Defense Industry: Investing Essentials

It's always a brave new world for the defense industry. Here's what you need to know to invest in it.

Aug 20, 2014 at 6:49PM

The Iraq War is history. The war in Afghanistan is winding down. And with the wind-down, a lot of investors may be thinking that the defense industry is "history" too.

But here's the thing: History repeats itself. We're seeing that in Iraq right now, as the ISIS spreads mayhem across the Mideast. Meanwhile, to the north, Russia has proven itself newly aggressive in Ukraine and Crimea, while to the east, a rising China is flexing its muscles -- and pushing to impose its will on its neighbors.

In short, it's a dangerous world out there, Fools. So long as it remains so, there will be a future for the defense industry. Here's what you need to know to invest in it.

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It's a dangerous world out there. You may need a 100,000-ton Gerald R. Ford-class nuclear aircraft carrier to deal with it. Source: U.S. Navy.

What is the defense industry?

A subsector of the aerospace and defense industry, the defense industry in particular focuses on large-cap corporations (and in many foreign countries, state-owned enterprises) whose primary customers are nation-states, and whose primary products are military hardware and services. Depending on the company, these may include:

  • Military aircraft (everything from F-16 fighter jets to B-2 stealth bombers to combat helicopters to new-fangled unmanned aerial vehicles)
  • Warships (submarines, destroyers, aircraft carriers)
  • Ground defense (tanks, APCs, and guns both big and small)
  • Ammunition for all of the above (rockets, missiles, bullets, cannon and howitzer rounds)
  • Military satellites and also dual-use satellites (such as surveillance satellites, America's Global Positioning Satellite constellations, and their European "Galileo" and Russian "Glonass" counterparts)
  • The rockets that put those satellites in orbit, and the engines that power those rockets

The complex electronics systems and software products that permit all of the above to operate correctly, electronic warfare systems such as radar -- and radar-jamming -- and software and hardware components of both "cybersecurity" and "cyber warfare" also fall under the category of defense products and services.

How big is the defense industry?

Defense is big business in the United States, with the defense budget consuming approximately 20% of the federal budget in recent years. Globally, the U.S. accounts for about 41% of worldwide defense spending.

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Source: U.S. Department of Defense Fiscal Year 2014 Budget Request (link opens a PDF)

But that still leaves nearly 60% of global defense spending to account for. Consulting firm Deloitte estimates that the next five biggest markets for defense products are China, France, Japan, Russia, and the U.K. -- accounting for 23% of global defense expenditures combined. The next 19% of global defense dollars go to the militaries of Australia, Brazil, Canada, Germany, India, Israel, Italy, Saudi Arabia, South Korea, and Turkey.

Defense spending as a percentage of the global whole drops steeply from there, but all-in, the global market for defense products tops $1.72 trillion annually -- and makes up as much as 85% of the total value of the global aerospace and defense market as a whole.

How does the defense industry work?

Excellent question. Clearly, defense is the proverbial 800-pound gorilla of the aerospace and defense market, accounting for the vast majority of spending in its parent industry. So understanding how this money gets spent is crucial for investors in defense.

The good news for investors is that defense spending is an unusually "transparent" market, in which it's easy to track the broad ebb and flow of revenues over time. This is because most countries publish, and make easily available, information on their planned defense budgets ahead of time -- often, years ahead of time.

Data on U.S. defense spending, such as is laid out in the table above, is just one example. You can find similar reports on anticipated defense expenditures in "white papers" published by the Australian government, in public announcements by the Russian Ministry of Defense and the Japanese Prime Minister. Even nominally communist China publishes a defense budget. (Although there's quite a bit of disagreement about how forthcoming China is in the information it contains).

Once the budget is set, the governments in question typically hold tenders, inviting bids from local and foreign defense contractors, to provide the products and services they require. A winning bid is accepted and, typically, the winner is announced.

Caveat: One wrinkle that investors should be aware of is that most major defense contracts awarded in the West these days may name a single winner. But the firm that "wins" the contract and is named the "principal contractor," rarely does all the work itself. No sooner does a firm win a contract than it turns around and parcels out much of the work to other defense contractors. (Indeed, oftentimes defense companies bid as a "team" from the get-go).

The result is that no matter who wins a contract, as often as not, "everyone" in the industry tends to benefit.

What drives the defense industry?

As with most industries, you can say that the defense industry is driven by two primary factors: risk and opportunity. It's just that the defense industry has its own peculiar take on the definitions of these terms.

From a risk standpoint, the more dangerous the world, the more nation-states perceive a need to spend money on defense. The country that spends the single greatest percentage of its GDP on its military, for example (10.3%), is one currently involved in an on-again, off-again civil war: South Sudan. The next three top spenders (again, as a percentage of GDP) all reside in the turbulent Middle Eastern neighborhood: Oman, Saudi Arabia, and Israel.

But opportunity also plays a role. The United States, for example, the single greatest spender on defense in absolute dollar value, is protected by wide oceans to both east and west, and has inoffensive neighbors to both north and south. Yet as one of the world's wealthiest nations, the United States still spends freely on defense -- enough to make it the No. 1 defense market globally by a wide margin. Meanwhile, a surging economy and valuable oil reserves combine with numerous, sometimes aggressive neighbors to make China and Russia, respectively, the No. 2 and No. 3 defense markets in the world.

Simply put, therefore, defense spending is likely to increase both when nation states think they need to spend more on their militaries -- and also just because they can.

Caveat: The wrinkle investors want to be aware of here is that defense spending by defense companies' host countries may ebb and flow. But the companies are not limited to their host countries' markets. As defense spending has trended down globally in recent years (dropping 1.9% in 2011, then 1.3% in 2012, followed by an estimated 2.5% decline in 2013 according to Deloitte), defense companies are more and more often looking to new markets abroad to shore up their revenue streams.

Where will they go to find the defense contracts that will fill up their revenue streams? Turn to your nearest newspaper headline to find out. Wherever conflict is, there will the defense industry go to find new markets for its products.

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Defense Industry Abrams Tank
Try telling an Abrams main battle tank that the defense industry is "history." Go ahead. Try. Photo: General Dynamics.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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