Conflict is always an unhappy subject, but it remains an area of real focus across the globe. Cross-border collisions of ideology, hegemony, raw materials, and even survival, mean national budgets reach astronomical levels, especially in the US, by far the world’s largest military spender.

In 2022, global military budgets hit an all-time high of $2.2 trillion, according to data released by the Stockholm International Peace Research Institute, or SIPRI, the eighth consecutive year that spending has increased. By far the sharpest rise in spending (up 13%) was seen in Europe. This was largely accounted for by Russia and Ukraine in the wake of war.

Amid a major escalation of violence in the Middle East, defence stocks have been on an almost universal upwards trajectory, leading portfolio managers and analysts to examine the potential long-term effects of a more protracted conflict in the region.

Yet the link between conflict and profit is not as simple as the investing public may occasionally imagine, argue Morningstar analysts. ‘We see October’s sudden price increase in defence stocks as an overblown and simplistic reaction to the outbreak of war in Israel and Gaza,’ says Nicolas Owens, equity analyst at Morningstar.

‘The dots between military combat and the profit of a defence contractor do not connect nearly as directly as they seem to in the investing public’s imagination.’

Owens and his team see no reason to alter ratings or valuations of defence contractors considering the latest violence, believing that long-term development and resupply of missile defence technology is already baked sufficiently into their forecasts.

AN ETHICAL QUESTION

Some industries feel more taboo to invest in than others. Nobody wants to see war happen, but when it does, the defence industry is there. Defending our way of life and the freedoms we take for granted is also part of a larger picture, and that will attract many investors to turn to the sector for typically steady returns from relatively low-risk businesses.

At its core the defence industry produces the vehicles and aeroplanes, weapons and defence systems needed to wage a war, and to defend oneself from aggressors. But it also comprises otherwise mundane companies like data centre and IT network businesses, warehouse operators to manage inventory and administrative functions, and software companies to provide vital data.

Equity market investors have long recognised that defence is becoming a long-term growth theme.

WHAT IS THE CURRENT BACKDROP?

The war in Ukraine has fundamentally shifted the geopolitical calculus and has accelerated what might be called the fragmentation game – a dynamic that breaks up and realigns global supply chains to account for what will become a multipolar world over time.

The US and China were already engaged in the fragmentation game since the early days of the Trump administration with Europe reluctant to get involved because of its deep trading relationships with China and especially Germany’s dependence on selling machines to China and getting cheap energy from Russia.

The war in Ukraine and Russia’s attempt to weaken Europe through its energy exports pulled Europe into the fragmentation game. ‘Europe’s defence budgets are now increasing at a rapid pace and will continue growing over 10% a year over the next five years,’ says Peter Garnry of Saxo Bank.

‘Central and western European states spent $345 billion in 2022, which in real terms surpasses the spending in 1989, the last year of the cold war. The new spending level takes central and western European countries almost on par with military spending in East Asia, highlighting that Europe is still a formidable power.’

BIG MILITARY BUDGETS

European defence companies continue to see strong order intake as Europe is significantly increasing its defence spending in a response to the war in Ukraine. ‘Our defence theme basket, which is one of the best performing baskets over the past year, and especially driven by European defence stocks such as Saab (SAAB-B:STO), Hensoldt (HAG:ETR), Norway’s Kongsberg Gruppen (NSKFF:OTCMKTS) as well as Leonardo (LDO:BIT) and Rheinmetall (RHM:ETR).

In March 2023, German arms manufacturer Rheinmetall joined Frankfurt’s DAX index after seeing its share price surge 124% in 2022.

The Dusseldorf-based company has now joined Germany’s corporate titans such as SAP (SAP:ETR), Volkswagen (VOW3:ETR) and Siemens (SIE:ETR) on the nation’s blue-chip index.

In a country still haunted by the Second World War, German weapons manufacturers are not celebrated like its world class carmakers or engineering firms, yet it remains a major player on the global stage. Germany was the world’s fifth-largest arms exporter between 2018-2022, according to a report earlier this year SIPRI, ranked just behind China and accounting for 4% of the global market.

