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The heightened level of geopolitical tensions in the wake of the Russian invasion of Ukraine has prompted investors to take greater interest in companies in the defence industry.
There are many from which to choose. The best known are those operating in the traditional fields of military and naval equipment, such as aircraft, ships, tanks, armoured personnel carriers, missiles, and antitank or antiaircraft systems.
They generally operate with high margins, and defence spending is likely to keep rising over the next decade to meet the increased level of threats. They also have additional strengths, primarily connected with their strong relationships with the governments that buy their equipment and systems and the long-term nature of these relationships.
Once companies have been approved as suppliers to the defence department, in whichever country, they tend to remain suppliers for a very long time. Many of the major defence contractors in the U.S., such as Boeing, Lockheed Martin, Northrop Grumman, Raytheon, General Dynamics, and L3Harris, have relationships stretching back to World War II and before. British Aerospace, the principal U.K. defence supplier, can trace its roots back to the Royal Ordnance Factories, which supplied gunpowder, cannons, and muskets in the eighteenth century.
The North Atlantic Treaty Organization (NATO) requires its members to make a commitment to spend at least 2% of their GDP a year on defence, a promise more honoured in the breach than in the observance since the end of the Cold War in 1991. The only major European countries to meet the target at present are the U.K. and Poland, although the invasion of Ukraine has led to a rapid rethink by other countries. Germany now plans to spend over €100 billion annually (US$99 billion) on defence in the next few years, although that will still leave it below the 2% target.
All this increased spending from Europe is matched in Asia. Concern over Chinese intentions, particularly towards Taiwan, has seen South Korea, Japan, the Philippines, and Indonesia step up military spending. Taiwan itself receives the newest generation of aircraft, missiles, ships, and submarines from the US.
China’s major regional rival, India, is also raising its spending substantially, particularly on its navy. This is to counter the perceived threat from the expansion of China’s deep-water fleet, which now includes several aircraft carriers.
The U.S. defence budget for fiscal 2022 (which ended Sept. 30) was US$722 billion, up $17 billion, or 2.4%, from fiscal 2021. The U.K. government spent £50 billion (US$58 billion) in 2021-22 (to April 30). It aims to double that to £100 billion (US$116 billion) by the end of the decade in 2030. Canada’s sent C$23 billion on defence in 2022 and plans to increase that by C$8 billion a year for the next five years.
One of the issues emerging from the ramp-up of military spending in response to the invasion of Ukraine is capacity constraints. It’s difficult to try to rapidly increase output for equipment that has limited production runs and has been starved of investment for years as countries reduced military spending in a globalizing world.
All this leaves defence contractors exceptionally well positioned for years of sustained growth in revenues and earnings, assuming they can keep costs under control. With many contracts on a cost-plus basis, or with some form of inflation provision, defence companies enjoy sustainable high margins and limited competition, given the security and relationship issues discussed earlier. No government is keen to leave itself unprepared if a new supplier ends up being unable to produce equipment on a timely basis.
Defence companies like Lockheed, Northrop Grumman, Raytheon, and L3Harris sell at reasonable valuations with price/earnings ratios in the 18-21 range, with 2% dividend yields. But the simplest way to gain exposure to the sector is to buy an aerospace and defence ETF. This approach offers wide ranging exposure and avoids any issues arising from delays in a particular program.
Invesco Aerospace and Defence Invesco ETF (NYSE Arca: PPA) invests in businesses that “are involved in the development, manufacturing, operations and support of U.S. defence, homeland security, and aerospace operations.” There are 56 holdings in the ETF, and it is rebalanced quarterly. Some of the top names include Boeing, Raytheon, and General Electric, as well as Lockheed Martin, Northrop Grumman, General Dynamics, and L3 Harris. The ETF has over $1.5 billion in assets, and trades around 150,000 units a day.
The fund has been an outperformer this year and over the last 12 months, down -10% and -9.4% respectively, compared with -19% and -16.4% for the S&P 500 Composite Index over the same periods. The five-year average annual compounded rate of return to Oct. 31 is 12.0%. The ETF paid $0.66 in dividends in the last 12 months.
This ETF is for investors comfortable with owning arms manufacturers and willing to accept a relatively low dividend yield in exchange for owning a wide range of major companies with longstanding relationships with the U.S. and other NATO and allied military forces in a period of increased defence spending and growing demand.
Gavin Graham is Chief Strategy Officer of Calgary-based SmartBe Investments. He is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management. This is an edited version of a longer article that first appeared in The Internet Wealth Builder newsletter.
Notes and Disclaimer
Content © 2022 by Gavin Graham.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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