Four F-35 combat aircraft are officially handed over from Lockheed Martin to Denmark's Ministry of Defence's Material and Procurement Agency on Oct. 1.RITZAU SCANPIX/Reuters
The Hamas terrorist attack on Oct. 7 and the ensuing fallout, as horrible as it was, was a stark reminder of the precarious state of global geopolitics. The risk of a broader conflagration is high and rising, with the potential to bring in allies on both sides and to become a global conflict. This would add a third region of concern to the list of continuing and potential wars, on top of Ukraine and the China-Taiwan tensions.
Beyond having traditional hedges in the portfolio (gold, for example), there is a strong bull case to be made for having aerospace and defence exposure at a time of heightened risks throughout the world. Fundamentals are solid, with market-beating earnings growth pencilled in, which makes valuations more attractive than they may appear at first glance. We believe there are a number of opportunities, both in equities and credit, for investors looking to add to the portfolio.
For some time now, we have been recommending defence stocks as a long-term secular theme. In July, 2022, our expectations were for about a 20-per-cent increase in global spending by 2025, to US$2.5-trillion, from US$2.1-trillion in 2021. With the benefit of hindsight, those estimates appear to have been very conservative, with the United States and its allies sending multiple rounds of military aid to Ukraine since then. Spending in 2022 alone jumped to nearly US$2.3-trillion, putting upward pressure on the US$2.5-trillion estimate.
Similar assistance is being offered to Israel. U.S. President Joe Biden recently called for US$106-billion in additional military and other aid to be budgeted to help Israel, and Ukraine, in their fights. The U.S. is also transferring equipment to Israel, to include beefing up the Iron Dome missile defence system. With the increasing need for militaries to stand at the ready, prior weapons and equipment transfers will need to be replenished and inventories restocked to ensure capabilities are not compromised in times of need.
For the defence companies themselves, this translates to a steady stream of recurring revenue as new contracts are signed and equipment purchased for years to come – not only to refill shrinking stockpiles, but also to increase and expand overall readiness. With all of this in mind, it is curious to see that global aerospace and defence stocks have underperformed the broader MSCI All Country World Index.
Charting relative strength reveals the sector is stuck in a clear downtrend: Defence stocks are down 2.5 per cent year-to-date, compared to a 6-per-cent gain in the overall ACWI.
The results are more interesting on a regional basis. The U.S. (68 per cent) and Europe (20 per cent) account for the two largest areas in this sector, with a notable divergence as the latter (up 21 per cent year-to-date) is vastly outperforming the former (down 8 per cent year-to-date).
So, what is driving the U.S. underperformance? The answer lies in the large caps (minus 10 per cent), with both small caps and mid caps comfortably in the green in 2023 (plus 14 per cent and 25 per cent, respectively).
The questions then become: Is there still value in this sector and why are U.S. large caps underperforming so badly? We believe the answer is currency related.
These are large international companies affected by the prior run-up in the U.S. dollar and its negative effects on revenue translation from abroad, which we believe should ebb in the coming quarters given our downbeat view on the U.S. dollar.
In terms of value, running a simple stock screen of U.S. (both overall and broken down by company size) and European defence stocks points to a very attractive fundamental backdrop. At a quick glance, it may seem like it will be hard to squeeze future gains out of this group with price-to-earnings ratios – both in absolute and relative terms (to their respective benchmarks) – in upper percentile readings anywhere from 80th to even 100th percentile prints (data back to 2010).
Where things get interesting is on the earnings front – seeing strong revisions, on balance, over the past three months and double-digit growth for 2023.
At a time when markets are bracing for flat-to-negative earnings growth this year, investors in the aerospace and defence sector are expecting earnings-per-share growth anywhere from 15 per cent (in the U.S. small-cap space) to a whopping 96 per cent (for mid caps). Even in the case of U.S. large caps, which remain the laggard with a slight negative earnings-per-share estimate revision over the past three months, the consensus is still pencilling in an above-market expectation of 36-per-cent growth.
Looking at the next three years, estimates are pointing to annualized growth of 25 per cent to 35 per cent across all indices we are looking at. Thus, on a price/earnings-to-growth ratio basis, we are seeing readings at, or below, 1.0x. There is clear value here in contrast to the ratios of about 3.0x+ at the headline levels. While absolute price/earnings ratios may appear elevated, we would classify these stocks as growth at a reasonable price. (The price/earnings-to-growth ratio considers expected earnings growth and not just current earnings. Traditionally, a ratio of under 1.0 can indicate a stock is undervalued and a potential buy. Above 1.0 can indicate an overvalued stock.)
What jumps out in our analysis is how badly U.S. large-cap aerospace and defence stocks have underperformed their peers despite equally attractive valuation/fundamental support. We would expect a catch-up trade on this front, and this presents as perhaps the most interesting opportunity (though all areas screen well).
Beyond the stocks, the debt of these companies also screens well when compared to the solid fundamental outlook. The average paper now yields 6 per cent across the sector, the highest since at 2006, while some offer as much as 8 per cent.
Bottom line: At a time when it is hard to be bullish on the outlook for wide swaths of the global equity market, aerospace and defence offer an appealing option for those looking to add equity exposure.
Investors can look for opportunities both in the U.S., across small-, large- and mid-cap peers, and Europe, though we believe there is significant potential of a catch-up trade from the large caps that have not performed as well despite similar underlying fundamentals. At the same time, credit offers another avenue of exposure for those willing to explore that area of the market.
In an increasingly uncertain world, sometimes the best offence is a good defence.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Marius Jongstra is vice-president of market strategy for the firm.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.