The last few years have been incredibly challenging for the global defence industry. Cutbacks to US defence budgets have really hurt and with the US being the biggest military spender in the world by a huge margin, sequestration has caused profitability at a number of defence companies to come under severe pressure. When taken alongside similar cuts to the budgets of other developed nations due to austerity, it’s clear why the defence sector has been a tough place in which to do business.
That’s at least partly why the likes of Rolls-Royce (LSE: RR) and Chemring (LSE: CHG) have posted disappointing results. In the case of Rolls-Royce, its bottom line declined by 10% last year and is due to fall by a further 57% in the current year. This has the potential to cause the company’s shares to come under pressure in the near term – especially since Rolls-Royce has a new management team and an uncertain long-term outlook.
Similarly, Chemring has made a loss in each of the last two years and has recently conducted a fundraising. This has sent the company’s share price lower by 80% in the last five years, but with Chemring due to return to profitability in the current year there’s light at the end of the tunnel. In fact, Chemring trades on a price-to-earnings-growth (PEG) ratio of just 0.8 and this indicates that it could be worth buying for the long haul. Meanwhile, Rolls-Royce is due to return to profit growth next year, with its PEG ratio of 0.6 indicating that it could prove to be a sound turnaround play as well.
Despite their potential as turnaround stocks, BAE (LSE: BA) seems to be a better buy than both Rolls-Royce and Chemring. It has been able to more successfully navigate the difficulties within the global defence sector better than its two sector peers and this has helped its share price to outperform the FTSE 100 by 48% in the last five years. And with great uncertainty regarding the outcome of the US election, holding a more secure and stable defence play could prove to be a sound move in future months and years.
Furthermore, with BAE trading on a price-to-earnings (P/E) ratio of just 13.2 there’s plenty of scope for an upward rerating. Certainly, BAE’s PEG ratio of 1.9 is higher than the equivalent figures for Rolls-Royce and Chemring, but with BAE having a more stable outlook and better revenue visibility, it comes with less risk. Plus, BAE’s dividend yield of 4.2% is well-covered and shareholder payouts could be set to rise at a brisk pace over the medium-to-long term.
So, while all three stocks have appeal, BAE seems to have the most enticing risk/reward ratio – especially with the future for the defence sector being highly uncertain.
Peter Stephens owns shares of BAE Systems. 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.