Weekly Musings – NFO Pick (HDFC Defence Fund)

29 May 2023 , 10:10 AM

We do recollect how, in 2021, the balanced advantage funds (BAF) NFOs by SBI Mutual Fund and ICICI Prudential Mutual Fund changed the face of that segment. A novel fund that is current open is the HDFC Defence Fund, which opened for NFO subscription on 19th May 2023 and the subscription to the NFO will close on 02nd June 2023. Of course, being an open ended fund, it would be available for NAV linked purchase and redemption once the allotment under the NFO is completed. 

However, the real issue here is the novelty of the story. Defence has long been a key area of focus for fund managers, but absence of supply had been a major challenge. Thanks to the defence in-sourcing polices of the government under the “Atma Nirbhar Bharat” program; defence companies have been able to boost exports and have overflowing order book positions. In the last one year, defence index has been one of the top performers in the market. Obviously, the time was ripe for the launch of a dedicated defence fund. That is exactly what HDFC Mutual Fund has done by pioneering the HDFC Defence Fund in India.

Where and how will the HDFC Defence Fund invest?

As the name suggests, the fund will invest in defence and defence related stocks with defence in-sourcing being the core theme. That means; the fund will look to leverage on the defence in-sourcing story in a big way.

• Broadly, the investment theme of the fund would be defence, aerospace, and allied sectors. In terms of the universe of stocks to invest in, the fund will invest in pure defence plays and in diversified plays that derive minimum 10% of revenues from defence related activities. So, while the NSE Nifty Defence Index will be the benchmark, the universe will be the list approved by the Society of Indian Defence Manufacturers (SIDM). The fund will be managed by Abhishek Poddar.

   

• Within defence, the fund will apply 3 broad themes, which will act as the triggers for investing by the fund. The first trigger pertains to companies that are contributing to the indigenization of defence manufacture. This will be within the dedicated list of the Indian defence department. The second theme will be very niche players in the defence space, that focus on R&D to enhance offerings. Lastly, it will also look at defence companies looking to scale up manufacturing volumes, probably for the PLI benefits.

   

• The HDFC Defence Fund will invest more than 80% corpus in listed defence plays getting more than 10% revenues from defence, at least. Its performance will be benchmarked to the Nifty Defence Index on TRI (total returns index) basis. Currently, the fund has an addressable market cap of $37 billion, which is a good universe to start with; with 60% large caps and 78% PSUs.

   

• The fund will carry an exit load of 1% for redemptions within 1 year. Just to give a picture of the opportunity matrix, the Nifty Defence Index has grown EPS at 17.5% CAGR, which is much higher than the 12.5% for Nifty 50 companies. The Nifty Defence Index has also delivered CAGR returns of 63.45 in last 3 years, so that is a lot of wealth creation that has happened. 

One concern is that the Defence Index is already trading at a P/E of nearly 27X. However, it would boil down to how quickly the earnings play catch up.

India defence story – A macro perspective

When the NFO is out, the big question is; what is so exciting about the theme? Let us look at some of the key macro drivers for the India defence story. Firstly, defence spending is on the rise globally and in India amidst rising geopolitical turmoil. The Russian invasion of Ukraine has given reasons for smaller nations to invest more in defence. The other big trend is that countries like India with manufacturing skills, have been looking at indigenizing the supply chains so that they can be more reliable in times of strife.

An important issue is on defence spending as a share of GDP. Since 1995, India’s defence spending as a share of GDP has been consistent around 2.5%. In contrast, the US spends up to 3.5% on defence, which is substantially larger in absolute terms. In absolute terms, Indian defence spending is just about one-third of China and one-tenth of the US. There is ample room to grow and scale up; with defence companies being the biggest beneficiaries. There is one interesting macro idea here. 

While India’s defence outlay has grown 9% CAGR in last 6 years, indigenous purchase of defence equipment grew at a CAGR of 18% in last 5 years. Of course, one can celebrate the 8-fold growth in defence exports in last 8 years, but that is on a small base. Overall, India’s indigenous defence purchases increased from 54% in 2019 to a possible 75% in FY24. However, this more pronounced in the army but much lower for the air force and Navy. So that is an area of opportunity. 

India defence story – The regulatory landscape

The big regulatory enabling feature for Indian defence sector has been the Atma Nirbhar Bharat plan of the Indian government. Government has gradually expanded the negative list of defence imports and farm out these orders to Indian companies. This will be the big boost for the defence stocks and for the HDFC Defence Fund. There are also other changes to the regulatory landscape. For instance, 74% FDI is already permitted in defence companies under the automatic route. In addition, there is the legislative enablement of 100% private participation, expansion of the negative list and focus on R&D driven business. 

What would actually impress the HDFC Defence Fund is that the government defence orders have been fair to the domestic PSE and private sector companies. Defence exports, drones, new age technologies would all be big opportunities for HDFC Defence Fund in the coming years. Of course, the big thrust of the HDFC Defence Fund will continue to be on indigenization. It looks like the macro landscape and the regulatory landscape are broadly in favour of defence stocks and that is material for the HDFC Defence Fund.

HDFC Defence Fund 101

What are the challenges that investors must be wary of in a defence fund? Broadly, there are 3 concerns that investors in the HDFC Defence Fund may have to contend with. Firstly, the Indian investable defence landscape is dominated by the PSE defence stocks. As much as some of the defence stocks have rallied, PSEs could have an overhang on valuations. 

Secondly, the defence index is already trading at around 27X price earnings ratio (P/E ratio). The question is whether it would really leave a lot of room for appreciation on the table, net of costs. Lastly, the 10% defence revenue condition will leave out a lot of diversified companies who still dominate defence orders in absolute terms. However, defence related investing is an idea whose time has come and the fund timing is bang on target.