Why I'm Bullish on Defence

LONDON -- So-called "sequestration" -- automatic spending cuts, half of which are allocated to defense -- came into effect in the U.S. this month after Congress failed to agree a budget.

Bad, but not that bad
It's an added threat on top of planned military spending cuts. But a report from rating agency Fitch last week suggested that sequestration won't have such a dramatic impact on European defense companies as many fear. It thinks:

  • Exposure to U.S. defense spending is limited;
  • Defense procurement will be protected;
  • Defense companies are good at restructuring to maintain cash margins.

US Department of Defense (DoD) contracts typically have lead times of around three years, so procurement spending will be little affected in 2013. The DoD is saving money by cutting operational expenditure such as training.

BAE most exposed
With 30% of its revenues coming from the DoD, BAE  (LSE: BA  ) is the most exposed. But Fitch estimates its 2013 revenues will suffer by 2% or less. The company has a 17% interest in the F-35 Joint Strike Fighter project, which has largely evaded budget cuts.

Like most of the sector, BAE is pursuing emerging market sales and reducing its dependence on defense. But its entrenched position in the U.K. and U.S. defense markets underpin its secure cash generation.

On a price-to-earnings (P/E) ratio of 9 and with a prospective yield of 5.3%, the twice-covered dividend makes it a great income stock.

More expensive, better growth
If only Rolls Royce  (LSE: RR  ) were so cheap! The world's second-largest jet engine maker is on a prospective P/E of 17.6. Revenues grew 9% last year compared to a 6% contraction at BAE. Civil aviation accounts for over half of sales, with defense a fifth.

Meggitt  (LSE: MGGT  ) is the only other U.K. aerospace and defense company to make the FTSE 100. The aircraft brake manufacturer saw a 6% rise in revenues last year, and confidently increased its dividend by 12%. On a projected P/E of 13, it's yielding 2.6%.

Overweight
One fan of the aerospace and defense sector is Invesco Perpetual's star fund manager Neil Woodford. He has 8% of his £22 billion funds invested in BAE and Rolls Royce. That's a big bet on a sector that represents less than 2% of the FTSE's total capitalization.

Woodford's stock-picking track-record is unmatched. His high income fund has grown at an annual compound growth rate of 12.6% since its launch in 1988, turning each £1,000 invested into £19,365. According to Hargreaves Lansdown, it's "the best performing of any fund investing in the U.K. since it launched".

You can learn more about how Woodford selects stocks in a brand-new report from the Motley Fool: "Eight Shares Held by Britain's Super-Investor" -- now updated for 2013. It's full of insights into his investment style. You can download it by clicking here -- it's free.

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