As the world’s power centers shift, countries are spending more on defense, including nations like Japan—which has steadily increased such spending in recent years —to maintain weapons supplies during active wars on two continents and to ensure longer-term security.
As a result, defense contractor stocks have been on a roll.
This is not to say that defense stocks are outshining some other sectors, like tech; investing in defense has not been an exercise in market beating. The iShares US Aerospace & Defense ETF has risen 15% this year, per Morningstar. Meanwhile, the S&P 500 is up 19%.
Lockheed Martin is the top defense contractor for the U.S. and its European allies by revenue. Its stock is up 23% this year. Among European companies, the U.K.’s BAE Systems (ahead 26% in 2024) is No. 1. Lockheed and Northrop Grumman (10%), also a U.S. company, lead in defense artificial intelligence globally. The largest military drone maker is Lockheed, as well.
The point of investing in defense is that the sector, especially its largest companies, usually offers superior dividends due to dependable cash flows, and their stock performance is non-cyclical.
As Tensions Mount, So Do Budgets
The increased defense spending is coming as historically high levels of globalization, rising steadily since the 1960s, may have peaked during 2020’s global pandemic. In addition to the impacts of this trend on the costs of production of goods, the shift is also resulting in higher tensions in different regions of the world.
Against this changing backdrop, the largest U.S. defense companies (defined as earning more than half their revenue from making weapons and meeting other military needs, such as artificial intelligence) out-yield the index. The largest, Lockheed, has a 12-month trailing yield of 2.3% versus the S&P 500’s 1.2%. In 2022, a poor year for the market as a whole, the S&P 500 fell 18%, while the defense ETF increased 10%.
“Defense is a safe place to invest, with mature business es growing at single-digit rates, and you should go for the biggest players,” says Lamar Villere , a partner in and portfolio manager at asset manager Villere & Co. “A lot of portfolios are driven by consumer demand. It’s nice to have different drivers.” His firm owns Lockheed stock, “and its 2.3% yield is a good insurance policy,” as it acts to cushion market fluctuations.
In addition, he expects that Pentagon and U.S. allies’ military appropriations will be will grow, given the world’s current unrest, namely the Ukraine war and the Gaza conflict. The GOP presidential nominee, former President Donald Trump, has proposed boosting the U.S. defense budget and his Democratic opponent, Vice President Kamala Harris, has gone along with the increase in military spending overseen by President Joe Biden.
In the post-Vietnam era, Pentagon and defense stocks have had ups and downs. U.S. military spending soared during Republican George W. Bush’s tenure, as the U.S. rallied to fight terrorism and the Iraq war. It slipped for much of Democrat Barack Obama’s presidency, aided by a 2011 agreement with Congress to shrink federal expenditures. Then the military budget rose again under Trump’s 2017 to 2020 administration and under Biden’s. Most recently, military spending totals $841 billion for fiscal year 2024 (which ends September 30); in fiscal 2020, Trump’s last year in office, it was $778 billion.
“Both parties are pro-defense,” Matt Benkendorf, CIO for quality growth at Vontobel Asset Management, told Barron’s. “Given the state of conflict in the world, geopolitical risks are getting hotter, not cooler.”
Institutional Involvement
Institutional investors do not own a lot of defense contractors’ stocks now: At the California State Teachers’ Retirement System (assets: $345 billion), for instance, the top five defense companies make up a little less than 0.5% of the portfolio. “This is a quiet industry,” says Tony Bancroft, a portfolio manager at Gamco Investors and head of its new Gabelli Commercial Aerospace & Defense ETF.
Until the current Ukraine war began in 2022 , environmental, social and governance sentiment in Washington and other Western capitals fostered opposition to large defense spending, including among institutional holders. “I don’t see an ESG block in portfolio” purchases anymore, Bancroft observes.Indeed, many big pension funds such as the New York State Common Retirement Fund and the Maryland State Retirement and Pension System have about 1% of their holdings in the stocks of military contractors, in line with the defense shares of the S&P 500, and their positions represent an increase from the past.
A Global Trend
The rise in defense expenditures is a worldwide trend. The Stockholm International Peace Research Institute calculated that military outlays have been expanding for the past nine consecutive years. The U.S., China, Russia, India and Saudi Arabia made up almost two-thirds of this growth. The U.S. has placed huge orders for new tanks and pilot-flown warplanes.
In Europe, since the Russian invasion of Ukraine, North Atlantic Treaty Organization allies have pledged to increase their military spending by more than 2% annually after years of few or no hikes. Even in Japan, which since its World War II defeat had shied away from having a large military, the government intends to enlarge defense spending by 60% over the next five years. Adding to the impetus for higher defense spending is that older equipment, such as the M1 Abrams tank, needs to be replaced, Bancroft specifies.
The expansion plans go far beyond buying new artillery pieces, fighter planes and tanks. Drones and counter-drones (unmanned aircraft designed to knock them down) are in demand. Plans also are afoot to power military vehicles with batteries, which presumably would give them a better ability to run, since they would not have to be refueled as often as gasoline- and diesel-based transport.
AI is also a hot new area for defense appropriations. The U.S. Department of Defense requested $1.8 billion for AI spending for the current fiscal year, doubling the amount from the previous year. The Air Force, for instance, is developing an unmanned fighter plane powered by AI.
All that is bound to translate into greater appetites for military equities, the thinking goes. As Gamco’s Bancroft notes, “we have two hot conflicts. There is as much turmoil in the world as in World War II.”
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Tags: aerospace & defense, China, defense stocks, Gabelli, iShares US Aerospace & Defense ETF, Japan, Lockheed Martin, NATO, Pentagon, Ukraine
