Talk to us a little bit about the rationale of the defence fund because as I told you that there opinion is divided. Some are saying that bulk of the price orders or all these positives are already priced in, others say the story is structural. The data shows the stocks have run up indeed. You have raised a defence fund. Talk to us about the rationale of that and how are you differentiating between low valued and high valued stocks in defence now?
Pratik Oswal: So, essentially we launched a defence passive fund. It is called the Motilal Oswal Nifty India Defence Index Fund. So, it is a passively managed fund. Essentially, you are looking at a stock portfolio of 15 stocks and it is market cap weighted. So, the bigger stocks will get a higher weightage. We believe that defence is a space where stock picking becomes extremely difficult because there is so limited number of stocks.
A passive fund makes more sense because you have only 15 stocks that sort of qualify for this index and we hope to have a lot more stocks that qualify for this index in the future. But essentially, we believe that, this is obviously a great long-term opportunity for a lot of investors. As a house at Motilal Oswal, we are long on most of these stocks. We have them in some of our active portfolios as well. And we believe that defence as a theme has a very small percentage allocation towards something like a Nifty 50 or a Nifty 500.
A lot of our investors who want to take long-term bets on the sector can now do through a passively managed fund. In terms of long term what do we see as an AMC, I think there are a lot of growth levers in this space.
We believe it is a very large theme as India becomes more export oriented. Today, only IT and pharma tends to be big exports. But over the next decade, we believe manufacturing can be out there as well and defence is a part of that is also large.
We already export to 75 different countries, exports are up 3.5 times and we believe the government’s mandate is to reduce imports by around 70% in the next five to six years’ time, so we believe that exports is a big opportunity, import substitution is a big opportunity.
And also our defence budget itself, while the world grows at 3%, our defence budget is growing by about 10% every year and it is already 13% of our overall budget for the year. So, it is a very hard hitting, very big item and we believe a lot of it will come to our own companies as we scale up from here.
What is it exactly that we are looking at in terms of global spends because while India may be the fourth biggest when it comes to the defence spends, but we are still way far behind from a US and China, wherein the average defence spending per year for US is over $900 billion.
Pratik Oswal: Overall, I think if we look at global spend in defence, it is currently at about $2.4 trillion. It is growing at about 3%. What we have seen is because of the recent wars that are currently ongoing in the Middle East, in between Russia and Ukraine and also tensions happening in other parts of the world, defence spending, defence budgets have increased globally.
I talked about the 3% move. Last year, 2023 calendar year, overall budgets have increased by about 20% globally. So, what we are seeing is that globally also a lot of countries are now spending an increasing amount on defence, I think this is because of geopolitical connections mostly and I think this will also augur well for Indian companies who are going out there and also getting these mandates to the manufacturer.
You are making a very interesting point. Let us scratch a little further. You are saying that up till now, yes, the stocks may have run up, some of them, a clutch of them, half a dozen of them, but you see the opportunity of defence widen and the big becoming bigger and beyond the most obvious names, new categories also getting created because it is a long term. Can you talk to us a little more about it? Some of the companies you expect to become index components in the next few years, is it?
Pratik Oswal: Yes, so the way the index is structured, it is actually a few largecap names and a lot of smallcap names. I think 60-65% of the index will be large and midcap and about 35% will be smallcaps.
So, the opportunity is in both sides. You have obviously smallcap names that are getting very healthy order books. You also have a lot more companies that will qualify for this index over the next few years.
So, if you look at the criteria for screening, what really qualifies for a company to be in this index, it is two things. It is basically companies that are part form of SIDM, which is the Society of Indian Defence Manufacturers, so they have to be a part of that.
And about 10% of the revenues have to come from defence. So, what that means is that you only can allow serious, I would say manufacturers who are serious, who have a bulk of the revenues coming from the space to qualify and we believe a lot of companies are already in the space, but maybe their revenue component is not meeting the criteria which we will hopefully see over the next sort of few years’ time.
I think a couple of weeks back one of the ministers announced that we want our defence exports to be upwards of 50,000 crore by the end of the decade in about five years’ time, so I think that also is a big driver for this index.
I also agree with the fact that order books are very strong. And order books, obviously, do not affect your P&L and balance sheet.
The only way you are able to make order books into reality, which is P&L and balance sheet, is to expand capacity. So, I think the ability for these companies to really go out there and make sure that their manufacturing capabilities are expanded to cater to these order books will really determine their stock prices in the future.
If you just look at the profit numbers, yes, I do agree cash flow numbers may not be as high, but if you look at the overall profitability, I think most of these companies have doubled or tripled their profits just in the last three to four years’ time.
So, I think there is a lot of growth that is being priced in the index and that is why you are looking at valuations to be where they are right now. But we believe that this really may not be a short-term thing, but a very big structural sort of growth story in the long term.
But a lot of credit, as well, goes to the government, as you as well alluded to the kind of thrust that we have seen on the entire defence space. The question is, now, with the coalition government, do you think that we could see compulsions changing, decision-making changing, maybe even priorities for the defence space changing and that could alter the dynamics of the sector as a whole?
Pratik Oswal: So, that was a risk factor and that was one of the reasons why we sort of delayed the launch, because honestly this sector the customers is just one person. It is the Government of India and we believe that there needs to be a lot of clarity before we go out there and launch this sort of a fund.
And what was very, I would say, encouraging is that the communication and from what we heard from various departments and various sort of ministries is that there will be ongoing I think the same amount of push that we have seen in defence that has been in the last three years will continue in the future as well.
So, what we have seen is that this sector has had also a change in landscape, where there was a lot of bureaucracy and red tape, there was a lot of hurdles when it comes to domestic procurement, which is also eased under this government.
Second is obviously more self-reliance in this index and also third is forex, which most people do not talk about is that this sector is, actually we were net importers of defence equipment.
We have a very large import bill, probably one of the highest import bills across all categories and there is an opportunity if this import can become actually net exports over the next decade.
As you know forex is also a big part of the government’s agenda when it comes to currency sort of stabilisation.
They have done a very good job in the last two or three years’ time. So, we believe that the communication has been very consistent and if you just look at the stock prices of these companies, it shows that the government continues to progress in the same way.
