What happened
Russia's invasion of Ukraine has sparked fears that the Cold War is going to heat up again, and that means more defense spending. Defense stocks have been moving higher as a result.
Aerovironment (AVAV 0.06%) shares gained 24.8% in February, according to data provided by S&P Global Market Intelligence, and shares of L3Harris Technologies (LHX 0.34%), Northrop Grumman (NOC 0.10%) and Lockheed Martin (LMT 0.01%) were up 19.5% and 11.5%, respectively.
So what
We don't yet know what will become of Russia's incursion into Ukraine but can pretty safely assume nothing good will come from it. The base case for buying defense stocks is that the world is a dangerous place, and investors got a sobering reminder of the danger in February.
While we don't know the outcome of the invasion, the response from NATO-alliance countries and other Western European nations would suggest strong and growing demand for defense equipment. The West is both supplying military hardware to Ukraine and bulking up its own security out of fear that Russia could eventually turn its attention elsewhere.
Image source: Getty Images.
For years, the United States has complained its European allies are failing to live up to their NATO-treaty agreement to commit at least 2% of gross domestic product to defense spending. That's unlikely to be a concern for long. Even Germany, long a laggard when it comes to defense spending, committed more than $100 billion in investment to refresh its military in the days following Russia's push into Ukraine.
Investors should note that not all of that money will go into new equipment, and some of the funding that goes to contractors will inevitably go to European countries. But U.S. defense companies are likely to get a large chunk of what's spent. For example, in February, Poland placed a $6 billion order for new U.S.-made equipment, including 250 tanks made by General Dynamics (GD 0.28%), which was up 10% for the month.
For Lockheed Martin, the European position shift could open up new markets for the F-35 fighter, a program that has underwhelmed of late. Germany, a country that just a few months ago wasn't even on the radar to buy the plane, as well as other NATO allies, could now be interested. Northrop Grumman is a major contractor to the U.S.'s nuclear-triad deterrent, with billions in contracts to manufacture a new bomber and to refresh the aging Minuteman intercontinental ballistic missile.
L3 Harris is a fast-growing military communications and space contractor that should benefit from a renewed focus on intelligence. The company also likely got a boost in February because it raised its dividend by 10%. And Aerovironment, a relatively small drone manufacturer, tends to be one of the more volatile defense stocks and prone to larger moves than some of the more established defense titans.
Aerovironment could also be of interest to investors because although outright NATO involvement in combat in Ukraine seems unlikely, there are clearly opportunities for drones of all sizes to monitor and patrol the situation. Note that another military drone manufacturer, Kratos Defense & Security Solutions (KTOS -0.79%), was up a similar 24% for the month.
Now what
In one sense, the February moves were likely an overreaction. Even in times of emergency, government procurement is a slow process. This is a long timetable for manufacturing, so it could take years for whatever added spending comes from the conflict to hit the bottom line.
But the February jumps follow a period where the entire sector underperformed the broader market. Even with February's results, the SPADE Defense Index trails the S&P 500 by 25 percentage points over the past three years. The sector was out of favor due to a range of worries, including the 2020 presidential election, the pandemic's impact on supply chains, and a government focus on domestic spending over defense.
Arguably, the underperformance was an overreaction, and the February jump was the result of investors getting a reminder that demand for these companies' products is unlikely to wane.
It's impossible to say what will happen to these stocks in March, just as it's impossible to know what will ultimately happen in Ukraine. But investors can take some comfort looking past the near-term uncertainty. These are stocks that offer predictable growth, strong cash flows, and in the case of the larger contractors, dividends yielding upwards of 2%.
For those interested in investing in defense right now, I'd suggest a buy-and-hold basket that includes titans Northrop and General Dynamics, along with L3 Harris and one of either Aerovironment or Kratos.
