Warpath to profitability?

Opinion

The defence industry is often overlooked by investors. It’s perceived as boring compared with technology or worse, it’s just an unethical way to put profit in the portfolio.

Since the February 2022 invasion of Ukraine by Russia, however, the defence industry has drawn significant investor interest. Notably, the perception has changed. That includes some of those who might have felt investing in defence was distasteful; they now see it as a needed buttress against rising authoritarianism.

Of course, another shift is financial — based on the forecast injection of hundreds of billions of dollars in additional spending by NATO members.

Canada alone is expected to increase military spending about $70 billion annually to meet its most recent defence commitment of five per cent of gross domestic product.

The big question for many intrigued investors is whether they’ve already missed the warship.

“Our view is that type of information gets incorporated into market prices really quickly,” says Ben Felix, chief investment officer with PWL Capital in Ottawa.

“The implication of that is by the time you read about it in a Free Press article, any advantage that you may have got by investing in that theme is already gone.”

That said, the defence industry landscape and recent performance are still of interest to inquisitive investors who might consider putting their money to work when prices pull back periodically.

For the time being, however, many defence company share prices have hit lofty heights, including a handful of Canadian firms such as satellite technology company MDA Space Ltd. Its share price is up more than 50 per cent year to date.

As well, aerospace company Bombardier’s share price “has almost doubled in recent months, so obviously, all of the talk that has been going on is certainly helping,” says Brian Donovan, New Brunswick-based president of StockCalc.com, provider of valuation models for investors.

“It tells you that there is an interest shift into this space.”

StockCalc tracks performance of thousands of North American equities, including about eight Canadian firms with defence industry revenues.

One even has a footprint in Winnipeg: Magellan Aerospace Corp., which makes components for military aircraft. Its share price is up more than 80 per cent YTD.

If those gains sound lofty, consider some firms listed in the United States and Europe.

Notably, artificial intelligence firm Palantir is up 106 per cent this year. Even more impressive, its share price is up nearly 1,600 per cent over the last five years.

A key driver is its defence contracts with the U.S. and partnerships with other technology and manufacturing companies involved in defence. That includes L3 Harris Technology, which, like Palantir, operates in many industries. Its drone technology business is a big defence revenue driver. (That said, its share price growth YTD is much less than other defence stocks.)

In Europe, the most notable defence growth story is manufacturing conglomerate Rheinmetall AG. Among the many defence technologies it manufactures are Challenger and Leopard tanks. Its share price is up about 200 per cent YTD, and more than 2,000 per cent in the last five years. The big driver is Germany planning to spend more than a trillion dollars on defence in the next five years.

That investors are now turning onto the defence sector is understandable (given the headlines) and somewhat ironic at the same time because it has not been a lacklustre industry for long-term performance.

Publicly traded companies involved in the U.S. defence industry have collectively provided returns on an annual basis that have outpaced the S&P 500, says Scott Sacknoff, manager of the SPADE Defense Index in Washington, D.C.

“There is a long history of defence outperforming.”

And it very well could continue to outperform, given the U.S. defence budget is expected to surpass US$1 trillion annually for the first time in history, he adds.

If anyone has deep knowledge of the defence sector, it’s Sacknoff.

The SPADE Index, which he manages, consists of leading U.S.-based defence companies and has outperformed the S&P 500 by roughly more than 1,000 basis points (or 100 percentage points) over the last 25 years.

Yet until Russian President Vladimir Putin decided to invade Ukraine in 2022, defence was a profitable but sleepy market corner.

The explosion in defence spending has changed that, leading to greater investment and even a rush of new investment products, notably exchange-traded funds (ETFs).

Prior to 2022, investors largely had three ETFs to choose from, including one of the longest running: Invesco Aerospace & Defense ETF.

For investors looking for exposure, the Invesco product is worth a look. Since launching in 2005, it has had steady growth. Investment data firm Morningstar data shows US$10,000 invested in 2005 would be worth nearly US$120,000 today. In turn, the ETF has Morningstar’s highest rating.

Sacknoff notes the ETF’s performance is driven by the underlying SPADE index, which uses a modified market cap weighting to address the downsides of passive investing that lead to over-concentration in overvalued stocks.

“In simplest terms, this involves ensuring that large companies aren’t too large, and small companies aren’t too small.” He adds the index’s annualized return over 15 years is 17 per cent.

“You have never lost money in any product tracking our index if you invested and held onto it for at least three years.”

Yet one might ask, would that still hold true today?

“The big question is whether earnings and revenues will catch up to the high valuations,” Sacknoff says.

Only time will tell. Yet not all companies on the index are surging in price, including Lockheed Martin, manufacturer of the F-35 fighter that Canada and other NATO countries have contracts to buy.

Its share price is actually down slightly this year.

What’s more, U.S. President Donald Trump’s scattershot economic policy is likely to lead to downside market volatility, presenting buying opportunities for defence companies.

Yet their long-term tailwind is likely not going away soon.

For the time being, however, this high-flying sector seems more of a minefield than a warpath to profitability.

Joel Schlesinger is a Winnipeg-based freelance journalist

joelschles@gmail.com