Targeting defense stocks amid rising global tensions

U.S. defense contractors are well-positioned amid global rearmament plans, says Fidelity’s Clayton Pfannenstiel.

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Recent threats to Western democracy—most notably, Russia’s invasion of Ukraine, but also greater concern around China’s intentions toward Taiwan—have catalyzed a new global awareness of the need for greater investments in defense, points out Fidelity’s Clayton Pfannenstiel.

“With global defense spending poised to increase substantially, I think it could provide a sizable tailwind to the performance of U.S.-listed defense contractors,” according to Clayton Pfannenstiel, co-manager of Fidelity® Select Defense and Aerospace Portfolio (FSDAX), along with Chad Colman.

In an industry characterized by lengthy business cycles, they focus on investing with a long-term time horizon, across a spectrum of companies that are well-positioned for growth. More specifically, Clayton and Chad favor firms with strong business models, balanced capital allocation, and high recurring free cash flow, trading at reasonable valuations.

Pfannenstiel indicates that the U.S. defense budget appears set for sustained growth, while, across the pond, Germany announced a €100 billion fund for rearmament, on top of an existing commitment to increase defense spending to 2% of gross domestic product, representing a 46% uptick versus prior spending levels.

Moreover, he cites a recent article in The Economist indicating a similar move being contemplated by Japan that would take that nation from the ninth-largest to the third-largest defense budget globally.

Elsewhere, Pfannenstiel notes that Australia is looking at the largest expansion of its military since the Vietnam War.

The co-managers believe that the sheer scale of these planned increases in defense budgets overseas could overwhelm local defense companies, likely requiring these nations to do business with U.S.-listed providers.

In their view, opportunities are particularly strong for U.S. firms to participate in aerospace, missile defense, munitions, and defense electronics. Potential beneficiaries within the portfolio include Lockheed Martin (LMT) and Elbit Systems (ESLT).

Among major defense contractors, Lockheed Martin—the fund’s largest holding on November 30—has generated the most non-U.S. sales, at around 28%. Meanwhile, Elbit, an Israel-based defense contractor listed in the U.S., has derived roughly half of its revenue from outside the U.S. and Israel, according to Pfannenstiel.

With international defense as a percentage of sales ranging from 12% to 28% among major U.S. defense contractors, the co-managers conclude that there’s plenty of room for U.S. companies to expand their international footprint while assisting the global rearmament effort.

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