Capital.com Research Team2020 was notable for many things but one underappreciated fact was that it was the year in which the globe began a massive drive to rearm.
In the midst of the pandemic, when governments were confronted by a major global contraction in economic activity, we also witnessed a historic rise in military spending across the world.
In fact, according to the Stockholm International Peace Research Institute, last year saw the highest annual increase in global military spending since the new millennium, reaching close to $2trn.
This was the result of a number of converging trends that came to the forefront throughout last year.
Most prominent is the decline of the relationship between the US and China. Relations between the world’s largest economies have long been falling but in 2020 they became outright hostile, with the US government accusing Beijing of constant cyber attacks and aggression against American allies in Asia.
And Asia is only one hotspot. The Council on Foreign Relations have identified several areas where local tensions could spill into conflict, and analysts within NATO agree, stating that geopolitical tension is here to stay for the foreseeable future.
This renewed global tension has inspired governments who had been falling behind with their defence spending to begin ramping up, especially in areas of research and development of military technologies.
And the fragility of global supply chains demonstrated by Covid-19, alongside the continuous threat of a Chinese annexation of Taiwan, the country that provides a quarter of the semiconductors vital to modern military equipment, has pushed Western governments to develop domestic military production industries that have previously been neglected.
This concern led to the implementation of the “Defence Authorisation Act” in the US, and has encouraged the British government to engage in the largest spending increase in their armed forces since the end of the Cold War. This amounts to some £24bn being invested, with a particular focus on the development of new technological domains, including artificial intelligence (AI), cybersecurity and space.
And the global tension is likely here to stay. A KPMG report warns business executives that geopolitical risk will remain at an elevated level for the next few years. They identify four key trends causing this, of which the China/US standoff is only one alongside the disruptive effects of rising nationalism, climate change and technological revolution.
Investing in such an environment can be perilous as the stock market will often react in unpredictable ways in the event of emerging news and political developments. However, the instability is likely to move defence industry stocks as governments look to hedge against it by investing in their military capacities.
Deloitte researchers explain that the structure of the industry means that growth in defence stocks is likely to return slow and steady growth rather than the explosive returns of many disruptive technology stocks. This is because the industry relies on long turnaround times for new products and deals between the government and private sector are often slowed by regulation and political oversight.
However, the Deloitte analysts are confident that the industry looks set to continue to grow and is being buoyed by several trends, including the desire of Western governments to repatriate industry from China, and the new space race, in which defence companies often play a major role.
What are defence stocks?
Defence sector stocks are the equities of any company that composes the global military and defence sector. This industry is diverse enough that it includes a wide range of themes and draws from a number of outside industries.
This means there is a split between so-called ‘offensive defence’, which includes weapon systems and military vehicles, and the companies who play logistical or medical roles within the wider industry.
This also means that investors who are hesitant to place their funds into such defence stocks will still have a rich amount of choice for companies to invest in.
The Deloitte report referenced above offers some warnings that defence stock investors must bear in mind. The defence industry, the report clarifies, is extremely sensitive to political developments, and growth risks being disrupted by changes at the top of governments, new technology or a changing geopolitical environment.
How to buy defence stocks
Those who wish to invest in defence stocks could place their funds into the three largest defence companies by market capitalisation.
This allows investors to gain exposure to firms with the advantage of an established brand name, a long demonstrated history of engineering ability and deep links with the world’s militaries and governments.
Some defence stocks to buy include the largest companies by market cap;
Honeywell
Technically, Honeywell (HON) is the largest defence firm by market capitalisation but this is largely to do with the various subsidiaries of the company. It is a massive conglomerate with a market cap of $152.32bn that has gained a dominant position in several key industries, with the defence sector being one alongside aerospace, production systems, chemicals and building technology.
This brings a degree of diversification for investors who would prefer not to overexpose themselves to a single, often volatile, industry. Its defence operations are focused on the manufacturing of rocket technology and Honeywell’s designs are vital for the construction of the iconic F30 fighter jet and the Chinook helicopter, used to transport ground troops and heavy payloads on operations.
Recent stock action has been moderate, with HON sporting a YTD return of 3.73% and a one-year growth of 27.34%. In the last five years the stock has delivered 111.41%.
