Manufacturers of fighter jets, battleships and missiles are usually one of investors’ best defensive havens when economies get shaky. This time around, geopolitical conflict and tension are making them key components in the offensive arsenal as well.
Normally, when a downturn erodes demand or some exogenous shock rocks the market, the US government budget, and particularly spending on the military, tends to remain stable. This makes stocks of companies such as Lockheed Martin Corp., Northrop Grumman Corp. and others attractive when fears of recession increase.
There are some risks, including a president who emphasizes social programs over defense. That’s usually balanced over time by an administration that seeks to build up the military. The pendulum never strays too far from the average defense spending, which has been 3.8% of gross domestic product over the past three decades. This gives defense companies steady, but usually not stellar, sales growth.
That’s changing at a magnitude that likely matches the sudden increase this year in the geopolitical risk profile. The arms orders are pouring in. General Dynamics Corp. announced on Aug. 25 that it would supply 250 Abrams tanks to Poland with a total price tag of about $1.1 billion. Northrop Grumman was contracted in August to bolster US missile defense systems, which could generate $3.3 billion in revenue. Lockheed Martin scooped up a $4.4 billion order in June to supply as many as 255 Black Hawk helicopters, including options, to the US and foreign militaries.
Nations are ramping up military spending as they watch Russia’s war against Ukraine. Even more unsettling is China President Xi Jinping’s increasingly close relationship with President Vladimir Putin of Russia, including the participation of Chinese troops in joint exercises being hosted by Russia. This only heightens concern over China’s recent display of military might around and over Taiwan when US House Speaker Nancy Pelosi visited the island in August.
The investor rush to defense stocks was an obvious move after Russia invaded Ukraine on Feb. 24. The stocks have all gained this year, although a bit unevenly. Pure-play companies like Northrop, Lockheed and Huntington Ingalls Industries Inc., which makes naval vessels, have all risen more than 18% this year. General Dynamics, which makes private jets in addition to tanks and nuclear submarines, has risen 11% and Raytheon Technologies Corp., which sells jet engines to Boeing Co. and Airbus SE as well as for military aircraft, has posted just a 5% gain.
These are stellar results compared with the 16% drop in the S&P 500 Index this year. So the stocks are no longer cheap, but the momentum on orders for military hardware is just getting cranked up.
“You can clearly make the case that you've got a possible upside surprise with spending on defense,” said Bill Stone, who as chief investment officer helps manage $18 billion at Glenview Trust Co. Stone bought Lockheed, Raytheon and General Dynamics in 2021 as a defensive play and is hanging on to them as revenue is poised to swell. “They’re not screaming buys anymore, but there’s definitely upside.”
Investing in defense stocks can be controversial. After all, these companies make products that are designed to kill people or take out buildings and bridges. If this were a peaceful world, the money and work it takes to build weapons would have to rank as the worst allocation of capital. These investments don’t increase productivity or meet a need that improves consumers’ lives. To the contrary, the purpose of the weapons on which governments around the world spent $2 trillion in 2020 is precisely to destroy productivity, assets and people’s lives.
Of course, the planet isn’t peaceful. The so-called peace dividend after the collapse of the Berlin Wall and Soviet Union is fading into history. Nations and their citizens might feel vulnerable if they fall behind while other countries — some with hostile pasts — are arming up. It’s easy to understand why Poland would want to buy 250 Abrams tanks.
Still, defense companies have recently been lumped in with energy companies on the losing side of the environmental, social and governance investment trend. The money managers who were skeptical about defense companies perhaps weren’t thinking things through. Phebe Novakovic, the chief executive officer of General Dynamics, and Honeywell International Inc. CEO Darius Adamczyk pushed back against the negative scores on ESG ratings for defense companies as a danger to national security in 2021, well before Russia’s invasion of Ukraine made apparent this realpolitik reality. Adamczyk said the ESG movement’s logical conclusion would force governments to take over publicly traded arms makers to ensure they didn’t go out of business. “Are we on a path to nationalize all defense companies? Because if they become uninvestable, then you have to nationalize them. That’s the only path there is,” Adamczyk said during an August 2021 interview at Bloomberg’s headquarters in New York.
It’s doubtful investors now would want to deprive Ukraine of long-range High Mobility Artillery Rocket Systems, made by Lockheed, or Javelins, the shoulder-fired rockets that can bring down a tank and that are manufactured by a joint venture between Raytheon and Lockheed.
The reality is that global defense spending for the two decades through 2020 (the latest year for which numbers are available) has grown at a 5% clip. Over that period, China’s defense spending has expanded at an average of 13% a year and Russia’s at an average of 11%, although Putin hit his pinnacle on military spending in 2013 right before the oil market crashed in 2014.
The US still spends three times as much as China on the military, according to 2020 budgets. Both have been ramping up spending over the last two years, and now the rest of the world also is arming up. And the US may have a way to go because spending dropped to 3.3% of 2021 GDP, below the average over three decades.
In a report titled “Into the new Cold War,” RBC Capital Markets analyst Ken Herbert this week initiated coverage of defense companies, saying “the elevated defense spending (with less volatility) will justify a positive re-rating on the sector.” While Russia’s war on Ukraine is bolstering demand, “the persistent China risk will support long-term sentiment and funding upside.”
The upshot is that even though defense companies have outperformed the S&P 500 quite handily this year, they’re not near full valuation as backlogs to build weapons swell. Investors won’t have to focus on demand but on each company’s ability to operate efficiently. Until there’s peace, there will be a need for the instruments of war.
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