Why I'm Bullish on Defence Shares

It's been a bad month for the defense investors. Shares in sector leader BAE Systems  (LSE: BA.L  ) (NASDAQOTH: BAESY) are down 6% over the past 30 days while fellow FTSE 100 (UKX) member Meggitt  (LSE: MGGT.L  ) is down 7%.

The latest rout was triggered by a trading statement from mid-cap Cobham  (LSE: COB.L  ) , which warned that sales within its U.S. defense business would decline during 2013 irrespective of whether automatic U.S. federal budget cuts (known as "sequestration") takes place or not. 

So all the talk now is of defense cutbacks and the so-called U.S. "fiscal cliff." The sector is truly out of favor.

Well call me contrarian, or just plain cynical, but I don't believe that we're witnessing a permanent decline in military spending. In fact, there are three particular reasons why I think the defense sector remains attractive. But first, let's look at what's putting downward pressure on the share prices.

Sequestration
For a start, there's no question that defense spending in the U.S. and the U.K. is in cyclical decline. Austerity-driven budget pressures make sure of that.

On top of that decline is the threat of sequestration. In August 2011, a divided president and Congress put a gun to their own heads. If they do not agree on budget and spending cuts by the end of this year, spending programs will be automatically cut, or "sequestered."

The across-the-board cuts, from 2013 to 2021, are split equally between discretionary domestic spending and defense spending, with the Pentagon having no say in how they are applied. That creates uncertainty for defense contractors. But "overseas contingency operations" -- budget-speak for wars -- are excluded from the sequester.

Defense companies are also feeling the effects of the wind-down of operations in Iraq and Afghanistan.

Bullish
That leads me on to my bullish long-term outlook.

Firstly, there is no shortage of potential flash points for military conflict involving the U.S. The Middle East is an obvious one. An attack on Iran's nuclear facilities could change the outlook overnight. Instability in the region and U.S. support for Israel makes for enduring tension.

Secondly, I don't think the U.S. will readily give up its global military superiority. Just recently, a congressional committee warned that China was "on the cusp" of using credible submarine-launched, air-dropped, and intercontinental nuclear weapons. The committee described China as the largest challenge to America's supply chain and the most threatening power in cyberspace.

Military power follows from economic power, and in recent years the U.S. has been in retreat economically. But the tide will turn with the U.S. set to enjoy low-cost energy self-sufficiency on the back of the shale gas revolution. I cannot see U.S. politicians allowing China to gain military supremacy.

Strategy
Thirdly, defense companies are responding to the downturn in defense spending with a three-pronged strategy:

  • Diversifying into non-NATO markets;
  • Developing civilian applications, and;
  • Rationalizing operations and costs.

That will stand them in good stead when the core defense markets recover.

BAE
With a market cap of £10 billion, BAE is the best proxy for the defense sector on the London market. The firm's failed merger attempt with EADS was a belated attempt at a massive diversification into civilian aerospace, and one that might have cost BAE shareholders dear.

One of the most vocal critics of the deal was Neil Woodford, who runs Invesco Perpetual's major income funds. He has called for the company to concentrate on delivering shareholder value rather than making mega-deals.

BAE is aggressively pursuing Middle Eastern sales of the Eurofighter Typhoon jet, ironically in partnership with EADS. Success there would wash away the disgrace of the EADS debacle.

Meggitt
Unlike Cobham, which is anticipating revenues to decline during 2013, Meggitt's relatively bullish recent trading statement foresees modest growth for next year, helped by a more diversified business. While more expensive than BAE, Meggitt's shares were arguably oversold and a forward P/E of 10.5 looks relatively cheap.

But for value it is hard to beat BAE, which trades on a prospective P/E of just 7.6 and yields 6.3%.

That's one reason why BAE is in Neil Woodford's funds, but high-yield investing is more than just about buying the stocks with the highest yield. It's important to identify companies that can continue to deliver growing dividends. And Woodford's stock-picking expertise is second to none. Remarkably, he enjoyed a nine-year run from 2000 to 2008 when he consistently beat the FTSE All-Share Index. And during 2011, his funds returned double the index.

You can find out more about how Woodford goes about picking stocks in this special report from the Motley Fool: "8 Shares Held by Britain's Super Investor." It's free, and you can download it by clicking here.

Tony Reading owns shares in BAE Systems, Meggitt and Cobham. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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