We may not exactly be bullish on the U.S. stock market in aggregate, but along the way have been identifying the proverbial needles in the haystack – secular sector themes where current pricing is too low relative to the expected profits and cash flow. Aerospace and defence stocks have long been in that bucket, and we thought it was time for a review and update, especially as geopolitical tensions escalate and defence budgets across the planet expand sharply.
The impetus for this review is also driven by the July durable goods report out of the United States that showed capital goods orders in the defence sector surging in each of the past three months and accelerating at a 22-per-cent year-over-year rate. This is a trend that will support future earnings growth in this section of the stock market, so we remain resolutely upbeat. To illustrate with some numbers, our first sector report published back in 2022 cited a forecast of US$2.5-trillion in global defence spending by 2025. Recently released data for 2023 from the Stockholm International Peace Research Institute put total outlays at US$2.4-trillion, an all-time high, and up 7 per cent year-over-year (in real terms) in what was the largest annual increase since 2009.
Safe to say that US$2.5-trillion forecast will be achieved earlier and forecasts for the coming years will need to be revised higher.
Let’s dive deeper into the sector – focusing on the U.S. and European companies that comprise the vast majority of public market exposure. It goes without saying that price performance continues to be strong, jumping 32 per cent over the past year on a global basis and outperforming the broad MSCI All Country World Index by roughly 10 percentage points over this period. Regionally, the group has surged by a similar 32 per cent in the U.S. and by nearly 43 per cent in Europe.
While we are not surprised to see such significant run-ups in stock prices, there is no denying that these companies are no longer as cheap as they previously were. Valuations, as measured by forward P/E ratios, are now seen in the top 10 per cent of historical readings (data back to 2010) while trading at wide premiums relative to their respective benchmarks. Mid-cap U.S. defence stocks are the one exception, trading at a smaller (though still elevated) historical multiple.
Such valuations do not make the group a poor investment, however. Secular growth stories can justify higher multiples through market-beating earnings growth. Defence stocks (large- mid-, and small-caps) are expected to boost annualized profits between 14 per cent and 18 per cent over the next three years in the U.S., while their respective benchmarks (S&P 500, S&P 600, and S&P 400) are projected to book average gains around 10 per cent each over that same period. In Europe, at a whopping 24 per cent expected net income will increase at eight times the projected pace of the MSCI Europe Index.
Benchmarking multiples against expected earnings growth through the PEG ratio (P/E ratio divided by growth) may not be as attractive as they were – going from at or below 1.0x nearly 12 months ago to between 1.5x to 2x currently, shifting to “fairly valued” from “undervalued” in the process. But there is one clear standout winner that we believe should draw investors’ attention – Europe.
Even with a 40-per-cent rally over the past year for defence stocks in the region, the 23 times forward multiple is benchmarked against 23-per-cent annualized earnings growth expected over the next three years. Thus, a PEG ratio of 1.0x – registering as “undervalued” – compares with a whopping 4.5 times “overvalued” reading for the broader MSCI Europe stock index. To a smaller degree, we can add U.S. large-cap defence stocks as an option worth exploring, purely from a “catch-up” trade potential, though more clarity from Boeing BA-N on its production outlook may be required for a positive turn in sentiment in the sector. (Given its size, Boeing is dragging down the performance of large-cap defence stocks).
The future is not just about earnings, but also the potential for an expansion in total returns. As pointed out in the FT, the huge wave of new orders and demand will translate to an increase in free cash flow – expected to double from 2021 levels to US$52-billion by 2026 for the largest 15 contractors. For U.S. mid-caps, Bloomberg estimates show they will also double over this timeframe (and surge by 150 per cent for small caps). In Europe, projections are for a 110-per-cent increase.
There is no doubt that a portion of this windfall will be reinvested to expand production and accelerate output. But it is also not farfetched to believe that investors will benefit from higher dividends and increased buybacks as a result.
All-in, the defence story remains intact, making this group of stocks an attractive option for the portfolio. That said, after a considerable run-up, position sizing and trimming exposure for any outsized positions may be warranted – particularly in the U.S. This is not to say that we do not believe in this theme. Instead, risk management after a huge rally is prudent. Regionally, we continue to favour European defence companies, with the sector across the Atlantic offering the most compelling risk/reward profile at this time.
Marius Jongstra is vice-president of market strategy with Rosenberg Research
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