Quick Bites | Investing in Defense Stocks?

Although some might not want to invest in defense-related companies for ethical reasons, it is still worthwhile considering what is occurring in this sector, particularly as recent developments support an overweight position.

Global military spending is poised for significant increases as the world system destabilises due to increasing geopolitical rivalries. The US has recently ramped up its defense spending, which was further bumped by allocations of funds for Ukraine. Going forward, the US defense budget is likely to stay flat or even rise in real terms. Many other countries, including Australia and most countries in the Indo-Pacific region, are following suit. European countries such as Germany are frantically ramping up spending after decades of neglecting their defense expenditure and over-reliance on the US defense umbrella.

Source: BCA Research


As the chart above shows, the order books of the leading US military contractors are currently full, and backlogs are growing, as they struggle with timely delivery while navigating materials, components, and labor shortages.

While both sales and earnings growth are to maintain the current robust pace, the industry is not cheap like it was in 2021. Yet, a significant short-term headwind for defense stocks over the next 12-24 months could be a likely ceasefire in Ukraine once the conflict reaches a stalemate. However, there is no shortage of other conflicts that could soak up defense-related products: the conflict over Iran in the Middle East, ongoing US-China competition over Taiwan, the unresolved issues posed by North Korea, etc. It seems there are always reasons for a range of both major and minor countries to spend more on national security.

It is likely that Russia and Ukraine will not sign a peace treaty, and the entire Russian sphere will remain highly unstable in the wake of the Ukraine war, leading to sustained concern for national security among the European states. The generational shifts in both German and Japanese foreign policy toward greater defensive capability will remain the signal amid the inevitable noise.

In Australia, investing in aerospace and defense is limited to a very small number of companies, most of which are unproven small caps. Some have been listed for many years, and yet their performances have in most instances been patchy and volatile, such as Codan, Austal, Quickstep, Titomic, Droneshield, and EOS. Apart from Codan and Austal, most of these companies are extremely small, have limited liquidity, and would not be regarded as investible by most fund managers.



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