Rheinmetall, which makes parts of the Leopard tanks that Berlin has sent to Ukraine, posted record results in 2022 (to 31 December) and has been racing to hire more staff and boost capacity  through 2023.

BAE SHARES HAVE RALLIED

Among the defence stocks to have benefited from recent geopolitical instability is BAE Systems (BA.), which is the UK’s largest manufacturer. Its shares have posted a 21% gain this year and have rallied more than 7% since the most recent conflict in Gaza. BAE produces everything from GPS communications products to boats and naval canons and has just won a trilateral contract to manufacture next-generation nuclear submarines for the South China Sea-oriented Aukus pact.

In August, Morningstar analysts maintained their Wide Moat Rating on the company, while raising their fair value estimate for its stock to £11.70, reflecting an environment of higher defence spending over the medium term. This compares with a current share price of £10.47.

But Morningstar’s Owens says the leap between the situation in Israel and the belief that BAE Systems will stand to benefit specifically from events in the region is a big one. ‘Live footage of Israel’s domestically-developed short-range missile defence system referred to as the ‘iron dome’ demonstrates capabilities most closely associated with RTX’s (RTX:NYSE) and BAE Systems’ munitions portfolios, neither of which exceed 10% of company revenue,’ he says.

WHICH COMPANIES CAN I INVEST IN?

RTX is the renamed Raytheon Technologies, one of the world’s largest defence contractors.

‘When combat depletes munition stockpiles, they will be resupplied from allies’ existing stockpiles with zero impact to the manufacturer that previously delivered them’, says Owens.

Eventual orders for more of the weapons may come, if current production rates will not refill stockpiles in time, but ‘adding capacity is expensive and time consuming, and thus not a bullish outcome in our view,’ says the Morningstar analyst.

In use since 2011, the Iron Dome is a mobile collection of surface-to-air rocket launchers distributed across 10 ‘batteries’ throughout Israel. As for defence giant RTX, which makes missiles and targeting systems, It sits among the major US defence companies Morningstar analysts believe are undervalued.

The UK sector is rather threadbare these days after overseas takeovers of Cobham, Meggitt and Ultra Electronics, with BAE and defence technology firm Qinetiq (QQ.), which was spun out of the Ministry of Defence in the early 2000s, standing out. Rolls-Royce (RR.) is largely a civil aerospace company with limited exposure to defence spending.

CAN I PLAY THE THEME THROUGH FUNDS?

Very much so if you’re willing to take an unfussy approach. Most of the global defence leaders are included in the S&P 500, so a general S&P ETF gives some exposure, while BAE is in the FTSE 100, as is Rolls-Royce, although it doesn’t have as big of a footprint in defence. Babcock (BAB) and Qinetiq are part of the FTSE 250.

Getting more specific exposure is trickier. The HANetf Future of Defence UCITS ETF (NATP) and VanEck Defense UCITS ETF A (DFNG) are two small ETFs that have several defence companies in their top 10 holdings, plus a load of more general engineers and other stocks that you might not call defence firms as such, but may earn part of their revenue from specialist suppliers to the industry, such as French firm Thales (HO:EPA), or US networks kit manufacturer Cisco Systems (CSCO:NASDAQ).

Both ETFs are small, with £11 million and £80 million of managed assets and neither is cheap, with annual charges running at 0.49% and 0.55% respectively, but they may be worth further investigation for some investors.

OUR TOP STOCK PICK

LOCKHEED MARTIN

(LMT:NYSE) $449.41

The biggest defence company in the world, Lockheed Martin produces top fighter jets like the F-35A aircraft and has a $7.8 billion contract with the US government to produce missiles and electronics. It’s a stable company, although the stock has fallen around 6% this year.

But that, we believe, presents an opportunity. Return on capital and equity stand at 21.6% and 67% respectively, and low double-digit operating margins have scope to rise. Net profit has consistently grown faster than revenue and free cash flow has been impressively consistent over recent years.

Net debt needs watching, net gearing is 149% of assets according to Stockopedia data, but that free cash flow and the long-term nature of contracts suggest a company capable of managing above average debt levels.

At $449.41, the 12-month rolling price to earnings multiple is 16.8, while the shares carry a prospective 2.85% income yield.

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