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  1. Home
  2. / Investing
  3. / Stocks

Geopolitical Tensions Could Prove Positive for Defense Stocks

The Pacific is not unique in terms of governments shoring up defense capabilities, including major purchases from U.S.-based companies.
By KEVIN CURRAN Jan 08, 2022 | 07:00 AM EST
Stocks quotes in this article: NOC, BA, LMT, RTX, TXT, LHX, GD, BWXT, CW, HII, SAIC, PLTR

Uncertainty in geopolitics is rarely a positive for investors, especially the scale of which we are seeing at present. Whether it be still-simmering tension in Afghanistan after a U.S. exit, faltering authoritarian governments in Belarus and Kazakhstan, or the saber-rattling of Beijing over territories in the South China Sea, there is plenty to trouble one's mind.

However, these tensions are apparently encouraging many governments fearing either direct impacts or spillover effects to bolster their own military capabilities. In many cases, this includes significant purchases from U.S.-based aerospace and defense firms such as Northrop Grumman (NOC) , Boeing (BA) , Lockheed Martin (LMT) , Raytheon (RTX) , Textron (TXT) , L3Harris Technologies (LHX) , and General Dynamics (GD) .

"One of the attractive things about investing in the defense sector is that it's always there and over time it's always growing," David Luxton, Executive Chairman at weapons technology firm Kwesst Microsystems (KWE), told Real Money. "The times we're in are becoming more fragile and perilous geopolitically and I don't see that improving in the foreseeable future."

The China Challenge

Without a doubt, the biggest worry for the U.S. and its allies in the Pacific is the rise of China. As of late, the U.S.' allies are taking this threat quite seriously, as indicated by their significant purchases from the aforementioned firms.

The most groundbreaking purchase was found in the early fall, when Australia left France jilted by the AUKUS deal, awarding significant mandates to defense firms like General Dynamics, BWX Technologies (BWXT) , Curtiss-Wright (CW) , and Huntington Ingalls (HII) for naval technologies.

Morgan Stanley analyst Kristine Liwag appraised the deal as a positive for all of the above-mentioned firms while adding Raytheon's selection to equip the new purchases with armaments, will be quite accretive to the Waltham, Massachusetts-based firm as well.

As such, she rated both General Dynamics and Raytheon "Overweight" as the deal will take years to develop and therefore a significant investment.

However, Australia is not only nation adding to investments in weapons and defense capabilities. In fact, the Department of Defense announced quietly at the close of 2021 that Japan had agreed to a $471 million contract with Boeing to upgrade its F-15 fleet.

The new contract is likely only the beginning for Quad-member Japan, which approved a record-breaking 5.4 trillion yen ($47.2 billion) defense budget for 2022 on Christmas Eve. With Quad compatriot India recently agreeing with Lockheed Martin presently on establishing a joint venture with Tata Advanced Systems to manufacture F-21 fighter manufacture in India and, of course, Taiwan upping its defense capabilities, all signs point to a blockbuster year for military spending in the region.

"China rising as a power and testing the dominant power of the U.S. and the growth of regional hegemons is escalating tensions," Kwesst's Luxton said, summing up the situation. "From an investment standpoint, this makes defense sector investment, in general, more attractive."

Europeans at Attention

The Pacific is not unique in terms of governments shoring up defense capabilities, however. Indeed, tensions in Kazakhstan, Russia's aggression in breakaway regions of Ukraine, and continued concerns along the Poland-Belarus border have turned European attention to defense buildup after decades of relative complacency as spillover effects from any of these issues could easily impact the EU and its immediate neighborhood.

For example, non-NATO countries Switzerland and Finland both selected the F-35 for new fighter jet programs in 2021. The latter is particularly significant, as its border with Russia encouraged its president to suggest accession to the treaty organization, which would also likely increase defense spending mandates.

"The sovereignty of several Member States, also Sweden and Finland, has been challenged from outside the Union," Finnish President Sauli Niinisto said in a New Year's address to his nation. "This makes the EU an involved party. The EU must not settle merely with the role of a technical coordinator of sanctions."

Obviously, moving beyond the economic realm necessitates defense capabilities and therefore likely spending in the defense arena. Needless to say, the U.S.-led NATO group is also keen to spend and live up to the standards set in spending by the agreement.

"Given the deteriorating security environment, investment is needed in our country's defenses," the newly minted Czech government said in a document released on Friday morning. "We will push for the legislative entrenchment of this level of defense spending as a minimum."

That sentiment is by no means unique to the leadership in Prague either, as Warsaw and the Baltic capitals appear to be following suit. Given historical tensions with Russia across the region, this trend is not likely to subside in the near term.

All this comes atop a $768 billion defense bill, over $20 billion more than initially requested, recently passed by the U.S. Senate and sent to the President Biden's desk.

Defending Against Downside?

To be sure, many of these tensions are not entirely novel and, after a strong year for many defense stocks, there is reason for caution on current valuations.

Andrew Shoemaker, Director of Investment Research at Capital Estate Advisors, was one such expert advising a modicum of suspicion.

"We feel that large-cap defense stocks are currently overvalued," he told Real Money. "When looking for opportunities in Defense, we have focused on small caps at this time because we feel that valuations are presently more reasonable at that market cap."

Shoemaker said that while he has liked Raytheon in the past, the entry point at present is not necessarily optimal. Further, he noted Science Applications International Corp. (SAIC) and L3Harris Technologies could well be interesting investments, though, ideally, at more modest multiples.

"As an aside, we are keeping a close eye on Palantir (PLTR) ," he added. "Their growth has been impressive."

It is also worth noting that not all defense spending is broadly positive for all stocks. For example, the AUKUS deal actually hurt Lockheed Martin, which was set to supply submarine combat systems under the auspices of the previous France-Australia agreement.

As with anything in investing, homework will be paramount moving forward as investors attempt to parse the best contractors providing defense systems to an increasing number of governments eager to spend in the sector.

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At the time of publication, Curran had no positions in any securities mentioned.

TAGS: Investing | Politics | Stocks | Aerospace | Defense | Asia | China | India | Australia | Europe | Japan | Russia

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