With tensions accelerating in North Korea – US President Trump tweeted Wednesday “talking is not the answer” – this might be the time to invest in US defense stocks. Even though valuations are high, and investors shouldn’t expect earnings multiple expansion, demand is likely to increase in what is a major “growth industry”, particularly for missile defense spending, a Bank of America US Trust analyst told ValueWalk. What’s more, increased mergers and acquisitions and a dramatic increase in spending by Germany and Japan are factors likely not priced into the market that will drive stock prices higher.
The steady military buildup over the last decade is now increasing exponentially, missile defense spending to rise amid conflicts
One of the most consistent societal behaviors throughout history has been an armed conflict somewhere in the world.
It’s not just the "unfortunate" historic trend towards war that drives the investment thesis, but the dramatic ramp up that is occurring over the last decade, a trend that is significantly gaining speed of late, that should motivate investors, said Joseph P. Quinlan, head of market & thematic strategy at Bank of America’s U.S Trust Division. That trend isn't just in the US, as spending by nations around the world is set to rise.
“While it is unfortunate, the reality is It's hard to find industry growing faster than the global economy,” he said, pointing to a world where conflict appears at every corner.
He sees a rising tide of conflict from the Middle East to North Korea to potential superpower conflicts with China in the South China Sea and Russia in Eastern Europe. A conflict could arise that doesn’t involve the US, as China and Pakistan could be engaged with India in conflict and Sunni – Shia conflict in the Middle East has potential to expand. “What isn't priced into the market is the massive military build-up anticipated by Japan and Germany,” with large manufacturers in the US likely to be the primary beneficiary. Quinlan says recent geopolitical developments are "simply stunning and emblematic of a very different world.”
The increasing demand for highly technical military weaponry plays into US hands, missile defense spending to soar
But it isn’t just the growing trend towards war bolstering the thesis. War is becoming increasingly complex and computer-driven, which is likely to impact some stocks above others. He notes that a wide variety of highly technical military systems could be in need of an upgrade for which US military suppliers are the most prudent game in town.
India, for example, previously purchased defense systems from the United Kingdom, France, Russia and India, but is now looking to the US to provide an enhanced technical upgrade. Part of that upgrade could include missile defense spending, particularly for those nations as well as nations within a missile-range of North Korea or Iran, as well as significant increases in US defense spending.
In the US alone, Quinlan is looking for an acceleration in missile defense spending. The Missile Defense Agency has requested $7.9 billion in funding for 2018, a 5% increase over the 2017 request, and this is only one branch of the military as an increase in missile defense spending could go up by “many billions,” a promise made by President Trump. Such spending by World War II powerhouses Japan and Germany could multiply this factor in dramatic fashion.
Drones are another area where “the US has first mover advantage,” he said, pointing to large firms as the premier suppliers of precision military equipment with sophisticated targeting and control mechanisms. He did note that generic, low-priced drones, however, could be manufactured overseas and be disruptive to the low end of the industry, bolstering his preference for large leaders in the space.
In large part, the sophisticated technology driving the next phase of warfare, where intelligent bombs meat swarms of drowns talking to one another where “machines talk to each other more than humans” is the future. Calling cybersecurity is the ultimate growth industry, there is a pause in his investment enthusiasm.
He says concerns regarding artificial intelligence expressed by visionary Elon Musk are real and that while US must remain a leader in the space, sophisticated technology falling in the wrong hands could be disastrous. “You don't need a nuclear bomb anymore,” because the right combination of AI, drones and cyber capabilities could be just as destructive.
Aside from the moral drawback of the investment, Quinlan notes valuations are high -- average forward 12-month PE multiple of 20.9x, well above the five and 10 year averages of 15.4x and 12.9x earnings. However, the overall dramatic growth in the market, as well as unanticipated mergers and acquisitions, are likely to drive stocks higher, he says.
Specifically the report states regarding Asia and missile defense spending:
“Of the past 3,400 years, humans have been entirely at peace for 268 of them, or just 8 percent of recorded history.”
—Chris Hedges, author of What Every Person Should Know about War
Key investment takeaways:
• Despite being one of the oldest activities in the world, war remains a growth industry.
• Multiple geo-political hotspots point to rising global military expenditures over the near-term.
