The U.S. and Europe are likely going to continue to boost defense spending, preparing not for the war tomorrow but decades from now. Moreover, European nations will likely feel that they need to be more self-reliant on defending themselves.
My firm has created a basket of U.S. and European defense stocks. On a valuation basis, these companies are so cheap that we should make money with them even if the China–U.S. relationship normalizes. If tensions escalate, they’ll skyrocket. We are not hoping for that scenario, of course, but we are prepared for it.
Defense companies needed to adjust and they did. Their contracts with governments are usually structured as percentage of completion. To put it simply, they finish 20% of a submarine and the government sends them a check for 20% of the agreed price. These milestones got pushed by the coronavirus a few quarters into the future. So the defense companies will incur some extra short-term costs but their long-term fundamentals are not impacted by the virus. Also, the virus does not make their business path-dependent — they are still profitable and cash flow-generative businesses that can honor all of their obligations from their cash flows.
Defense companies have another thing in common – they are terrific businesses. They are either monopolies or operate in a cozy competitive (oligopolistic) environment. For instance, in the U.S., Huntington Ingalls Industries /zigman2/quotes/201887483/composite HII +1.06% and General Dynamics /zigman2/quotes/208560027/composite GD +0.82% make submarines, with each taking a 50% market share. Barriers to entry and switching costs are enormous and further complicated by security clearance required for employees, which are extremely difficult to obtain.
The market today is going bananas for subscription as a service businesses; defense companies truly are subscription as a service businesses. They are building, servicing and upgrading aircraft careers, ships, submarines and planes, and training armed forces for a customer whose check will never bounce. In addition, long-term contracts ensure that revenues will flow. These businesses have a good return on capital, stable margins and usually conservative balance sheets. And all because they got inconvenienced by the virus, these stocks can be had at bargain basement prices.
How does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which holds positions in Huntington Ingalls Industries and General Dynamics.