German Chancellor Scholz’s announcement that he is making 100 billion euro available from the federal budget to strengthen national and European defence has not missed the mark. German Rheinmetall shares extended gains on Tuesday, adding another 18 percent after to close at an alltime high of 157,20 euros, down from its 52-week average of 76.28 euros. ETFs focused on defence and aerospace have also gained since the war in Ukraine.
Defence stocks have been an unwanted child among (European) investors for years. Just as tobacco companies were phased out of the portfolio earlier, listed companies in the field of defence met a similar fate among many parties - partly due to investors’ focus on ESG criteria.
But on Sunday, Chancellor Olaf Scholz made an unprecedented U-turn in foreign and defence policy on behalf of the German government: his government will supply weapons to Ukraine in its fight with Russia, it has agreed to partially disconnect Russia from the international payments system Swift and it is freeing up €100 billion to defend “freedom, democracy and prosperity” in Europe.
Largest defence ETFs
With the war over Ukraine, security and defence are back in investors’ minds. Not only does Rheinmetall, which is involved in the construction of the Leopard tank, now have a white foot with investors, but defence and space ETFs have also seen significant inflows in recent weeks.
The largest ETF in this area is the iShares US Aerospace & Defense ETF (ticker: ITA). It has a total of almost 2.5 billion dollars under management. Last year, this ETF gained more than 5.8 percent after expenses. But year-to-date, the ETF stands at a gain of 4.72 percent, against the market average of 2 percent. Despite this, there has still been an outflow of EUR 417.15 million over the past 12 months. But that trend seems to have reversed. Since roughly 9 February, 22 million dollars in new money has poured in.
The ETF has 13 companies in its portfolio. The largest position is held by Raytheon Technologies Corporation (a weighting of 22.6 percent), followed by Boeing (17.7 percent), Lockheed (5.92 percent) and parties such as General Dynamics Corporation and Northrop Gunman. Other large ETFs in this area are Invesco Aerospace & Defense ETF with 630 million euro in assets under management and SPDR S&P Aerospace & Defense ETF with 1 billion euro in assets under management.
New arms race
Defence companies performed weakly in the stock market in 2020. The reason was the expectation that new President Biden would invest substantially less in defence - but the opposite is the case. The Democratic administration shares with Republican predecessor Donald Trump the view that the United States is competing with China for world hegemony. The US defence budget for 2022 is 777.7 billion dollar - an unprecedented record. In the coming years, more investments are expected in further modernisation of the US defence apparatus and in high technology.
For a long time, the United States criticised the European member states of NATO for not spending 2 per cent of its gross national income on defence. But that era seems to be over with Russia’s attack on Ukraine’s sovereignty - Germany, through Chancellor Scholz, has announced that it will spend more on defence than the two-percent-of-GDP threshold. Even the red-lantern bearer The Netherlands seems to have changed its mind.
Defence companies are literally defensive stocks. Generally, there is no sharp increase in valuation. On the other hand, the shares of these companies are interesting for income-oriented investors, who have a preference for stable growth and dividend yield.
Focus on three parameters
Analysts warn that investors should keep a close eye on three parameters: is there free cash flow? This is essential for defence companies, because it is not always clear whether contracts concluded with the client actually run to the end. For investors, this is an essential question, because often in the initial phase of a project, large expenses are incurred by the company.
In addition, there is the risk of so-called “corporate backlogs”. These are future contracts that have been awarded but not yet executed. Essential here is the question of how much of the backlog has been financed and how much still has to be approved by the government or the US Congress.
Finally, there is the parameter of “book-to-bill ratio”. This is the parameter that compares the value of orders received in a given quarter with invoiced (and paid) bills. This reveals the growth potential (future cash flow) of the company. A growth company must have a “book-to-bill ratio” of at least 1.0, which means that orders have been booked for future production in line with what has been delivered so far.
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