• As the premier global arms supplier, U.S. defense leaders, despite elevated valuations, still look attractive.
Given the sobering statistic mentioned at the outset, world peace remains the rarest of commodities. Military conflict has been a staple of life for centuries, with the 21st century—unfortunately—no different. America has been at war for roughly ninety percent of the time since 2000, with no end in sight; the Trump Administration recently pledged to continue fighting in Afghanistan, the longest running war in U.S. history.
Today, span the globe, and the world seems to be on fire. The Middle East is littered with failed states, with a non-state actor called the Islamic State of Iraq and Levant (Isis) still a formidable foe in the region. The roots of ISIS also extend beyond the Middle East, with the number of ISIS-inspired attacks multiplying over the course of last year, hitting targets in the United States, Asia, and of course, Europe, with last week’s terrorist attack in Spain but one more example of the work of ISIS.
Beyond ISIS there is Russia’s annexation of Crimea and military presence in Syria; China’s military build-out in the South China Sea that threatens the region’s military and economic stability; the growing virulent feud between Sunni Saudi Arabia and Shiite-led Iran; North Korea testing a nuclear bomb; and the simmering standoff in the Himalayas between China and India.
All of the above is simply stunning and emblematic of a very different world from the past and reaffirms our investment thesis to be long defense—or to build/maintain positions in large cap U.S. defense firms.
Asia and the Middle East are the main sources of medium- to long-term growth in defense spending driven mainly by pervasive regional conflicts. There’s no short supply of tensions in these regions. Many of these countries are gearing their defense budgets toward modernization efforts yet lack the technological expertise to develop their own military capabilities internally and must rely on imports from the world’s leading defense companies, many of which reside in the U.S. This includes imports of air and missile defense systems, advanced communications systems, aircraft, and various support and training services, just to name a few. U.S. defense companies have helped fill much of this external demand, so much so that about 80% of U.S. arms exports are destined for the Middle East and Asia.
North Korean tensions portend accelerating missile defense spending
Against a backdrop of intensifying rhetoric and posturing from North Korea, we expect an acceleration in missile defense spending in the U.S. to counter the threat. Indeed, the Missile Defense Agency (MDA) has requested $7.9 billion in funding for 2018, a 5% increase over the 2017 request, and is likely to receive support for this request as congress works to pass a budget this fall (this does not include the missile defense-related funding through other branches of the military). Outside of the president’s promise to increase missile defense spending by “many billions,” the administration is currently conducting a review of the current ballistic missile defense strategy, with findings expected by early 2018.
And the need for defense against ballistic missiles is not contained to tensions with North Korea. The MDA estimates there are over 6,300 ballistic missiles in the world that are outside of U.S., NATO, Russian and Chinese control, while a recent report from the Defense Intelligence Agency notes that for peers, “the last decade has seen a dramatic increase in ballistic missile capabilities to include accuracy, post-boost maneuverability, and combat effectiveness.”
Overall, we expect to see increased missile defense spending as a means to update current aging systems, achieve more robust capabilities and expand the interceptor capacity to meet evolving threats.
The rise of China
“The rise of China” is a popular refrain and speaks mainly to the mainland’s stunning economic ascent of the past three decades. Yet there is another side to the “rise of China,” and it pivots around the nation’s stunning military advances over the past few years. Soaring defense spending has pushed China toward technological parity with the U.S. Ditto for Russia, which continues to prioritize the advancement of its defense technology. The rise of near-peer potential adversaries, or what the DoD refers to as “pacing competitors,” poses a number of challenges to the United States and is likely to result in rising research and development (R&D) spending over the near-term. The 2018 DoD budget request increases R&D as a percentage of spending to 13%, compared to the 11–12% range of the last decade and represents over an $11B increase from 2017 R&D budget levels. With pacing competitors seemingly breathing down our necks on key technologies, we expect the prioritization of future R&D increases.
The rise of China’s military capability has kick-started an arms race across Asia, with U.S. companies the primary beneficiaries. Though defense spending in the Middle East makes headlines, the reality is that the upside for defense spending in Asia is higher. A large number of countries in close proximity to China have had to ante up spending to keep pace with China’s martial advancement. Note from Exhibit 2 that relative to the Middle East, there is considerably more upside to defense spending as a percentage of GDP in Asia than in the Middle East.