It’s been a bumpy week for the FTSE 100, yet Rolls-Royce Holdings, Babcock International Group and BAE Systems (LSE: BA.) shares have muscled through it nicely.
The blue-chip index fell around 1.5% last week after a strong run, but defence stocks didn’t notice. Over the last week, Babcock is up 3.7%, BAE System edged up 1.5% and Rolls-Royce climbed 5.5%.
Over 12 months, those figures stand at a staggering 98%, 31% and 122%, respectively, as defence sales rise in response to Moscow’s actions. They got a lift yesterday (1 September) after news broke that Norway has agreed to buy at least five British-built Type 26 frigates in a £10bn deal.
Over five years, the numbers look even starker. Babcock has skyrocketed 300%, but BAE has surged 250% and Rolls-Royce an unbelievable 1,450%. Such returns inevitably stretch valuations. Today, their price-to-earnings ratios stand at 20, 26 and 54, respectively. That doesn’t leave much room for disappointment though. Investor expectations are as high as their share prices, if not higher. Even the mildest disappointment could be crushing.
Big FTSE 100 winners
Still, the long-term backdrop looks supportive. Rising global tensions continue to drive demand for defence hardware, with European governments willing to spend despite tightening public finances.
BAE underlined the positive picture in its half-year results on 30 July, upgrading full-year sales growth guidance to between 8% and 10%, up from 7% to 9%, after what chief executive Charles Woodburn called another strong performance. It’s enjoying sustained momentum and so are Babcock and Rolls-Royce.
A note of caution. BAE’s order intake slipped to £13.2bn from £15.1bn a year earlier. It’s a handy reminder that even defence groups cannot expand endlessly. If cash-strapped countries such as France are forced to trim spending, then growth might slow. Yet the order book remains huge at £77.8bn, boosted by major submarine contracts, so this does not look like a huge concern yet.
Looking ahead
So what do the experts say? Analysts remain upbeat. Consensus forecasts suggest Babcock could climb to 1,235p over the next year, a potential rise of 19.5% from today’s 1,035p. They expect BAE to advance an impressive 18.7% to 2,118p. Rolls-Royce, despite its huge run, is still projected to gain another 12% to 1,219p.
The geopolitical threats are showing no signs of fading, with hopes of peace in Ukraine receding and concerns about other parts of the world persisting. The big question is whether the West has the money and will to stand up to face those threats.
I think these stocks could continue to deliver, although not at the explosive pace of recent years. Long-term investors who don’t have exposure to this key sector might still consider buying, but should temper their expectations.
Those already sitting on big gains might consider letting them run. I hold both BAE Systems and Rolls-Royce shares, and have absolutely no intention of selling them. I expect a bit of bumpiness over the year ahead, but that’s to be expected with any stock or sector. I plan to hold both shares for years if not decades. And if the sector dips, or we see a wider stock market sell-off, I’ll consider buying Babcock. It’s the cheapest of the three and I quite fancy completing the hat-trick.
