Sometimes the best offence is a good defence

War. It changes things. With change comes uncertainty. In Tolstoy’s epic War and Peace, the main protagonist, Pierre Bezukhov, reflected on the idea that “All we can know is that we know nothing. And that is the height of human wisdom”. While this may hold eternally true, when Russia commenced its invasion (translates into Russian as “special military operation”) of Ukraine earlier this year, we could say, with a fair amount of certainty, that countries around the world, especially European nations, will be placing a lot more focus on protecting their own borders against a potential invasion.

How will this event impact European military spend?

In 2006, NATO Defence Ministers agreed that their respective countries would commit, at a minimum, two percent of their respective country’s gross domestic product (“GDP”) towards defence spending. Prior to the invasion of Ukraine, many NATO nations were spending below the two percent threshold but it is likely that they will now increase their spend in line with the agreed upon target with some even opting to spend well above. European defence contractors such as BAE Systems, Rheinmetall and Thales, to name but a few, are likely to benefit from increased spend by European nations.

What about the United States?

Don’t bring a machine gun to a tank fight. That is the philosophy of the US when it comes to defence as its spend exceeds that of all other NATO nations combined. The US spends roughly four percent of its GDP on defence and from a global perspective, it spends far more than any other nation on defence, at least in absolute US dollar terms. However, this is where things become a little more interesting. Adjusting for purchasing power and the cost of the US deploying and maintaining forces outside of the US, the “adjusted” defence spend for the US is actually below that of Russia and China when combined.

The majority of defence spend by the US is allocated to military personnel, military housing, training and maintenance. A little under one third actually goes towards modernisation – new equipment and arms.  Over the past two decades, while the US committed large sums towards funding operations in the Middle East, Russia and to a greater extent China, have ramped-up and focused their military spend on new technologies. While increasing defence spend on modernisation to combat the threat from China may have already been on the radar, events in the Ukraine have already prompted the US government to increasingly allocate more funds towards modernisation.

Which companies are likely to benefit from increased defence spend?

As mentioned above, European defence contractors are set to benefit from increased spend by European nations. That said, while US defence contractors supply predominantly to their biggest customer, the US government, they also supply equipment and weapons to other nations. Given the advanced technologies and capabilities available from US defence contractors, it is likely that many European countries may opt to look offshore, as appears to be the case with Belgium, Denmark, Germany, Italy, the Netherlands, Norway and Switzerland (non-NATO member) who recently placed orders for Lockheed Martin’s F-35 fighter jets.

The recent aggression from Russia and the growing threat from China combined with the absolute size of defence spend by the US, which is expected to increase going forward, means that US defence contractors are likely to see sizable benefits in the future. To be more specific, companies that are focused on areas of modernisation which are of strategic importance for the US government are likely to see the most growth. Key areas include space (think satellites rather than billionaires flying into space), missiles and missile defence and the most contentious area of all, nuclear arms. Specific US defence contractors that operate in one or more of these segments include General Dynamics, L3Harris, Lockheed Martin, Northrup Grumman and Raytheon.

Do defence contractors make good investments?

Over the past two decades, US defence contractors have consistently outperformed the S&P500 Index, a broad measure of US equity markets. The COVID pandemic era was a challenging period for these companies but in general, US Defence contractors have enjoyed strong relative outperformance against the overall market.

The structure of the US defence industry is such that it operates as a near-monopsony wherein there is only one major customer, the US government, albeit split between its various departments or branches (Air Force, Navy, Army etc.). In addition, the US defence industry has gone through a long period of consolidation, which was encouraged by the US Department of Defence and a likely factor behind US defence contractors earning favourable returns on capital, well in excess of the cost thereof. To this point, consolidation was a likely factor that enabled defence companies to develop and maintain strong economic moats.

These moats, which are often characterised as wide and enduring, are underpinned by a number of elements. “Products” are often complex and require extensive expertise and the main customer is often quite discerning as to its suppliers. In addition, the product development cycle can be quite lengthy as well as costly. This makes it incredibly difficult for new companies to enter the industry as barriers to entry are incredibly high. Lengthy product cycles also provide a window to a period of sustained, predictable revenue. Contracts are often structured as cost-plus which does reduce the risk of overruns but can lead to potentially lower profits. The customer is however quite unlikely to switch suppliers given the mission-criticality of products, lack of alternative suppliers and the substantial cost associated with switching.

What if I want to invest in a company that will benefit from increased defence spend but I don’t want to invest in a company that manufactures arms?

There are a number of companies that are not associated with the manufacture of arms but are still likely to benefit from an increase in defence spend. Many of these companies are located within the semiconductor (Microsoft, Qualcomm) or IT services sectors (Leidos, Booz Allen Hamilton). In addition, there are companies predominantly associated with commercial aerospace that also supply components to the US military (Transdigm, Ball). For these companies indirectly associated with defence spend, it is important to understand they while they may benefit from an increase in defence spend, it would be less likely that they benefit to the same extent as the defence contractors themselves.

Tolstoy is not renowned for his stock market prowess but his wisdom certainly transcends. No matter which companies you choose to invest in one would be well served to heed the following when investing: “The two most powerful warriors are patience and time”.