Defence, PSU stocks outperform as budget narratives gain traction

“Sentiment had already improved after the latest EU-India free trade agreement announcement,” said Siddhartha Khemka, head of retail research at Motilal Oswal Financial Services. “The recent market correction created further tactical pre-budget opportunities in select defence and public sector names.”

Oil and gas stocks also gained on firmer crude prices and attractive valuations after a phase of under-performance, lending support to the broader PSU space, said Devarsh Vakil, head of prime research at HDFC Securities.

Fiscal relevance

Defence and PSU stocks have outperformed the broader market on expectations of higher defence spending in FY27 and the growing fiscal importance of state-owned enterprises.

The PSUs sit at the centre of the government’s fiscal calculus. Beyond executing infrastructure and energy investments, they are a key source of non-tax revenue through dividends and surplus transfers. For FY26, the government projected a 25% year-on-year rise in dividends and profits from central public sector companies to ₹69,000 crore. That underscores their role in supporting the fiscal glide path, as the government has foregone revenues through goods and services tax (GST) rationalization and income tax relief even as capital and defence spending continues to rise.

Between FY21 and FY26, India’s defence budget expanded at a compound annual growth rate of nearly 18%, rising from about ₹3 trillion to ₹6.8 trillion. The sustained ramp-up reflects the government’s post-pandemic push to strengthen domestic manufacturing and security spending in a more fragile geopolitical environment. Last year’s India-Pakistan tensions, following the terror attack in Pahalgam and India’s subsequent military response, have only reinforced that priority.

Defence and PSU stocks have, therefore, commanded outsized attention on Dalal Street, helping them buck selling pressure in the broader market.

Budget euphoria

Ahead of the Union budget presentation on 1 February, the Nifty 50 has fallen 3% over the past month. In contrast, the Nifty Defence index is up 5%, while the Nifty PSE index has gained 3% during the same period.

Even so, the rally remains selective. About 45% of defence stocks and 60% of PSU stocks have lost value over the past month, Mint’s analysis shows.

Gains have been concentrated in a few large players. Oil India, ONGC, Bharat Electronics and Coal India are among the consistent outperformers, with Oil India jumping nearly 27% in a month. This underscores the absence of a broad-based sectoral upswing even as budget-linked narratives gain traction.

Valuations partly explain this restraint. The Nifty 50 currently trades at an 18% premium to its long-term average, while the Nifty Defence and Nifty PSE indices command a steeper 26% premium. Beneath the index level, the valuation stretch is widespread. Nearly 70% of defence stocks and around 80% of PSU stocks are trading above their long-term averages.

Despite improving risk appetite, rich valuations and modest earnings growth may cap further budget-day upside in these sectors, experts said.

Great expectations

Historically, Budget expectations have rarely translated into sustained price action. Over the past five years, defence and PSU stocks have delivered mixed returns in the month preceding the budget, with sentiment typically neutral to mildly cautious, Mint’s analysis shows.

Against this backdrop, defence stocks have rallied ahead of the budget as markets price in a sharper step-up in defence spending. Brokerages are pencilling in around 13-15% year-on-year rise in defence allocations in FY27, even as some economists remain more conservative.

QuantEco expects defence allocations to rise by 10-10.5%, broadly in line with nominal GDP growth, pointing to continuity rather than acceleration. Budgeted defence expenditure grew 9.5% in FY26 and 5% in FY25. “Anything meaningfully below 15% could disappoint the market,” Vakil said.

Vakil expects the budget to focus on strengthening domestic defence manufacturing and exports. “The industry is looking for PLI (production-linked incentive) support for drone manufacturing, smoother customs procedures and tariff rationalization,” he said. He added that such measures could improve Indian defence companies’ competitiveness and integrate them deeper into global supply chains, particularly as Europe steps up defence spending.

As a result, Data Patterns India, a defence and aerospace electronics maker, surged nearly 14% on Wednesday, outperforming its peers in the Nifty Defence index.

Even as budget expectations continue to support defence stocks, experts caution that the trade has increasingly shifted towards execution. With most large defence companies already carrying order books stretching six to eight years, incremental budgetary increases are unlikely to materially alter earnings trajectories over the next two years, said Sonam Srivastava, founder and fund manager at Wright Research PMS. Instead, execution capacity, delivery timelines, working-capital discipline and export volumes are becoming the key drivers of performance.

Khemka of Motilal Oswal Financial Services echoed this distinction, noting that while part of the recent rally reflects tactical pre-budget positioning, earnings-led gains are more structural. Results from Bharat Electronics, he added, reinforced positive sentiment across the defence space on Wednesday.

Bharat Electronics significantly outperformed Street expectations in the December quarter, with consolidated net profit rising 21% year-on-year to ₹1,580 crore, compared with estimates of around ₹1,480 crore.

Structural overhang

PSUs, by contrast, face a more pronounced structural overhang. After a sustained re-rating, valuation headroom has narrowed as earnings momentum has slowed. This partly reflects a moderation in the government’s capital expenditure push, according to experts.

Budgetary capex grew at an average annual pace of 25% between FY21 and FY24. But it slowed to roughly 11% across FY25 and FY26 as fiscal consolidation took priority, a Crisil report showed. A simultaneous slowdown in PSU-led investment compounded the pressure.

PSU capex, as a share of GDP, has fallen from about 2% in the pre-covid period to roughly 1% in recent years, and is expected to remain broadly flat into FY27, according to Nuvama Institutional Equities.

Large PSUs such as the National Highways Authority of India, Indian Railways, Coal India and NTPC retain strong balance sheets and enough headroom to step up capex. However, their focus on dividend payouts to the government over growth spending could hinder meaningful valuation upsides, noted Nuvama.

HDFC Securities’ Vakil added that the recent rally in PSU stocks is largely driven by expectations of asset monetization or privatization announcements in the budget. “It’s a typical pre-budget build-up that often fades once actual numbers are announced,” he said.

Looking ahead, Nuvama expects total government expenditure to rise about 10% in FY27, with capex allocations up around 13% on a low base. However, without a visible improvement in execution, working-capital efficiency and earnings quality, incremental policy support is unlikely to materially lift PSU valuations, said Srivastava of Wright Research.