Defense Stocks Look Promising In The Year Ahead

by: Jonathan Baird, CFA

Global defense spending is at its highest level and rising.

A combination of geopolitical and technological factors suggest that spending will continue to rise.

Defense companies using the most sophisticated technology appear to have long-term appeal.

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This article first appeared in the Jan. 2, 2019, Globe & Mail; the version below is updated as of close of business Jan. 29, 2019.

Recent headlines attest to the deteriorating global geopolitical environment: The U.S. has adopted a protectionist trading policy, Brexit is symptomatic of a host of problems facing the European Union, the North Korean nuclear issue remains unresolved, and the U.S. and China are engaged in a contest for global influence in the 21st century. These are but a sample of the macro issues that will challenge investors in coming years. However, turbulent times also produce opportunities. The defense sector is one such opportunity as it is well-positioned to benefit from two converging influences.

The anxiety and uncertainty produced by the current geopolitical climate has raised the risk of military conflict. The United States' withdrawal from global leadership has produced a multipolar global order that has increased the number of potential theaters of conflict. China and the U.S. regularly saber rattle in the South China Sea. Iran and Saudi Arabia vie for influence in the Middle East. Moreover, the Trump administration's stated reservations about the European Union and NATO suggest a weakened Western coalition to adversaries. It would not be surprising if Russia was emboldened to test the resolve of the NATO alliance. The U.S. might eventually tire of the lack of progress with North Korean denuclearization and resort to military intervention. These are the major, though by no means only, areas of concern.

These geopolitical issues are driving military spending higher. The Trump administration authorized the biggest defense budget in American history, worth some U.S. $700 billion, in May. The U.S. accounts for more than a third of world spending on military equipment. China has also been aggressive in building its military capability and is now the second largest purchaser of weapon systems. Saudi Arabia has become a major buyer of military equipment as well and is now in third place globally. Increased defense spending is really a widespread phenomenon. For example, NATO increased its defense expenditures in 2016 for the first time since 2009, and raised spending again in 2017. This trend in global defense spending is expected to continue for the foreseeable future.

Technology will be the second driver of defense spending in the years ahead. The rapid pace of technological advance in the 21st century puts unprecedented pressure on all armed forces to both update existing assets and purchase newly developed products to remain combat effective. Artificial intelligence is a major focus of defense contractors in developing a new generation of smart and/or autonomous weapon systems. In fact, products incorporating artificial intelligence promise to largely replace current weapons systems in coming years. China and Russia are the current leaders in the development of hypersonic weapons. Hypersonic weapons are missiles that travel more than 5 times the speed of sound and to which there is currently no effective response. Billions of dollars have been and will be spent on the development and deployment of hypersonic weapons and countermeasures against them in the coming years.

Two conclusions can be drawn for investment in the defense sector. First, given the undisputed impetus to ever greater use of technology in weapon systems, companies that produce products that incorporate the most sophisticated technology, such as aircraft or missile systems, should be preferred. Candidates for consideration are U.S.-based companies such as Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), L3 Technologies (LLL) and General Dynamics (GD) among others. An alternative to purchasing individual stocks is the iShares U.S. Aerospace and Defense ETF (ITA), which provides broad corporate diversification.

The second investment conclusion is that, because of fracturing political unity in the West, it might be desirable to diversify holdings in the defense sector geographically. Weakening alliances could prompt shifts in buying patterns. European defense contractors that merit interest include BAE Systems (OTCPK:BAESF) (U.K), Rolls Royce (OTCPK:RYCEF) (U.K.), Airbus (OTCPK:EADSF) (France), and Thales (OTCPK:THLEF) (France).

Since being first discussed in the February 2017 issue of the Global Investment letter, defense stocks (using the ITA ETF as an industry proxy) have gained 28% vs. a 12% advance for the S&P 500 at time of writing. The average current trailing price earnings ratio of the stocks mentioned in this article exactly matched the price earnings ratio of 19.7 for the S&P 500 at time of writing, while offering substantially better earnings growth prospects.

The greatest risk to investment in defense contractors would be a lessening of global tensions and a move toward peaceful cooperation, the prospect of which is unfortunately quite dim.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.