How to invest in the changing defense landscape

Military spending is increasing around the globe.

  • By Dryden Pence,
  • U.S. News & World Report
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As many political commentators speculate about a possible military conflict with Iran, market watchers have naturally begun to wonder whether defense companies will benefit. The argument for a boost, however, actually started to crystallize earlier this year, when the White House released a budget proposal asking for billions more in defense spending.

But the U.S. is far from the only country with a growing emphasis on defense spending. Europe, in response to rising threats abroad and calls by President Donald Trump for NATO members to increase spending, has actually been one of the major sources of growth for U.S. defense companies over the last year.

NATO members in 2014 pledged to spend 2% of GDP on defense. Today, NATO estimates that only seven of the organization's 29 members meet that threshold, with non-U.S. members averaging about 1.48%. However every NATO member except Greece and Canada increased defense spending last year.

If, starting in 2020, every non-US NATO member reached the 2% target and global GDP grew per the IMF's outlook, more than $700 billion in incremental spending would be committed by 2024. This is the equivalent of an extra year of U.S. spending, and that's without factoring in NATO's aims to recognize space as a domain of warfare this year.

Given that rising military defense spending may well be a compelling investment strategy, it's worth exploring the types of stocks with the greatest chance at growth.

Contractors poised to benefit

Aircraft such as unmanned drones and manned jets would almost certainly become vital to a military buildup but so might tanks and other land transportation, as well as naval shipbuilders of aircraft carriers and submarines.

Long-range spying equipment comes in the form of cameras, audio recorders, 3D image production, infrared scanners and radar detection. While certain types of these devices are mounted on vehicles, others are handheld.

Actual firepower is essential to any military engagement, so the makers of automatic assault rifles, missiles, land-based explosives – and the body armor to protect troops from enemy assaults – may ramp up their sales to the U.S. government.

As recent events demonstrate, cyberwarfare has developed into a core component of military action. This means computers, data storage servers, software and skilled coders would be in even higher demand.

Companies to watch

Major firms like Boeing Co. (BA), Northrop Grumman Corp. (NOC), Lockheed Martin Corp. (LMT), Raytheon Co. (RTN) and General Dynamics Corp. (GD) are important players in each of the categories above. Meanwhile, the global technology company Cisco Systems (CSCO) provides an assortment of cybersecurity and networking solutions for the U.S. military, and Huntington Ingalls Industries (HII) is the biggest military shipbuilder in the country.

Investors also may be able to find other companies that specialize in a particular category, perhaps by serving as a competitor or as a supplier to the major defense firms. These smaller players also may have more upside potential.

For instance, Kratos Defense & Security Solutions (KTOS) operates in missiles, drones, cybersecurity and signal monitoring. Axon Enterprise (AAXN) manufactures body cameras and tasers. And TransDigm Group (TDG) supplies advanced engineering components to several of the largest military aircraft makers.

Buy signals

The simplest approach to buying stocks based on this investment strategy is to hold the SPDR S&P Aerospace & Defense ETF (XAR). This fund saw a 32.07% return through the first half of 2019, while the S&P 500 gained 18.5%. However, large basket ETFs can be unwieldy and susceptible to style drift. Investing in individual stocks – particularly large caps – may give an investor the opportunity for similar returns with both volatility and capital gain management.

Investors seeking buy signals can look for asset flows into individual defense stocks by a handful of top-performing mutual funds over the previous reporting period. That may be a strong indication of institutional conviction in a defense company.

Another idea is to track government spending on defense by the awards and contracts granted according to publicly available portals such as USA Spending and the Federal Procurement Data System. Both portals not only update frequently but are sortable by date and include key information such as dollar amounts and vendor names.

To be sure, there is ample evidence to suggest that military defense investing is a viable strategy. Trump recently signed a $2.7 trillion budget deal suspending the debt ceiling through July 2021, raising defense spending 3% to $738 billion next fiscal year. However, if a new U.S. president is elected in 2020, the approach to defense spending could change drastically.

With that in mind, investors should pay close attention to not only which defense stocks are poised to rise, but also to how political developments unfold over the course of the next year.

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