April 4, 2023

Top Gun: Why Defense Stocks Will Continue Their Rise

War and international tension spell increased arms spending and, thus, higher military contractor share prices.

Reported by Larry Light

The war machine also is a profit machine, which nowadays is reflected in strong stock performance for the defense industry. Its market results are cyclical, albeit not in the usual way of tracking the economy: Instead, they are linked to government military spending, and the current trend is for more outlays on armaments.

Upshot: “Defense stocks are a good place to be,” thanks to this new emphasis on the armed forces by the U.S. and its allies, said Fall Ainina, director of research at James Investment. The U.S. is increasing orders for everything from missiles to mortars as it ships weapons to Ukraine to fight the invading Russians, while also strengthening the Pentagon to counter China’s expanding armed forces.

Defense stocks outpaced the broader market in 2022, and heightened spending is likely to continue, said Lauren Sanfilippo, a senior investment strategy analyst at Bank of America, in a research note. Perhaps owing to the military category’s cyclical nature, institutional investors tend to keep their exposure to arms-maker equities at around 1.6%—the sector’s weight in the market.

At the same time, environmental, social and governance edicts, which many allocators follow, do not categorically rule out defense-related investments. Some, though, avoid manufacturers of certain weapons that can injure civilians years after a conflict has ended. Example: cluster bombs, small munitions dropped from aircraft or fired from artillery, that are scattered over a wide area in wait for someone to stumble upon them.

This century, Pentagon budgets and defense stocks have had their ups and downs. U.S. military spending surged during Republican George W. Bush’s presidency as the nation geared up to fight terrorism and the Iraq war. It dipped for much of Democrat Barack Obama’s tenure, aided by a 2011 agreement with Congress to trim federal expenditures. Then the military budget rose again under Republican Donald Trump. While Democrat Joe Biden talked of trimming defense outlays, Russia’s invasion of Ukraine instead has prompted even bigger budgets for the Pentagon.

Military contractors’ stock performance has largely followed those trajectories, although small, quarter-to-quarter fluctuations are common for share prices and earnings. Weapons contracts are multi-year commitments, and the cash flow sometimes is not steady, which can affect equity prices. The question always is: What new deals has a contractor signed?

A good proxy for the industry is Lockheed Martin, the largest defense company, whose stock had a 32% advance last year, as the S&P 500 lost 19%. Thus far in 2023, the company’s stock is flat, with the index ahead 7%. The average analyst price target for the next 12 months is $500, per Nasdaq research. That would be a hike of 6% from the present $472 close on Friday.

As Morningstar analyst Nicolas Owens wrote, “Biggest isn’t always best, but Lockheed (and investors) benefit from the sheer scale of its tens of billions of dollars of contracts that provide defined, decades-long revenue and profit streams.” The same could be said for the other large defense contractors.

Through consolidation, the industry is a five-company oligopoly, controlling much of the Defense Department’s procurement. Aside from Lockheed, the companies in this group are: Raytheon Technologies, Boeing (40% of its revenue is military, with the rest commercial aircraft and other uses), General Dynamics and Northrop Grumman. “Only a few players dominate,” says Max Wasserman, co-founder of Miramar Capital, and their customer base is growing. “Worldwide demand [for arms] is up in places that had been sleeping, like Germany and Poland,” until Russia’s belligerence awakened them.

More broadly, the iShares US Aerospace and Defense exchange-traded fund, which covers 35 military contractors (including the five biggest such as Lockheed) and began in 2006, trails the returns of the big five firms. The ETF enjoyed a 10% increase last year, when the S&P 500 was deeply in the red. This year, however, the fund is up 3%, Many strategists think the small 2023 rise for the ETF stems from profit-taking.

Arms and the Allocators

Sure, periodically, military contractors have been controversial. A special Senate committee held hearings in the 1930s on the industry’s influence over U.S. politics, as rumbles of war were growing,. The panel’s chair, an isolationist North Dakota Republican named Gerald Nye, condemned the arms-makers as “merchants of death,” and accused them of maneuvering President Woodrow Wilson into entering World War I.

In the 1970s, fueled by animosity toward the Vietnam War, Congress whittled down the armed services’ budgets, and lawmakers decried what President Dwight Eisenhower first dubbed “the military-industrial complex.”

