For an investor who is aware of the risks and rewards, defence stocks can be valuable addition to a portfolio. This article looks at some of the top defence shares in the UK, what the underlying businesses do, and things to think about in evaluating them.
What are defence stocks?
A defence stock is simply a share of a company that provides some form of security product or service to military or law enforcement.
Often, the first thing that comes to mind when thinking about defence companies is design and manufacturing. Whether it’s weapons, vehicles or materials, cutting-edge products are often at the forefront of thinking about military businesses from an investment perspective.
But defence companies in the UK are much broader than just manufacturing. Weapons, vehicles and materials are certainly part of the story, but UK defence companies also provide other important services.
Some provide intelligence services that help make operators more efficient and more effective. Others provide training services to equip military personnel with the skills they need to stay up with the latest technological advances. And some are involved in cybersecurity, which are an increasingly important part of national security.
Top defence stocks in the UK
|BAE Systems (LSE:BA)||£22.72bn||Largest UK defence contractor with diverse exposure to global defence programmes.|
|Rolls-Royce Group (LSE:RR)||£7.8bn||Engine manufacturer. Defence makes up around 30% of the group’s revenue.|
|QinetiQ (LSE:QQ)||£1.72bn||Services company. Provides risk evaluation across air, land and sea, as well as cybersecurity.|
|Babcock International (LSE:BAB)||£1.66bn||Provides fleet management and support services for aerospace, marine and land forces.|
|Serco Group (LSE:SRP)||£1.67bn||Public services company providing management services for marine operations and bases, and support services across air, land, sea and space.|
BAE Systems is the UK’s largest defence contractor by market cap. The majority of the company’s revenue comes from its exposure to fighter jet programmes—most notably the F-35 Lightning and the Eurofighter Typhoon. BAE’s customers include governments in the US, UK, Australia and Saudi Arabia.
Rolls-Royce Group manufactures jet engines. While the majority of the company’s revenue comes from its civil aerospace division, it also has a strong business focusing on defence contracts. Its engines are used in naval vessels, military transport and aircraft.
QinetiQ is a military tech company. Its offerings to customers include products and services. Its products include advanced materials, human protection systems, and military robots. Its services include testing, evaluation and training. QinetiQ has both civilian and military exposure.
Babcock International specialises in the construction and decommission of nuclear power plants and submarines. It also offers fleet management services for military vehicles, provides technical training, and maintenance support for military infrastructure. Babcock’s client base is diversified across the UK, Europe, Africa, North America and Australia.
Serco Group provides base and operations management for the armed forces. It also undertakes projects in ship modernisation and aircraft maintenance. Serco also analyses cyber activity, and delivers training, strategy and leadership programmes.
How to invest in defence stocks
Here are five things to think about before investing in defence shares:
The outlook for defence spending
Defence companies sell their products and services to governments. As a result, the available market for defence companies depends on the size of military budgets.
So investors should think about what the future looks like for national spending in this area—whether governments are likely to ramp up military spending, or whether they’re likely to be looking to cut back.
One thing worth noting is that countries in the NATO alliance—including the UK and the USA—have commitments to spend at least 2% of GDP on defence. So military budgets for NATO countries are likely to expand and contract in line with GDP.
The primary advantage a defence company has over the competition comes from contracts. These can typically last for decades and they can be nearly impossible for a competitor to disrupt. Whether it’s a contract to supply fighter jets, to maintain ships or to provide training to military personnel, contracts are an extremely important part of a defence company’s competitive advantage.
When thinking about buying defence shares, it’s important to know what contracts a company has, how much they’re worth and when they expire. It’s also worth thinking about how difficult it might be for a government to switch to a different provider once the current contract expires.
Even if a company has a contract in place, it can still run into difficulties. For a manufacturing company, this can come from an increase in the cost of raw materials or disruption to its supply chain. Service companies are somewhat better protected against the threat of raw material increases, but they need to be innovative enough to stay at the leading edge of technological advancements.
As with several companies, investors in defence stocks need to be aware of how efficiently the company generates cash. Two good metrics to use for this are Return on Equity (ROE) and Return on Invested Capital (ROIC).
ROE is the company’s net income divided by its shareholder equity and multiplied by 100 to give a percentage. In general, a ROE >20 is good and >30 is very good.
ROIC is the company’s net income as a percentage of the assets that it uses in its operations. A ROIC >10 is generally good and >20 is very good.
Defence companies often benefit from customers contributing to R&D costs, allowing them to make stronger returns on equity and invested capital.
Lastly, investors thinking about buying shares in defence companies need to be aware of the company’s financial health. Two important metrics to consider here are Interest Coverage and Debt to EBITDA.
Interest Coverage measures the amount of interest that a company pays on its debt (found on the ‘interest expense’ line of the income statement) as a proportion of its operating income.
Net Debt to EBITDA measures the company’s short-term and long-term debt with cash subtracted as a proportion of the company’s earnings before non-cash charges (depreciation and amortization).
As a rule, it’s better for both numbers to be low. But more significant is how these numbers compare (a) to the company in previous years and (b) to the company’s competitors.
In general, it’s better to see a company reducing the amount of its operating earnings it spends on interest payments and the amount of debt it has relative to its cash earnings. And it’s also good to see that a company is in a strong position relative to its competitors in both cases.
Are defence shares right for you?
Investing in defence stocks can get pretty technical pretty quickly, and it can be easy to get blinded by the science. Naturally, military-grade technology is often at the cutting edge of innovation and can be inherently complicated and difficult to understand. The economics of businesses, however, can be fairly straightforward.
Defence companies that enjoy strong relationships with customers that have huge budgets can be an attractive proposition from an investment perspective. And there are plenty of accessible features for investors to fasten on to. Thinking about how long a company’s contract lasts, how strong its balance sheet is, and what sort of things might threaten its business can give investors a great way into investing in defence shares.