Why I'm Bullish On Defence Shares

BAE looks fairly valued and nowhere near the point of maximum pessimism. The coming decades are going to see the whole world deal with the fiscal strain of ageing populations. Military spending is the most obvious source of cuts. Iraq and Afghanistan have likely soured the US on large scale ground combat for a good ten to fifteen years.

The sector is truly out of favour? You forgot to mention Qinetiq which is up over 60% in the last year. The fiscal cliff may prove a drag, but US politicians, especially Republicans are always reluctant to reduce defense spending. Even the Tea Party types seem to like to spend more money on new toys for the boys when it comes to defense. The US could massively reduce its defense spending for several years and still be the strongest military force on the planet by a long way. This would go some way to solving US debt issues, but they are unlikely to do it.

I've no particular view on BAE, but I would just note :

there is no shortage of potential flashpoints for military conflict involving the US. The Middle East is an obvious one.

But their current activity implies a lot of Middle East flashpointery already. If you are looking to make money, then you are looking for what, 5% more conflict per year over a baseline of the current activity in Afghanistan, Somalia, Syria and so on. You've also got to look at the nature of the conflict - Afghanistan has been a fantastic war for BAE, as the US has required huge numbers of light armoured vehicles, a real sweet spot for them. You've got to think about the nature of future conflicts, will the US be so quick to put troops on the ground? Just think about how many BAE products have been used in Afghanistan/Iraq, versus how many BAE products have been used in Libya and Syria. Is the future of Western involvement in the Middle East going to look more like Afghanistan or Libya?

the US set to enjoy low-cost energy self-sufficiency on the back of the shale gas revolution.

The low-cost shale gas thing is a bit of a myth, recent US gas prices have been unsustainable thanks to a mix of mild winters, some licence technicalities, and "waste" gas from oil shales. Yes it's certainly plausible that the US could soon be in a position where it could get all its oil from the Americas, although shale oil is not cheap oil by any means, we're not going back to 1998. But if you buy that argument, are you not also saying that the US will lose interest in the Middle East, and so the likes of BAE will benefit less from point 1? Obviously the Middle East will always be important for setting global oil prices, but you can imagine that the US will be more minded to "contain" with naval forces rather than putting BAE armoured vehicles on the ground to intervene in detail.

I don't think the US will readily give up its global military superiority.

This sounds like the same argument the USSR used in the 1980s - it ended in bankruptcy. Or the UK in the late 19th century, they tried to cling on to a navy bigger than the next two powers but in the end they just couldn't outrun Germany and the US. You can't buck economics in the end, and we are moving to a world where economic power is no longer in the hands of just a few Western countries. Inevitably that will mean military power becoming more multipolar - just look at the huge high-tech air forces in the Arabian peninsula, which was a complete backwater in WWII.

You've also got to look at some of the pressures closer to home. From a low base, governments are getting cleverer at procurement, pushing more of the risk onto companies and introducing things like mandated affordability caps. There's a lot fewer cost plus contracts, and financial reality has closed down some of the more optimistic programmes like the US Marines' EFV. Those trends could play to BAE strengths in some cases - the Hawk is the cheap and cheerful, low-risk option for the US trainer programme, but could get stymied by the industrial considerations of needing to keep Boeing in the fighter aircraft game (qv what happened with the Airbus tankers). While advocating more defence spending, the Republicans in particular are keen on the idea of cutting costs through more competition, and at the moment many of the USAF's most expensive programmes are falling into a Lockheed Martin monopoly.

There's also the issue of competition - Western firms have enjoyed salad days since the Cold War as the Russian companies have struggled to keep up. Even dedicated customers like the Indians have given up on the Russians after a series of mishaps - in past times Western companies would not have had a chance of getting an aircraft deal with India, now Typhoon was a prime contender. But technology transfer is seeing new competitors start to emerge - Hawk is now seeing a Korean competitor, Singapore and South Africa are starting to win deals for armoured vehicles, and so on. Those countries will only go up the value chain, just like in domestic cars and computers and so on. Look how we used to sell lots of frigates and diesel submarines around the world, now all we can manage is the odd patrol boat.

That's not to say BAE doesn't have some bright spots - it's looking very good for Typhoon in the Gulf at the moment because the Israel lobby won't allow the US to sell the best toys to the Arabs. But the Red Queen needs to run much harder than that just to keep still.