At least one high-technology British manufacturing company is defying the doom and gloom.
BAE Systems (LSE: BA) is the third largest defence contractor in the world and one of Britain's largest manufacturers. It posted strong annual results last February with a 23% increase in underlying earnings per share of 37.1p, demonstrating that BAE is somewhat insulated from the global economic downturn. BAE's shares have been a strong performer since early 2003 having moved up from just over 100p to their recent trading range of between 300p and 400p.
BAE is the primary supplier to the UK Ministry of Defence; if you serve or have served in the military you've almost certainly used some of its products. BAE should be thought of as an Anglo-American business because its sales to the US Department of Defence now exceed those to the MOD. BAE is a global company, its major competitors are American and European defence and aerospace companies such as Lockheed Martin, General Dynamics and EADS.
Its shares are on a relatively undemanding historic price-earnings ratio of around 9.5 and the shares hold attractions for income investors with their dividend yield of just over 4%. One of the main reasons for investing in shares is the prospect of rising dividends and BAE have not disappointed its investors having increased its dividend over the last five years by approximately 9% per annum.
BAE's product range covers the entire military spectrum, examples of which are the RAF's Tornado fighter-bomber, the Challenger Tank, the Astute-class nuclear submarine and the British Army's L85 assault rifle. BAE also has a substantial business in maintaining and upgrading its products, an example of which was seen last week when the US Army awarded BAE a $601 million maintenance contract for its Bradley Armoured Fighting Vehicles.
Resolving the pensions question
One concern for investors in BAE is its pension schemes are currently in deficit to the tune of around £4.2 billion pounds (approximately one-third of its market value). Many companies' pension schemes are suffering thanks to the combination of poor stock market performance in recent years, increasing longevity and the imposition of income tax upon their dividends in 1997. BAE is better placed than most to deal with this problem and the interim management statement earlier this month confirmed that BAE's revised scheme funding plan was recently approved by the UK regulators.
May you live in interesting times
Defence spending is, to some extent, insulated from the broader economy. National security concerns tend to trump most other political matters and history tells us that the demand for military products can increase during economic downturns as countries start to make threatening gestures to foreign countries to distract their citizenry from the poor domestic economy.
The world is still a dangerous place as all over the globe people are fighting small wars over resources, trade, religion and other ideologies. The failed state of Somalia is exporting piracy to the high seas and stateless trans-national terrorist and organised crime networks have taken advantage of globalisation and peoples' discontent to spread violence around the globe. The Pentagon recently concluded that Mexico could easily become the next failed state due to the ongoing drug war with drug-related ultraviolence starting to spill across the border into America. However much politicians like to talk about the "peace dividend" defence spending is not going away.
Many military strategists argue that we now live in a world where the dominant form of conflict is "fourth-generation warfare" (4GW) where nation-states come under attack from stateless groups, through terrorism and other forms of asymmetric warfare. It is possible that 4GW will reduce the demand for "big ticket" military goods such as battleships, but 4GW will also increase the demand for armoured fighting vehicles, small arms, body armour, unmanned aerial vehicles and general security equipment, all of which BAE already produces.
Furthermore, the recent sabre rattling from some of China's generals and admirals has persuaded countries such as Australia, one of BAE's six "home markets", to substantially increase their conventional defence spending.
An ethical dilemma
BAE presents a dilemma for many investors are reluctant to invest in arms manufacturers on perfectly acceptable ethical and moral grounds. My opinion can be summed up by quoting Winston Churchill, "we sleep soundly in our beds because rough men stand ready in the night to visit violence on those who would do us harm." In order to do so these rough men (and women) must be provided with the necessary tools for the job and BAE is such a toolmaker.
Until we have technologies similar to the replicators of Star Trek and humanity has socially progressed to levels where violence has all but been eliminated, there will be a need for defence and thus a need for defence contractors. History has given us many warnings that societies which do not defend themselves can easily fall victim to the "Barbarians at the gates" and that those who beat their swords into ploughshares may soon end up ploughing for those who did not.
So, if you do not have ethical objections against the company's business, BAE shares provide a reasonably high income from a business that is to some extent protected against economic downturns. BAE produces goods and services that will continue to be in demand until human nature drastically changes.
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> Tony Luckett does not have a beneficial interest in any of the companies mentioned in this article.
