Is it time to get defensive and buy these 3 FTSE shares?

Our writer’s found three FTSE shares with exposure to the defence sector. But would they make a great investment in these troubled times?

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Here’s my take on three FTSE shares that have rallied against a backdrop of record-breaking defence spending of $2.2trn, in 2023. And with nearly 50 armed conflicts in the world, I doubt the market is going to slow soon.

However, for ethical reasons, investing in the sector doesn’t appeal to everyone. But I believe the primary responsibility of government is to protect its citizens, so I won’t rule it out.

With predictable, long-term contracts, shares in the sector have – excuse the pun — defensive properties. They could help balance some of the more volatile stocks in my portfolio. 

BAE Systems

From 2019-2023, BAE Systems (LSE:BA.) recorded a 30% increase in turnover and a 27% rise in post-tax earnings. This has helped push its share price 174% higher, since March 2019. During the year ended 31 December 2023 (FY23), it reported earnings before interest and tax of £2.68bn. Analysts expect this to grow by 7.3% in FY24, to £2.88bn.

At the end of 2023, the company had an order book worth an impressive £58bn – an 18.7% increase on a year earlier. This includes new contracts for the AUKUS and Dreadnought nuclear-powered submarine programmes.  

But its shares are currently yielding 2.5%, well below the FTSE 100 average of 3.9%. That’s disappointing for an income investor like me.

And they have a price-to-earnings ratio (P/E) of over 21. This is at a five-year high – and still climbing – suggesting an increasing mismatch between BAE’s stock market valuation and its underlying financial performance.

Rolls-Royce

In FY23, Rolls-Royce (LSE:RR.) generated 26.5% of its revenue from its defence division. And the business segment had a record order book at 31 December 2023 of £9.2bn. This means over 90% of sales for FY24 are secured.

Operating profit in FY23 was £562m, contributing 35% to the group. The margin was 13.8%, but the directors hope to improve this to 16%, by FY27.

Much of the recent share price growth — it’s up nearly ten-fold since its post-pandemic low of October 2020 — can be attributed to its civil aerospace division. In FY23, large engine flying hours were double what they were in FY20, and 80% of the FY19 number.

This has helped lift the shares to a forward earnings multiple of nearly 30.

However, they are too expensive for me, especially as the company doesn’t pay a dividend.

I’m therefore going to rule out investing in both BAE Systems and Rolls-Royce, on the grounds that I believe there are better (cheaper) opportunities elsewhere.

Babcock

Babcock International Group (LSE:BAB) plays a central role in the UK’s defence through its supply of warships and nuclear submarines to the British navy.

For the year ended 31 March 2023 (FY23), it recorded an underlying operating profit of £178m, on turnover of £4.44bn.

Analysts are expecting this to increase in each of the next three years — £291m (FY24), £317m (FY25), and £351m (FY26).

Impressively, the margin is forecast to rise to 7.7% by the end of FY26, compared to 4% for FY23.

Although Babcock’s shares have gained over 50% since March 2023, they are largely unchanged over a five-year period.

But compared to the other two, they are more reasonably priced with a forward P/E ratio of 13.6.

However, its dividend yield of 1.1% is paltry, which means I don’t want to invest.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Beard has no position in any of the shares mentioned. The Motley Fool UK has recommended BAE Systems and Rolls-Royce Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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