or significantly discounted companies or both. This creates the possibility of coming closer to the holy grail of investing with lower risks and for higher returns at the same time.