Raytheon
Next, we have Raytheon Technologies (RTX). Raytheon is a well-known name in the space and a recent merger with United Technologies has allowed it to leapfrog into second place in the industry, with a current market cap of $136.91bn.
The firm has a long history of working with the American military and developing and delivering complex systems, with their expertise being in missile defence systems. They have won a string of contracts with a number of Western militaries, with the most recent being one worth close to half a billion dollars to upgrade the weapon systems for the US Air Force.
The RTX stock has delivered 26.98% year-to-date return, delivering 48.27% one-year and 53.48% five-year return so far.
Lockheed Martin
Another purely defence play, Lockheed Martin (LMT) is a goliath with a market capitalisation of $101.07bn.
LMT is the company that looks set to gain the most from the US government’s attempt to pivot to a fully 21st century warfare strategy, with investments into stealth fighters and hypersonic missiles (missiles travelling five times the speed of sound) being a major part of Washington’s plan to see off its adversaries in Russia and China and a lucrative market for defence contractors.
The company is also playing a key role in upgrading both the American nuclear arsenal and the UK’s Trident weapons system. Because of the sensitive nature of this work, it can be hard to gain an accurate picture of how much this will net the company but congressional disclosures state the cost of upgrading the system to be 60 billion dollars a year up to 2030 in the US alone.
Investors with LMT stock will also gain exposure to the emerging space infrastructure as the company has signed deals with NASA, gaining them exposure to another rapidly growing industry.
With a solid history of paying dividends and exposure to multiple industries, LMT might be worth a look at any investor who intends to make a full frontal move into the defence marketplace.
Year-to-date the stock has delivered a modest growth of 2.82%, with one year loss of 1.94% and a five-year return of 56.85%
Investing in defence ETFs
Like all major industries, investors will find a range of Exchange Traded Funds (ETFs), which track the defence marketplace and offer exposure to a range of firms within the space.
iShares US Aerospace & Defence ETF
The largest by Assets Under Management (AUM) is Blackrock’s iShares US Aerospace & Defence ETF (ITA), which holds assets worth $2.66bn. The fund is entirely US focused and offers investors exposure to two of the largest defence firms, with Raytheon and Lockheed Martin making up the second and third largest holdings respectively.
Alongside these big names, there are also other major players in the defence industry, including firms with a focus on more niche areas such as AI and robotics research and logistics, thereby allowing investors wide thematic exposure as well.
The fund is available at an expense ratio of 0.42%, and has experienced year-to-date growth of 14.25%, five year growth of 12.56% and ten-year growth of 15.48% so far.
SPDR S&P Aerospace & Defense
The second largest by AUM is S&P Aerospace & Defence fund (XAR), which tracks defence firms in the S&P index and holds $1.24bn assets under management. The fund is slightly cheaper than ITA, costing an expense ratio of 0.35% and it has achieved year-to-date growth of 7.94%, a five year increase of 18.08% and a ten-year growth of 18.76%.
The fund is completely focused on US stocks meaning that it does not benefit from geographic diversification but does provide a large variety in the size of the stocks within, with large blue chips present such as Virgin Galactic all the way to small caps which represent potential growth.
Invesco Aerospace & Defense ETF (PPA)
The third defence ETF that investors could opt for is the Invesco ETF (PPA). A distant third with a total assets under management of $694.89m.
The fund tracks the SPADE Defence Index and is composed of a range of America, Israeli and Canadian firms. Present are the standard defence industrial firms which produce offensive capability, alongside a range of logistics, IT and Homeland Defence organisations that produce goods for national and international policing efforts, making it quite diversified.
Alongside that, it is also fairly exposed to other sectors, with IT, industrials and logistics being other notable inclusions.
PPA has largely recovered from the March 2020 crash and has been on a consistent uptrend, with a YTD increase of 9.42%, a five-year return of 15.55% and a 10-year growth of 16.83%.
The bottom line
Between a more competitive geopolitical environment, multiple technological developments and the emergence of the space sector, defence stocks are being buoyed by a number of fundamental macrotrends which make them look a potentially solid option for investors.
While the defence industry is unlikely to produce the massive and rapid growth that we might often see in more frontier markets in the technology sector, they have a long history of delivering consistent and gradual returns for investors and certainly have a role to play in a diversified and well balanced portfolio.
