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Why Bad News Is Good News For BAE Systems plc, Chemring Group plc & Avon Rubber plc

Chillingly foreshadowing another Middle East war, the former Chief of the Defence Staff, Lord Richards of Herstmonceux, said yesterday that he would be “most surprised” if Britain didn’t enter into combat within the next five years to counter the threat of ISIS. The Daily Telegraph reported him criticising politicians for being slow to recognise that “we need to approach this issue of Muslim extremism as we might approach World War Two back in the 30’s”.

His reference to the Second World War is telling. It has become fashionable in some circles to regard investment in the defence sector as unethical. But if Britain had chosen appeasement rather than war in 1939/40, concepts such as ‘human rights’, ‘racial equality’ and ‘religious freedom’ would have been banished from the Continent of Europe.

Ploughshares don’t provide much protection when people come at you with swords.

A bit of Gracie Fields

So it’s perfectly right that investors should finance defence, much as their forebears bought War Bonds. And it’s right that they in turn make a profit when the firm that makes the thing that holds the oil that oils the ring that works the thing-ummy bob that’s going to win the war makes a profit.

Three prime examples are BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), Chemring (LSE: CHG) and Avon Rubber (LSE: AVON).

No longer officially designated as national champion, BAE nevertheless remains the go-to contractor for Britain’s fighting ships, submarines and armoured vehicles — though the US, 40% of sales, is more important to the company. A significant position in the massive, and massively over-budget, F-35 joint strike fighter will boost earnings when that finally comes into production. A PE of 12 and yield of 5% makes BAE a great cornerstone share.

Faded darling

Chemring is a faded stock-market darling and an excellent case-study in investment appraisal. The shares ten-bagged between 2003 and 2010, and then the wheels fell off in 2011 as the West’s withdrawal from Iraq and Afghanistan revealed that the company had grown too fast and acquired too much, without control of costs or cash. The stock became a classic value trap and is now worth a quarter of its peak value.

Chemring is well into a turnaround programme under new management who have slashed debt, costs and non-core assets, but it remains a speculative and risky prospect. Adverse ‘timing of orders’ recently pushed the company into negotiating temporary relaxation of Debt:EBITDA covenants – a warning sign on top of a warning sign. Nevertheless the maker of counter-IED devices and anti-missile countermeasures would directly gain from any renewed Western intervention in the Middle East.

Carry on Growing

Smaller, stronger and more specialised, Avon Rubber has dual niche businesses that could grace a 1970s Carry On film: making gas masks and rubber products for milking cows. Three-quarters of revenues come from the defence segment, where the company has cemented a market position supplying respiratory protection against chemical, biological, radiological and nuclear hazards to the US military.

With shares that have seven-bagged in the past five years, a strong balance sheet showing net cash and – by my calculations – an average return on capital employed of 33% over the past five years, Avon is typical of the small high-quality growth stocks that are under the radar of many investors.

Diversification is financial defence

That’s one large high-yield cornerstone share, one speculative mid-cap turnaround, and one small-cap growth stock. But the defence sector as a whole provides good diversification: it’s likely to benefit in circumstances where the equity markets generally are under pressure.

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Tony Reading owns shares in BAE Systems, Chemring and Avon Rubber. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.