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BAE Systems (LSE: BA) shares have endured a gloomy November, falling more than 11%. Fellow FTSE 100 defence stock Babcock International Group (LSE: BAB) also slipped, down 6% over the month.
Even Rolls-Royce, which also has a defence arm, slumped a similar 6%. That’s quite a reversal for three of the UK’s biggest blue-chip winners in recent years. Have defence stocks peaked?
Big FTSE 100 winners
The first thing to say is that long-term investors have done very well. The BAE Systems share price is up a stunning 228% over five years, with dividends on top. Growth has slowed recently to 28% over 12 months, but that’s still pretty solid.
I’ve always thought BAE Systems is the type of company almost every investor should consider adding to their portfolio. It’s a standout in the UK defence sector, and given global uncertainty, there’s little sign of that changing.
Investing tends to be cyclical, and I suspect a bout of bumpiness ahead. Talks of a peace deal in Ukraine could hit defence stock sentiment if they progress (as I hope they do). The situation is far from resolved though and even if it is, global tensions will still remain. Europe is still arming itself against states it sees as potential aggressors.
On 6 November, BAE Systems forecast operating profits could rise by up to 11% this year, boosted by orders from Turkey for Typhoon aircraft and Norway for Type 26 frigates. It ended June with a massive £75.4bn order book, albeit down slightly from £77.8bn. The US government shutdown also caused concern about contract payments, but that appears to have eased.
Revenues and margins climb
The Babcock share price has done even better than BAE Systems, jumping 125% in a year. Five-year growth is almost identical at 221%.
Babcock’s update on 21 November showed a 19% jump in underlying operating profit to £201m, with margins improving too. Its contract backlog rose £400m to £9.9bn. That makes the November dip look odd but like I said, peace talks are in play.
Both stocks look pricey after their strong runs, with BAE Systems on a price-to-earnings (P/E) ratio of around 24, and Babcock at 22. Last time I checked, BAE nudged 28, so it’s better value than it was. Clearly, both are priced for success, and investors could react badly to any disappointments.
Of course, there are risks. If tensions ease with China and Russia, cash-strapped European governments could quickly shift their spending priorities. Order flow can be jumpy, while technical issues can cause problems. Personally, I see any slip as a buying opportunity to consider rather than a threat for investors happy to hold throughout the ups and downs of the investment cycle.
November’s setback doesn’t worry me. In fact, it could be an opportunity to consider picking them both up on a slightly lower valuation. I take a different position on Rolls-Royce though. It now looks seriously expensive with a P/E past 50, so I’d be urge caution there.
