Analysts predict steady growth for defence stocks no matter who is victorious on Nov. 8.Dan Kitwood/Getty Images
The U.S. presidential election is, mercifully, drawing to an end – and although there's a sense that the contest may no longer be close, it will not be until Nov. 8 that we know the victor for sure.
No matter the result, though, there are winners: the U.S. defence sector and investors who have stuck with its giants. Most defence stocks have shown healthy gains this year as it became clear that the U.S. military would likely be insulated from shock regardless of which party wins the election. That has led many to question the robust valuations for the shares, wondering whether the chance to profit has passed.
Bulls, however, note that while the U.S. government constitutes the bulk of defence spending, increasing global uncertainty means a whole new wave of spending from customers outside the U.S., giving the contractors opportunities to increase their top line and boost their already powerful cash-generating engines.
"The perceived threat environment is, in our view, the biggest driver of global defence spending, not politics," writes Citigroup Global Markets analyst Jason Gursky. "As such, neither Clinton nor Trump should materially impact the domestic outlook."
Roman Schweizer of Cowen & Co. concurs: "We see the U.S. defence budget outlook as positive regardless of who wins the White House in November. Under either Clinton or Trump, we expect U.S. defence spending to increase."
"We believe there is an oft-misunderstood new era of great power and regional rivalries that will challenge long-standing geopolitical/military balances and alliances," Mr. Schweizer said. "This new international security dynamic will continue to support increased defence spending in the United States, Europe, Asia and the Middle East." While that change is "quite obvious," he writes, its potential impact on spending is often underacknowledged.
Certainly, the defence sector is not the place to look for off-the-charts growth results. Mr. Gursky sees long-term growth in global defence spending at about 3 per cent annually, a "respectable level in a world of low-to-no growth." It's also a change from the outlook in the early days of the administration of Barack Obama, where his perceived pacifism and a crippling financial crisis created the forecast – ultimately proven wrong – that defence spending was in for a major, multiyear retrenchment.
It's true that – at least for now – the U.S. defence budget is still subject to a law called the Budget Control Act, or BCA. But Cowen's Mr. Schweizer says the BCA has always been modified upward when it comes to defence, and the current long-term trajectory of roughly 2.5 per cent annual top-line growth "is our worst case … Given the range of global threats, we do not believe a cut below the BCA defence numbers is politically feasible for any White House or Congress."
From a purely U.S. standpoint, Mr. Schweizer sees spending growth for key programs in aircraft, shipbuilding, missile defence and precision munitions, while spending on weapons typically used in ground wars, which has lagged, has begun to rebound and could experience steady growth over the next five years, he says.
More broadly, the global research team at Credit Suisse makes the case that defence stocks will benefit from increased spending across the world. They note European Union and U.S. defence spending, as a share of GDP, is 18 per cent and 10 per cent below their 20-year norms, respectively, but are on the increase.
Japan is debating amending its pacifist constitution, Credit Suisse says, which would enable it to increase defence expenditure beyond 1 per cent of GDP, and Chinese defence spending is increasing by around 10 per cent annually. And in Russia, defence spending is up nearly 50 per cent since 2011 – measured as a proportion of GDP – and is now double that of NATO by that metric.
While they call global defence stocks "a clear overweight," they also note the U.S. names have returned to their normal valuations of the 2003-08 period, i.e. a roughly 2-per-cent premium to the broader market. European defence stocks' P/Es are about a 20-per-cent discount to the U.S., "close to a 16-year extreme," despite strong earnings revisions. Credit Suisse's picks are Raytheon, Thales and Dassault.
While the U.S. stocks have broadly gained, analysts' estimates of their future earnings have increased as well – some so much so that there are stocks whose P/Es have actually shrunk in the past year. Examples: Boeing, Raytheon, General Dynamics and United Technologies.
While Citigroup's Mr. Gursky says "it's time to get a bit pickier … the easy money in the defence trade has been made," he still has a number of recommendations of companies where he sees both revenue gains and profit-margin expansion in the coming years. He likes Raytheon, General Dynamics, L-3 Communications Holdings and systems company Harris Corp. He also has buy ratings on Northrop Grumman Corp., Huntington Ingalls Industries Inc. and Lockheed Martin Corp., but place them "toward the lower end of the pecking order" because he isn't as sure about their ability to expand their profit margins, given their revenue mix over the next several years.
"In our view, if you own defence stocks, hold them," Mr. Gursky writes. "If you are underweight, beware given positive sentiment and a persistent threat environment that likely allows for resilient defence spending. And if you are looking to put new money to work, we think it's best to skate toward those names with both revenue and margin expansion on the horizon."
Vote defence stocks. It sounds like a winning campaign, no matter the Nov. 8 result.