3 Defence Stock Picks

VIDEO: As tensions mount between the US and Iran, Killik & Co's Rachel Winter turns her attention to the defence industry

Holly Black 8 January, 2020 | 11:40AM
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Holly Black: Welcome to the Morningstar series, "3 Stock Picks." I'm Holly Black. With me is Rachel Winter. She is investment director at Killik & Co. Hello.

Rachel Winter: Hello. Hi, Holly.

Black: So, you've got three defence stocks for us, quite topical. Where would you like to start?

Winter: Yeah. So, we're looking at this situation in Iran. Clearly, there is quite a lot of concern here. So, we thought it's quite a relevant time to be looking at these defence stocks.

So, the first one is a US company called Northrop Grumman. Big company, worth about $60 billion. They're involved in all aspects of defence. They're what we call a pure play defence company. So, basically, they don't do anything else other than defence. They have historically been quite successful with more traditional areas of defence, say, for example, logistics and strike, but they've also moved quite heavily towards new areas such as space and also cyber security. So, very topical at the moment, particularly with these concerns about Russia and Iran putting out cyberattacks on the rest of the world. At the moment, about 85% of the company's revenue comes from the US government. So, that's a very high number indeed. But I think it's quite reassuring at a time when we know the US wants to be spending more on defence.

Black: Do you find a lot of people have problems ethically with investing in defence stocks, but then also, like you say, they're investing in space exploration and cyber security. And arguably, they're not quite so ethically grey areas.

Winter: That's true. I think a lot of clients when we ask about ethical concerns, they do particularly mention defence stocks. And you're right in saying that tends to apply more to the traditional areas such as strike. I think some people still do have concerns about cyber security or cyber defence or cyberattacks, perhaps. But we're simply looking here at areas of the market that we think will perform well over the next few months. And I think it's up to into individual clients whether or not they want to have exposure to those.

Black: Okay. What's stock number two?

Winter: Stock number two is Airbus. So, quite a well-known airplane manufacturing company. They're more well known for commercial aircraft, but about a quarter of the company's revenue comes from defence and also helicopters. The company is particularly exposed to helicopters and owns about 50% of the market share for helicopters. They're particularly exposed to Europe and I think that's quite a good thing at the moment, because the US has been quite critical of European NATO countries for not spending enough on defence. So, any allies of NATO are supposed to be spending 2% of their gross domestic product on defence. At the moment, the US spends about 3.5%, but a lot of the major European countries, so Germany, France, Spain, they're spending much less than 2%. And I think the US will start to put some pressure on for those countries to spend more. And that's got to be good for European defence companies, such as Airbus.

Black: And is Airbus quite a good way to play this sort of theme, because it is diversified in that it's exposed to travel and tourism as well as defence?

Winter: Exactly. So, it's done quite well recently, because of the concerns about Boeing. Airbus there is really the only competitor in terms of commercial aircraft and then it's got the defence element, which does offer some degree of diversification.

Black: Okay. And our final stock?

Winter: Finally, it's a big name, quite well known. It's Rolls-Royce. So, as with Airbus, Rolls-Royce is probably more well known for its exposure to commercial aircraft. But it is still very successful in the military and defence space. So, about 20% of revenue comes from defence, particularly exposed to military transport, logistics. They're also working quite closely with the Navy. So, a lot of the nuclear submarines or the nuclear reactors in their submarines are serviced over the long term by Rolls-Royce. So, quite a long-term constant revenue stream there for Rolls-Royce. About 20% of the company's revenue is allocated to defence. Of that defence revenue, about half comes from the US and then the rest is divided quite equally between the UK and the rest of the world. So, quite diverse there geographically. And again, I think this company stands to benefit if allies of NATO do start to spend more on defence.

Black: So, the reason we're talking about these is because there are these tensions between the US and Iran building. But something we quite often say is that people should think about the long-term and try not to get bogged down in short-term politics and noise. But is situations like this slightly different?

Winter: I think over the long term or perhaps over the last five years in particular, a lot of the word has been underspending on defence. So, that example I gave about a lot of the countries within NATO not spending the agreed 2% on defence, I think that really shows how much a lot of these countries have been underspending. So, I think the problem of underspending on defence has been going on for quite some time. But this situation with Iran just highlights how important it is for all countries to have an up-to-date method of defending themselves.

Black: Super. Well, thank you so much for your time.

Winter: You're welcome.

Black: And thanks for joining us.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Black  is Senior Editor, Morningstar.co.uk


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