Explosive Potential: Is It Time to Load up on Defense Stocks?

Defense stocks have been climbing on the back of the war in Ukraine and, with geopolitical tensions mounting worldwide, could continue to boom over the coming years.

As the U.S. and its allies in Europe and Asia plan significant hikes in defense spending, investors anticipate sustained demand for the industry.

Defense stocks move in roughly ten-year cycles, usually gaining for about eight years, underperforming for two, before gaining again. Bill Schmick, an investment advisor at Otana Partners, says the growth phase is poised to start again, making 2022 prime time for exposure to this industry. Yet that does not necessarily mean investing in it is the right thing to do.

Is Might Right?

Defense stocks are not without controversy. Opportunistic profiteering from war, especially by politicians, is not a good look. At least two members of Congress, Earl Blumaneur and Diana Hashbargar, were found buying up defense stocks on the eve of Russia’s invasion of Ukraine. Both told the media their financial planners had made the purchase without their knowing.

Investing in weapons will never be morally acceptable to some people. For those who feel strongly about disarmament, online tools scour portfolios for links to defense contractors and suggest alternative assets. Yet with horrifying images from Ukraine streaming through social media feeds every day, mainstream public opinion on the matter could be shifting.

Gallup polls from February (before the invasion) showed roughly two-thirds of Americans agreed that it is important for the U.S. to stay No. 1 in the world in terms of military power. However, almost the same portion of Americans (about 66%) said defense spending is either about right or too little.

Putin’s war may have expanded those majorities further. In March, for example, over 70% supported Washington supplying Ukraine with military aid, which necessitates further defense spending.

More recent polls show that most Americans believe Biden is still not doing enough to support Ukraine. Moreover, recent atrocities by Russia could trigger calls for even harsher measures.

Just as the war has galvanized bipartisan support for further defense spending on Capitol Hill, that sentiment may be spreading to retail investors on Main Street. For those looking to bank on America’s military preeminence and the hard power that undergirds the liberal global order, 2022 could be the year to get in on the action.

New Geopolitical Reality

Putin’s invasion of Ukraine has profoundly altered the course of the 21st Century. It has shattered the post-Cold War dream of creating lasting peace through economic globalization and ushered back in the world’s old normality of interstate conflict amid a geopolitical fight for survival.

This has changed the strategic calculus for every major power on the globe. European unity has been reborn, and the continent is rearming itself, while Russia’s attempts to reestablish itself as Eurasia’s land power are floundering.

China has opted for ‘pro-Russian neutrality’ and is learning lessons from Putin’s mistakes for its own expansionist agenda, while India’s renewed non-alignment has isolated it from the rest of the democratic world. Yet, while Washington focuses on transatlantic security, it cannot take its eye off the Pacific, where a potentially more catastrophic war could break out.

China’s ambition to displace America’s security presence in its neighborhood threatens U.S. vital interests. It is also an existential risk to allies and partners along the Pacific rim. After seizing control over the whole South China Sea, eroding India’s borders in the Himalayas, and stamping out democracy in Hong Kong, Beijing now has Taiwan in its sights.

The U.S. Indo-Pacific commander predicts China will attack Taiwan within the next six years, while many other experts pin it before 2030.

Experts anticipate an amphibious assault on the island of Taiwan would be the largest in modern history. Unlike Russia, China is a military near-peer competitor of America.

Taiwanese semiconductors power much of the globe’s high-end technology, and a lasting disruption to their supply could wreak havoc on the global economy. All of this raises the stakes and makes a global conflict more likely.

Whether in the Eastern or Western hemispheres, the deep geopolitical forces in motion across the globe mean defense spending is likely to increase for decades to come.

Stocks to Watch

The biggest defense industry exchange-traded fund (ETFs) rose around 5% in the first two weeks of the war. Some firms soared even higher and seemed poised for further outsized growth.

General Dynamics rose 12% by March 4 and looks bullish going forward. Almost half of General Dynamics’ revenue comes from ground warfare (tanks, mortars, etc.). These platforms dominate the battlespace in Ukraine and will need more firepower if the conflict continues as is expected.

Analyst Cai von Rumohr predicts the company will likely get a boost in coming defense budgets and sales to European countries. Investors will want to watch out for its coming earnings call on April 27.

Meanwhile, Raytheon Technologies (RTX) rose by 8%. Ukrainians have wielded their shoulder-hosted weapons to slow the Russian advance. RTX co-produces the Javelin anti-tank missile. It also makes the Stinger that has downed many Russian fighters.

RTX also supplies America’s partners in Asia. The State Department gave the green light for a $95 million upgrade package for Taiwan’s Patriot Air Defense System, a flagship RTX product.

With a renewed focus on anti-missile defense systems in Japan and South Korea amid growing concern over Chinese and North Korean ballistics, the firm could see more demand from the region.

Another bullish case for RTX is that it is positioned perfectly for the hypersonic boom.

China and Russia are currently ahead of the U.S. in hypersonics, but Washington is pushing to catch up. Since RTX specializes in electronics and missiles, it is perfectly positioned for this. It is already partnering with Northrop Grumman on a new Hypersonic Air-breathing Weapon Concept. 

This is significant since industry players often make the most significant profit margins on R&D projects for new cutting-edge systems. This makes the outlook for RTX particularly strong.

Rather than picking winners, though, the best strategy may be betting on the whole industry. The last two decades have seen defense outperform the overall market.

“Defense stocks such as L3Harris Technologies, Northrop, Lockheed Martin, and Raytheon gained respectively 1,399 percent, 866 percent, 800 percent, and 509 percent compared to the S&P 500 Index advance of 297 percent from 2001 to August 2021,” wrote Schmick.

“I am not cherry-picking results either; most defense stocks have had similar returns.”

Originally published at Wealth of Geeks

By Liam Gibson