FY23 belonged to defence and PSU banks

Big sectoral gainers of FY23

If one looks back at the sectors that stood out in FY23, two sectors stand out. The biggest gainer of FY23 were defence stocks, followed by PSU Banking stocks. It is not often that you see PSU banking or defence among the top gainers. In fact, they came as a whiff of fresh air in a year when IT and digital stocks were in the red. The table captures the gist of FY23.

It is clear that defence stocks, that were quiet for a long time, are finally starting to see stock market outperformance. With 48.6% annual returns, defence leads FY23, followed by PSU banks at 36.3% returns in the year. Let us look at what went so right for defence stocks.

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What explains the FY23 rally in defence stocks?

The defence sector gave 48.6% returns on a price basis and, if dividends are added, total returns in FY23 were 50.5%. Most key defence stocks more than doubled from their lows in FY23. This includes Hindustan Aeronautics, Bharat Dynamics, Mazagon Dock Shipbuilders, Cochin Shipyards and Garden Reach Shipbuilders. Mazagon has been a 4-bagger in FY23. What was the big trigger? Broadly, 4 factors have supported the surge in defence stocks in FY23.

The first is simmering geopolitical tensions globally. Russia has intensified its war with Ukraine while China has been sabre rattling in the South China Sea. With rising instability in India’s neighbours, the government has to spend more on sprucing up defence. The second factor was the massive military modernization program undertaken by the government. After a long time, the focus of defence spending is shifting from routine expenses to genuine warfare modernization.

The third factor supporting the rally in defence stocks is the decision to substantially farm out orders to Indian companies. As part of the Make in India initiative, the Defence Acquisition Council (DAC) recently approved defence projects worth Rs70,500 crore, most of which will go to domestic players. But, what is really exciting the markets is the huge potential for defence exports. From Rs1,500 crore in 2017, defence exports have surged to Rs16,000 crore ($2 billion) in just 6 years. But the bigger kicker is that the defence exports are expected to grow 5-fold to $10 billion by 2030. That is the big story that is keeping investors interested in defence stocks.

What has gone right for PSU banks?

For a long time, the PSU banks embodied everything that was wrong with Indian banking. They had low ROA, high levels of gross NPAs, low capital adequacy and net interest margins (NIMs) substantially lower than private banks. The last one year has seen a sea change. The combination of capital infusion, merger of PSU banks into manageable units and the focus on efficiency and profitability has helped. But, in a way, the rising rates also came as a blessing in disguise for PSU banks.

While PSU banks saw a pick-up in credit demand and improved ROA, the real story was in the spreads. The 250 bps rate hike by the RBI seamlessly translated into higher lending rates. However, deposit rates normally catch up with a lag. During this interim phase, PSU banks are seeing record profits and NIMs consistently above 3%. To add to all this, is the valuation story. Nifty private bank index trades at a P/E of above 16X, while the Nifty PSU bank index trades at a P/E of below 9x. That is giving adequate margin of safety to investors, which explains the surge in interest.

Will this story continue? PSU banks may be hit by the global banking crisis, but the impact is likely to be marginal. But the big story for FY24 may continue to be defence.