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Weapons manufacturers and related defence industry firms have long been off-limits for most responsible investors, but Russia’s invasion of Ukraine and other perceived geopolitical threats have shed a more favourable light on the subsector in the past several months.
“Prior to the invasion of Ukraine, there had been pretty strong opposition to including defence names in ESG (environmental, social and governance),” says Jonathan Sakraida, equity research analyst at CFRA Research in Smyrna, Ga.
Previous conflicts, like the war in Afghanistan, were less “black-and-white” than the Russian invasion of Ukraine in the eyes of investors, he says.
The Ukraine war and the perception of rising threats to democratic nations from increasingly militaristic authoritarian regimes have even been a more frequent discussion topic in the ESG world.
“Strategies are evolving” for ESG funds, most notably in Europe, where more focus has been on integrating defence names not involved in making weapons, like cluster munitions, which are banned by international treaties, says Baltej Sidhu, ESG equity research analyst at National Bank Financial Inc. in Calgary.
“Rising defence spending is seen as a catalyst for the sector” as NATO members – particularly European ones – support Ukraine with weapons while worrying about their own security, he adds.
An overall rise in military budgets makes a compelling argument for investors of all stripes. Global military spending grew for the eighth consecutive year in 2022 to an all-time high of US$2.24-trillion, according to a report from the Stockholm International Peace Research Institute.
The U.S., China and Russia spend the most, but many developed nations are boosting spending. Notably, Germany has pledged to spend more than US$113-billion while Japan is in a five-year process of increasing its spending on military to a 2 per cent of gross domestic product from 1 per cent, a level not seen since the Second World War.
Defence manufacturers in focus
From an investment perspective, many large, publicly-traded companies – Lockheed Martin Corp. LMT-N, General Dynamics Corp. GD-N and Northrop Grumman Corp. NOC-N – are likely to see favourable tailwinds as a result, says Ken Herbert, senior aerospace and defence analyst with RBC Capital Markets in San Francisco.
“We are maybe seeing a new kind of arms race with higher spending globally and new tensions, and amid that backdrop, these stocks could certainly perform better,” he says.
Investors favouring ESG strategies may be surprised they may already have exposure through exchange-traded funds (ETFs) and mutual funds they own, Mr. Sidhu says.
“From a negative exclusionary mandate, defence-oriented companies would be screened out,” he says.
Yet, some ESG integration frameworks include defence companies making strides on the environment (i.e., reducing emissions), social concerns such as improved labour relations, and governance – especially with respect to bribery and corruption, he says.
National Bank Financial research shows about 3 per cent of ESG funds hold pure-play defence manufacturers, a similar exposure to tobacco companies, he adds.
Other large, tech-oriented companies with significant exposure to defence, such as RTX Corp. RTX-N –which owns Raytheon Technologies, the maker of the Patriot missile systems – are held by about 5 per cent of ESG funds, Mr. Sidhu says.
“Then, there’s the third bucket of diversified manufacturers,” that supply components for weapons manufacturers or provide services for the military, which are held by as much as 13 per cent of ESG funds, he adds.
Investors asking questions
ESG-focused or not, more clients Adam Hennick’s have had their interest piqued regarding defence companies as investments.
“Many have questions about [these companies] due to their popularity,” says Mr. Hennick, investment advisor with Research Capital Corp. in Toronto.
Yet, client portfolios don’t hold defence companies because, for one, their upside has likely been priced into the market already and, second, they can be polarizing.
Certainly, defence industry exposure is a double-edged sword for ESG investors, cutting more deeply toward avoidance and divestment, says Tim Nash, a fee-only advisor, specializing in RI strategies and president of Good Investing Financial Partners Ltd. in Toronto.
“It’s an interesting catalyst for conversations lately.”
Yet, most discussions are prompted by clients concerned about the conflict in Gaza, and their indirect exposure to it through owning, for example, Bank of Nova Scotia BNS-T, criticized recently over its investment in an Israeli defence company, he says.
Even for ESG-leaning clients who see defence companies as “defending democracy against bad political actors,” the financial case to invest in them is not as convincing as it was last year, Mr. Sakraida says.
“Moving into 2023, performance really hasn’t been amazing in the aerospace and defence industry just because there is less room to run,” he says.
Most growth arising from Russia’s invasion of Ukraine happened last year, when the subsector grew by almost 15 per cent even as the broad market fell by about 20 per cent, Mr. Sakraida says.
Today, tighter margins are a headwind for many companies working through large backlogs of contracts in place before inflation and supply chain challenges emerged, he says.
“Even if sales are eclipsing where they were pre-pandemic, their earnings are being weighed down by margin deterioration on the fixed-price contract structure,” he adds.
But not all defence companies are facing those challenges, says Mr. Herbert. That includes AeroVironment Inc. AVAV-Q, a drone manufacturer that’s part of the new tech-driven arms race.
“They’re all about sales into Ukraine and NATO countries,” he says, noting the U.S. aims to restock military drones by as much as four times pre-Ukraine war levels.
Eventually, most manufacturers are likely to work through backlogs and move onto newer contracts with better margins, leading to improved profitability, Mr. Herbert says.
“It’s certainly a thesis I believe, and one that investors are likely to buy into as well,” he adds.
Whether that upside potential is enough to overcome ESG investors’ longstanding apprehension about the sector remains to be seen, Mr. Sandhu notes.
“For many, it’s a very tough circle to square,” he says.
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