Defense Stocks: Are Wars Profitable?

Globally, there is an escalation in unrest and conflict. Israel is waging a war against Hamas terrorists in retaliation for their lethal attacks against civilians; Ukraine is defending itself against Russia’s military invasion of Ukraine last year; Iran and North Korea are escalating their nuclear threats. Meanwhile, the U.S. increasingly sees China as a preeminent security threat. These hostilities carry wide-reaching consequences, impacting not just international peace and security, but also influencing the global economy and the dynamics of stock markets worldwide.

While the broad market’s moves are mostly unaffected by warfare while it is geographically contained, some niches can see outsized gains or losses at a time of conflict. The losers depend on the type of conflict; as for the winners, defense companies, that supply weapons and military equipment, tend to profit the most, at times. Wars, while abhorrent, can also be profitable, so now might be a good time to buy defense stocks. However, there are many external factors to consider, including the negative effects of conflicts on the business lines of defense companies.

The Most Dangerous Time in Decades

In JPMorgan’s (JPM) October 13 earnings report, Chairman and CEO Jamie Dimon said, “This may be the most dangerous time the world has seen in decades,” a phrase we don’t often hear from bank managers. This is due to the ongoing Russia-Ukraine conflict, strained U.S.-China relations, and the Israel-Hamas war, leading to global uncertainty, especially in the economy and stock market. However, defense companies could be an exception, benefiting from these increased global threats.

Dimon emphasized the importance of the defense industry amidst this instability. Defense companies, unlike many other sectors, tend to thrive in periods of geopolitical turmoil. As global tensions rise, there’s a growing need for advanced defense technology, making this sector a key investment focus. In general, defense firms are known for their business stability, supported by government contracts and their role in national security.

Since Russia invaded Ukraine, leading defense companies have seen a sharp increase in demand for their products. In 2022, global military expenditures have reached their record high, with much of the increase attributed to Europe’s steepest rise in defense spending in the post-Cold War era. At the same time, the increasingly cold relationship between the West and China added to the defense spending expansion, particularly in the cyber defense area. Now, with the war between Israel and Hamas terrorists in the Gaza Strip threatening to spark a larger conflict in the Middle East, the U.S. and allied governments in the region are ramping up their military spending even more. From 2021 to 2020, the global defense market has expanded by 8%; in 2023 it is expected to show similar or higher growth figures, given that the number of conflicts globally is on the rise.

As the U.S. ramps up military assistance to its allies Ukraine and Israel, it will be obliged to increase investment in refilling its physical arsenals, in contrast to the previous decade’s views that most efforts should be directed at developing cyber warfare and defense capabilities. The increase in armament and military equipment spending will considerably benefit the U.S. government’s defense contractors, with the same trends apparent in the U.K. and Europe.    

Not All Wars Are Created Equal

So, as we are seeing conflicts sparking up around the globe and expect the war budgets to swell, investing in defense stocks seems quite a clear-cut decision. However, in reality, it is not such an obvious choice, to say the least, as companies in the Aerospace & Defense industry differ considerably on many metrics, which affect their performances.

When a conflict is all over the headlines, the first thing coming to everyone’s mind is loading up on stocks of companies that supply weapons, equipment, and technology used in warfare. That’s why, statistically, every time a conflict broke out, defense stocks as a whole have popped up; however, longer term, their performance seems to be unpredictable, depending on a myriad of factors. These include the length of the conflict, risks of its spreading or sparking subsequent conflicts in other areas, its geographical distance from the U.S. and its areas of influence, the level of concern it poses to U.S. security (which influences the budget considerations), and many more.   

For example, the Aerospace & Defense industry initially strongly outperformed the S&P 500 (SPX) as the U.S. invaded Afghanistan following the 9/11 attacks, but later gave back most of the excessive gains. In the second Iraq war, the outperformance of the defense was much more muted and lasted less time; in the Syrian civil war, defense stocks did well for longer.

When Russia invaded Ukraine on February 24, 2022, military stocks actually crashed after the initial increase (much of which happened before the attack), only to surge back strongly after the realization that this war would drag on, drawing in increasing military supplies from Ukraine’s Western allies. As the Russia-Ukraine war continued without making many headlines, and the general market sentiment soured at the end of the summer, the Aerospace & Defense ETFs tumbled more than the general market, only to rise again on the news of another war starting in the Middle East.

Source: Yahoo Finance

There are three main defense ETFs: iShares U.S. Aerospace & Defense ETF (ITA), Invesco Aerospace & Defense ETF (PPA), and SPDR S&P Aerospace & Defense ETF (XAR). While all three have outperformed SPDR S&P 500 ETF Trust (SPY), which follows the S&P 500 index, since the onset of the Russia-Ukraine war, the large disparities in performances and the volatility of the funds underscore the vast differences in performances of the underlying stocks. All the largest defense companies are present in all these funds’ top-20 holdings, albeit at very dissimilar weightings; in addition, the choice of stocks outside of the well-known defense bunch is also very different.

Not All Defense Stocks Are Created Equal

These findings point out a commonly missed aspect: not all companies in the sector are exclusively focused on defense. Many operate in both defense and commercial sectors. They produce a range of products like electronics, engines, and aircraft, which are used for both defense and non-defense purposes. Consequently, a company’s mix of defense and commercial revenues can influence its success or failure amid conflicts.

Many firms engaged in defense production obtain a large part of their sales from non-defense businesses. For instance, Boeing (BA), RTX (RTX), or General Dynamics (GD) have air defense-related and non-defense aircraft business divisions; with BA and RTX getting the majority of their revenue from the latter. On the one hand, they might appear to benefit considerably from Israel’s fight against terrorism. However, this situation also introduces uncertainty in the aviation sector, as airlines cancel flights to Israel and other Middle Eastern destinations, impacting the commercial side of these companies. The question then becomes: which aspect has a greater impact? What do investors perceive as more influential? The situation is not straightforward; perceptions play a significant role.

Even more important are each company’s fundamentals, which return to the fore after the knee-jerk reaction has played out. No single armament or equipment contract, however large, will heal an ailing balance sheet or immediately turn a money-burning company into a profitable one. Besides, even a large, profitable company will find it difficult to spark investor enthusiasm for more than a very short period, if it can’t show any significant earnings growth potential.

Source: Google Finance

For example, Lockheed Martin (LMT), the largest pure-play defense contractor in the world, has seen its shares struggle this year as it produced uneven quarterly results and as analysts forecast a decline in earnings in the next quarters. In another example, Northrop Grumman (NOC) has posted only four year-on-year EPS increases out of the last ten quarters, while next year’s projection is little more than flat; no wonder that the stock has strongly underperformed in the past year.

Research to Defend Your Capital

In conclusion, wars can be very profitable for companies who supply arms, military equipment, and security technologies. However, aspiring defense-stocks investors must look at the whole picture, taking into account other direct and indirect effects of the conflict on these companies revenues.

Investors who wish to capitalize on the firms helping governments defend their citizens from rising global instabilities are strongly advised not to take flashy headlines for granted. It is essential to dig into the data, analyzing companies’ finances, industry competitiveness, growth prospects and risks, and more.

Alternatively, investors can leverage the existing analysis, utilizing research done by Wall Street’s leading analysts. TipRanks has several tools that can help investors employ the vast amounts of data and research stored in its database, to their benefit. See the TipRanks table below for an overview of the performance of several prominent defense companies.