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Updated: Wed, 25 Jun 2014 08:00:00 GMT | By Mark Brown

Defence stocks continue climbing as global tensions shift

Secure returns in a risky world.


F-35 jet in flight

Governments continue to spend on next-generation weapons like Lockheed Martin's F-35 Joint Strike Fighter (Andy Wolfe/U.S. Navy)

Amid rising tensions over Ukraine, there was greater interest than usual in Russia's annual Victory Day parade on May 9. The show of strength didn't disappoint. More than 11,000 military personnel, 69 warplanes and helicopters, and 149 military vehicles paraded through Red Square to salute President Vladimir Putin, including the first public appearance of the Tor-M2U, a state-of-the-art anti-aircraft missile system.

Since the end of the Cold War in the early 1990s, governments worldwide have been looking toward a "peace dividend," an across-the-board decline in military spending. Those dreams were renewed with the recent U.S. withdrawals from Iraq and Afghanistan. Combined with government austerity that started in 2009, you might think the defence sector would be headed for tough times.

But you'd be mistaken. While the U.S. is cutting back its ground forces, the country continues to spend in other areas as it attempts to modernize its defence systems, complete with next-generation fighters like the F-35 and leading-edge warships. Other countries, such as Saudi Arabia, as well as civilian businesses, are ramping up orders with defence contractors too. And new threats, including cyberattacks , are attracting government dollars to a host of companies outside the big five defence suppliers (Huntington Ingalls, Northrop Grumman, Lockheed Martin, Raytheon and General Dynamics).

As a result, the shares of defence firms enjoyed big gains over the past year. Northrop Grumman, Boeing and Alliant Techsystems are all up between 70% and 100%. The SPADE Defense Index , which consists of 50 public companies, is up 132% over the past five years versus 105% for the S&P 500. What's more, despite their reliance on government contracts, defence stocks have been surprisingly resilient. The SPADE Defense Index has outperformed the S&P 500 in 12 of the past 16 years. In the few years it has lagged, it's almost always done so by a slim margin.

Last year was an unusually volatile one for the defence sector. Investors were scared off by the US$55 billion in automatic sequestration cuts to the U.S. defence budget. Not surprisingly, though, the cuts weren't nearly as deep as feared, says Stephen Wood, chief market strategist for Russell Investments. "The whole design of sequestration was to be a painful policy that no one in Congress would ever allow to come to pass," he explains. Investors who sold missed out on the subsequent rally.

Will this be the end of the cuts? Scott Sacknoff, manager of the SPADE Defense Index, thinks so. "There is too much pressure and news that security is being threatened if we cut any more. Defence is as much insurance as anything else," he says. Russia's provocative moves make further cuts even more unlikely.

Chart showing rising global military spending and outperformance of Defence stocks

Even as Washington tries to scale back its defence spending, it is keenly aware it needs to keep its defence supplier base healthy. To soften the blow of reduced spending, the U.S. Congress has more than doubled the amount defence companies can sell abroad, says Sacknoff. The move will allow these companies to diversify their customer bases.

General Dynamics is one of the beneficiaries of this policy. The company, which builds everything from weapons systems and munitions to ships and combat vehicles, has seen its combat segment sales fall 40% since 2009-a direct result of the U.S. withdrawals from Iraq and Afghanistan, says Nicholas Stark, an investment analyst with American Century Investments. But now the company is getting contracts on the international side for those systems, he says, pointing to a recent $10-billion agreement to sell armoured vehicles to Saudi Arabia. Similarly, Lockheed Martin's international sales have grown to 25% of total revenues, while Raytheon's are up to about 30%. Stark expects they will continue to grow.

When looking at defence stocks, beware of any company with large ties to a single big-ticket project, particularly if that project isn't on solid ground. The Joint-Strike Fighter, or F-35, is a prime example . Support for the program from mid-tier countries like Canada is already wavering . Should Canada drop out, others will likely follow, which would affect Lockheed Martin, as the F-35 program accounts for 16% of the company's total sales. Contrast that with Raytheon, where no single program is worth more than 5% of revenue, says Stark. Plus the company is well positioned to help out on the next battlefield-with electronic warfare.

Another way defence companies are diversifying their customer bases is by selling more to the private sector. The commercial business segment has been the biggest growth area for many aerospace companies in particular, says Sacknoff. Lockheed Martin is the largest contractor to the U.S. Postal Service, while Boeing's Dreamliner is sold out through 2020.

Foreign and commercial sales are likewise padding Canadian defence contractor CAE Inc.'s bottom line. Cameron Doerksen, an analyst with National Bank Financial, estimates the designer of flight simulators makes 40% of its sales to the defence sector, but only a third of that is to the U.S. CAE's main growth area is on the commercial side.

Another Canadian company with ties to defence is Héroux-Devtek, which specializes in aircraft landing gear. More than half of the company's sales come from the U.S. defence sector. But investors need to understand what types of aircraft it serves. While the U.S. air force is retiring some of its fleet early, the cuts are very program-specific, says Doerksen. Héroux-Devtek, he notes, builds landing gear assemblies for the Lockheed Martin C-130J Super Hercules, which remains a workhorse in the U.S. military, while CAE mostly provides flight simulators used mainly to train helicopter pilots. Going forward, the emphasis in the U.S. is going to be on the navy, aircraft and missiles, and less on tanks and land vehicles, says Stark.

When considering opportunities in the defence sector, be sure to consider the size and nature of the contracts. Look for companies in niches with large barriers to entry, and avoid smaller technology and consulting-type businesses, advises Stark. "They are the easiest to cut because they are short-cycle," he says. Large programs, like the US$3.3-billion contract to build destroyers for the U.S. Navy that Huntington Ingalls signed late last year, tend to be harder to cut.

Even after their recent gains, large defence companies are ideal for buy-and-hold investors, since they are stable and generate good dividends. As the Ukraine crisis has reminded us, human conflict is a given. If you're looking to add a defensive company to your portfolio, look at one with a little firepower.

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