Flying the flag for defence stocks: All systems go for sector often in firing line

The launch this week of a Future of Defense fund that will put money into the armaments and cybersecurity industries comes amid confusing signals from the industry.

In the aftermath of Russia’s invasion of Ukraine, investing in defense supplies – until recently viewed by many as an abomination – is increasingly seen as support for democracy.

Still, the direction of stock prices in recent weeks has not necessarily reflected the global spending boom sparked by the war in Ukraine and alarm over China’s intentions towards Taiwan, its South China Sea neighbour.

After a prolonged period of decline, spending reached $2.24 trillion (£1.74 trillion) last year, with British companies such as Chemring, which supplies materials and components for missile systems, reporting a rise in orders.

NATO members that have not spent 2 percent of GDP on defense pledge to meet this target. The HANetf Future of Defense fund, which will have the stock sticker ‘Nato’, will only support companies based in the countries that are members of the alliance or part of the Nato Plus group – Australia, New Zealand, Japan, Israel and South Korea.

Despite the rush to re-equip and form multi-year partnerships, shares in some major British and American defense names fell following last month’s failed uprising led by Yevgeny Prigozhin, the founder of the Wagner mercenary group. BAE slipped, as did Qinetiq, which is behind the Banshee drone.

It seems traders saw the brief coup as evidence of instability in Russia that could shorten hostilities in Ukraine. A shutdown would reduce spending on tanks, troops and the rest, with other implications for defense contractors.

Ukraine has been a hugely important testing ground for these groups’ technologies, revealing where innovation and upgrades are needed.

Some investors, committed to the cause of ESG (environment, social and governance), will not be disturbed by the post-coup price falls.

They will continue to eschew BAE, Qinetiq and other cybersecurity or weapons companies in the EQM Future of Defense index. Its constituents include Cisco, Northrop Grumman, Palo Alto and Raytheon, maker of the Patriot missile.

But Russian aggression has changed opinion. Even those committed to ESG strive for some degree of defense exposure.

In response, the Future of Defense fund is the second such launch. The VanEck Defense Fund, which launched in April, has interests in companies such as defense software specialist Palantir.

David Coombs, from Rathbone, sums up the case for a more nuanced view. ‘Defense can provide diversification in a portfolio because these types of companies are driven by geopolitical rather than macroeconomic factors.

“Countries are the largest and most trusted consumers, as a nation’s primary responsibility is to protect its citizens. I bought US group Lockheed Martin, maker of the Black Hawk helicopter for our core funds in 2016.

“The systems are of the highest quality and the largest customer is the US military, which buys only from US contractors.”

Ben Yearsley, of Shore Financial Planning, says that despite the change in the “mood music” around defense, few funds have big holdings because of the moral complexities or the requirement to meet ESG criteria.

As a result, they have relinquished the advantages of Rolls-Royce, the main manufacturer of engines for the military market.

Yearsley says: “Rolls-Royce is not a purely defensive stock – about 30 percent of its revenue comes from this business. But it’s been a big turning point story, with its stock up 92 percent over the past year to 151 pence.”

The analyst consensus rates Rolls a buy. Chloe Lemarie, at Jefferies, is targeting a price of 210 pence.

BAE, Britain’s largest defense contractor, is also a buy, according to consensus, with Morgan Stanley targeting a price of 1,208 pence, citing the company’s share buyback program and a dividend yield of 2.97 per cent.

This optimism is encouraging for those with money in the City of London Trust, where BAE, which builds combat vehicles, nuclear submarines, radar systems and jets, is the second largest holding company.

Trust manager Job Curtis says BAE’s wares are essential to defending democracies against dictators. Charles Woodburn, BAE’s boss, is equally candid, saying the pipeline of opportunities remains strong, underlining the uncomfortable truth that the world is a riskier place and governments will spend accordingly.

Investing requires flexibility. It would be short-sighted not to recognize that conventional warfare is taking place in Europe and may continue for some time.

I am placing long-term bets on British defense groups in a strategy to ‘support Britain’ – and as my way of supporting the Ukrainian people in their struggle for democracy.