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BAE Systems (LSE: BA) shares rose almost 10 times the speed of the FTSE 100 last week, climbing 17.05%, against 1.74% across the index. They were driven by the US raid on Venezuela, and calls by President Trump for a massive increase to the US military budget, from $901bn this year, to $1.5trn in 2027.
The current volatile situation may be bad news for world peace. But it’s good news for the UK’s biggest pureplay defence manufacturer, which has lucrative US naval, electronic systems and munitions orders. It’s a boost for smaller UK defence stocks too, such as FTSE 100-listed Babcock International Group (LSE: BAB). It was the second fastest riser on the blue-chip index last week, up 15.4%.
Over the last 12 months, these two stocks are up 73% and 195% respectively. Five-year performance is even more fabulous.
I’d much rather have global peace and that these two stocks were out of favour, but that’s not the world we live in. The post-Cold War peace dividend is spent. Today, investors have a defence sector dividend.
Attack of the FTSE 100 defence stocks
Rolls-Royce Holdings, which also has a weapons division, was last week’s fifth best performer at 8%. But have they gone as far as they can?
Rolls-Royce is staggeringly expensive with a price-to-earnings ratio of 62, although it has its fingers in other pies than defence.
BAE Systems has a P/E of 29.5, with Babcock at 28.8. Neither are cheap. Both boast massive order books of £78.3bn and £9.9bn respectively, giving production and revenue visibility for years down the line. While Babcock’s backlog is much lower, it’s the smaller company, with a market-cap of £7.3bn, dwarfed by BAE’s £60bn. Arguably, that gives it more scope for growth.
Interestingly, it appears that UK defence stocks now have one clear edge over their US counterparts. Trump also announced measures to block US defence contractor dividends and share buybacks unless they speed up weapons production. That’s a blow for investors in US defence stocks, as this new priority could squeeze free cash flow and margins. BAE Systems, Babcock and Rolls-Royce won’t face the same pressure.
Dividends
However, there’s also a risk here. The US government has threatened to shift contracts away from firms that prioritise shareholder returns over investing in plants and capacity. But would Trump really shift these contracts to British and European defence rivals who aren’t bound by these rules? There’s a risk investors are running away with this idea. That’s only my view.
It’s also worth mentioning that Germany is ramping up defence spending too, with plans for €649bn over five years for modernisation, while pressure’s growing on the British government to raise its game too. It’s short of cash though, as are other European governments who’d love to spend on other things given the chance.
As the awful Ukraine war drags on and the US makes threats over Greenland, unfortunately world peace looks a more distant dream than ever. Some won’t touch defence stocks on ethical grounds, but otherwise I think investors could consider exposure to BAE Systems et al. It’s just an expensive time to buy them, so I think share price growth must slow from here.
We might even see dips. Watch out for them.
