Flying the flag for defence stocks: All systems go for sector often in firing line

The launch this week of a Future of Defence fund that will put money into the armaments and cybersecurity industries comes amid confusing signals from the sector.

In the wake of Russia’s invasion of Ukraine, investing in defence stocks – until recently regarded by many as anathema – is increasingly seen as providing support to democracy.

Yet in the past few weeks the direction of share prices has not necessarily reflected the global boom in spending, sparked by the war in Ukraine, and alarm over China’s intentions towards Taiwan, its neighbour in the South China Sea.

After a long-ish era of decline, expenditure reached $2.24trillion (£1.74trillion) last year, with British businesses such as Chemring, which supplies materials and components for missile systems, reporting a surge in orders.

Nato members that have not dedicated 2 per cent of GDP to defence are promising to meet this target. The HANetf Future of Defence fund, which will have the stock market ticker ‘Nato’, will back only companies based in the countries that are members of the alliance or part of the Nato Plus group – Australia, New Zealand, Japan, Israel and South Korea.

On the radar: BAE supplies parts for the RAF’s Typhoon fighter jets

Despite the rush to re-equip and form multi-year partnerships, shares in some major UK and US defence names fell following last month’s failed insurrection led by Yevgeny Prigozhin, the founder of the Wagner mercenary group. BAE slipped as did Qinetiq, which is behind the Banshee drone.

It seems traders viewed the brief coup as evidence of instability in Russia that could shorten hostilities in Ukraine. A cessation would reduce outlay on tanks, troops and the rest, with other consequences for defence contractors.

Ukraine has been a hugely important testing ground for these groups’ technologies, revealing where innovation and upgrades are needed.

Some investors, devoted to the cause of ESG (environment, social and governance) will be unperturbed by the post-coup share price falls.

They will continue to shun BAE, Qinetiq and other cyber-security or weaponry companies in the EQM Future of Defence index. Its constituents include Cisco, Northrop Grumman, Palo Alto and Raytheon, maker of the Patriot missile.

But Russian aggression has shifted opinion. Even those committed to ESG are seeking a measure of exposure to defence.

In response, the Future of Defence fund is the second such launch. The VanEck Defense Fund, which debuted in April, has stakes in businesses such as the defence software specialist Palantir.

David Coombs, of Rathbone, lists the arguments in favour of a more nuanced viewpoint. ‘Defence can provide diversification in a portfolio because companies of this type are driven by geopolitical rather than macroeconomic factors.

‘Countries are the biggest and most reliable consumers, since it is a nation’s prime responsibility to safeguard its citizens. I bought US group Lockheed Martin, maker of the Black Hawk helicopter for our core funds in 2016.

‘Its systems are of the highest quality and its biggest customer is the US military, which will only buy from US contractors.’

Ben Yearsley, of Shore Financial Planning, says that despite the change in the ‘mood music’ around defence, few funds have huge stakes because of the moral complexities, or the requirement to comply with ESG criteria.

As a result they have foregone the gains offered by Rolls-Royce, the top manufacturer of engines for the military market.

Yearsley says: ‘Rolls-Royce isn’t a pure-play defence stock – about 30 per cent of revenues come from this activity. But it’s been a big turnaround story, with its shares up 92 per cent over the past year to 151p.’

The consensus of analysts rates Rolls a buy. Chloe Lemarie, at Jefferies, is targeting a price of 210p.

BAE, Britain’s biggest defence contractor, is also a buy, according to the consensus, with Morgan Stanley targeting a price of 1208p, citing the company’s share buyback programme and 2.97 per cent dividend yield.

This optimism is heartening for those with money in the City of London Trust, where BAE, which builds combat vehicles, nuclear subs, radar systems and jets, is the second-largest holding.

Trust manager Job Curtis says BAE’s wares are essential to defend democracies against dictators. Charles Woodburn, BAE’s boss, is similarly forthright, saying its ‘opportunity pipeline remains strong’, underlining the inconvenient truth that the world is a riskier place and governments will spend accordingly.

Investing requires flexibility. It would be short-sighted to fail to acknowledge that conventional warfare is taking place in Europe and may continue for some time.

I am placing long-term bets on UK defence groups in a ‘backing Britain’ strategy – and as my way to support the Ukrainian people in their struggle for democracy.