Asian defense sector draws institutional interest despite governance risks
Asian defense companies are gaining increased attention from institutional investors as regional defense spending surges and export opportunities expand, though government ownership and geopolitical tensions require careful consideration, according to Franklin Templeton Institute investment strategist Kim Catechis.
"The nature of the sector is such that there has always been a degree of government influence, either directly via ownership, or indirectly as national defense ministries are often the biggest and sometimes only buyers," Catechis told AsianInvestor.
For investors, the key risks centre around company decision-making, particularly in capital expenditure that may not generate economic value due to government priorities rather than commercial considerations.
"Export controls are a tool of policy - either to avoid strategic goods leaving the country or perhaps as a way of manifesting peaceful intentions," said Catechis.
"For example, South Korea does not export directly to countries that are at war. Japan does not export defence goods at all; however it is, I believe, very likely to do so in the next few years."
Rising geopolitical tensions are motivating governments to rebuild their defense industrial bases, providing fundamental support for the investment case.
POLICY EVOLUTION
The Japanese government's potential reversal of its defense export ban highlights the evolving policy landscape, though implementation remains uncertain.
"In principle, there is always a risk of policy reversal, especially in democratic countries where voters can change governments regularly," Catechis noted. "To be clear, Japan has not yet reversed its export ban.”
He emphasised the importance of careful due diligence "to ascertain which particular parts of the industry are best placed and offer the best combination of growth prospects and valuation."
ESG AND TECH
The defense sector's growth has forced institutional investors to reassess traditional ESG exclusions, with varying approaches emerging across the region.
"Some investors will have clear fiduciary responsibility to principles that preclude this type of investment and will be truly clear about what they can and cannot do. Others may be more able to align with government policy, if one emerged," said Catechis.
"Unsurprisingly, there is a wide range of investment policy in evidence today, with a range of speeds of implementation."
Dual-use technologies are emerging as a key opportunity, though investors must navigate complex technology transfer restrictions and export controls.
"The escalation of geo-economic concerns in the world is also affecting Asia," Catechis said.
"Fundamentally, the key risks cover investing in a technology based in a country that is subject to exclusions or other non-tariff barriers to export."
He advised investors to "consider all Asian companies in the sector but perhaps include an assessment of the home country's positioning in the world, by applying a different country risk premium."
MARKET OUTLOOK
India's position as the world's largest arms importer during 2019-2023 presents significant opportunities, though investors must carefully assess corporate governance structures.
"The private sector companies are dependent in many cases on obtaining defence contracts, so there is a degree of government involvement in the revenue growth assumptions," Catechis said.
"Looking at a map, India would seem to be motivated to modernise its armed forces, evidenced by its status as the biggest importer of arms."
Asian defense spending continues to grow, with China's defense budget reaching $471 billion in 2023, compared to $298 billion spent by all other Asian countries combined, according to the International Institute for Strategic Studies.
"The investment case for the sector is clear. What is underappreciated is its duration and its breadth," Catechis said.