Arms manufacturers are far from being the tobacco business, which pension programs, endowments and foundations largely eschew. Still, the scope of defense stocks’ fan base is limited. Finding a large allocator position in defense stocks is hard, as institutions tend to keep their allocations in line with the S&P 500 weightings for the sector.

A look at the defense holdings of the three largest U.S. public pension plans shows a remarkable similarity: They all own the top five contractors’ shares, amounting to 1.5% for the California Public Employees’ Retirement System, 1.4% for California State Teachers’ Retirement System and 1.1% for the New York State Common Retirement Fund.

At the Maryland State Retirement & Pension System, CIO Andrew Palmer keeps his defense holdings at 1.1% of assets under management. MSRP holds the top five contractors, with Lockheed its second-largest among the quintet, after Raytheon. “Lockheed is a Maryland company,” Palmer points out, since it is based in Bethesda, Maryland, right outside Washington, D.C., where much of its business is done.

Allocators do make changes to their defense stock positions at the margin. Caisse de Dépôt et Placement du Québec, the giant Canadian pension fund, has long had a position in Lockheed Martin. As of 2022’s final quarter, CDPQ had trimmed its holding in the stock by 41% to 150,000 shares.

The Lockheed investment, now worth around $93 million, is only about 0.30% of CDPQ’s portfolio. The pension plan declined to comment on why it made this move. In total, its exposure to defense is much smaller than its American counterparts, at 0.4% of assets.

Are Military Contractors ESG-Friendly?

It’s telling that CalPERS, CalSTRS, New York Common and the Maryland plan are all ESG supporters, yet own Pentagon contractor stocks in line with the index. Hardly anyone is pushing for them to divest and most prefer engagement to divestment, which was used with morally objectionable investments in South Africa during apartheid in the 1980s or tobacco stocks in the 1990s.

Today, any opposition to Pentagon spending is muted, amid alarm over Russia’s aggression in Ukraine and a possible Chinese attack on an independent Taiwan, which Beijing considers a province. “We don’t have a ban list” for investments, says Maryland’s Palmer, although he admits the MSRA stays away from Iran, Sudan and Russia, which are among the countries subject to sanctions programs by the U.S. Office of Foreign Assets Control.

The pro-military spirit prevails when it comes to ESG’s relationship to the industry. After all, U.S. warriors do kill people; sometimes non-combatants get in the way. Only about 11% of 395 ESG-oriented mutual funds and ETFs exclude military contractors, according to data from Morningstar Direct for Bloomberg. The ESG investment prohibition roster is larger for specific munitions dubbed “non-precision,” meaning they imperil civilians: 59% shun companies that produce controversial weapons such as cluster bombs, anti-personnel mines and nuclear warheads.

Nonetheless, that leaves a lot of investment managers that accept military products among their investible assets in general. BlackRock’s iShares ESG Aware MSCI USA—the world’s largest ESG-focused ETF— includes shares of missile manufacturer Raytheon Technologies, nuclear submarine maker Huntington Ingalls Industries and electronic warfare technology outfit L3Harris Technologies.

Among backers of the military-industrial complex, there’s a high-minded rationale for robust offensive capabilities: to ward off autocratic regimes’ zest for conquest that, if successful, would presumably crush ESG policies. Jan Pie, secretary general of the Aerospace and Defence Industries Association of Europe, has asserted, “If you don’t have security and stability, if you can’t defend the open values of democracies, you cannot have any kind of sustainability. Unfortunately, I think there is evidence of that going on in Ukraine as we speak.”

Certainly, as Senator Nye would attest, the notion of profiting off enormous carnage and ruin does have an unseemly aspect. The Ukraine war, the largest conflict in Europe since World War II, has demonstrated the enormous destruction that modern weaponry can unleash, with entire cities flattened.

But the defense industry has shown repeatedly that it has resilience. In 1956, amid the nuclear anxiety of the Cold War, folk singer Pete Seeger sang in a protest ballad: “Ain’t gonna study war no more.” The fortunes of the so-called merchants of death were climbing then and, despite some slumps, have continued ever since.