Secure your portfolio against the warfare of the future

This article was first published in MoneyWeek magazine issue no 997 on 1 May 2020. To make sure you don't miss out in future, and get to read all our articles as soon as they're published, sign up to MoneyWeek here and get your first six issues free.

No foreign power has ever managed to force a US aircraft carrier to abort a mission. But last month a virus succeeded where all America’s enemies have failed. The USS Theodore Roosevelt had to make its way back into harbour last month after an outbreak of Covid-19 on board.

A microscopic germ laid low one of America’s prime units of power projection and global policing, a nuclear-powered self-sufficient floating city with 6,000 crew and 80 aircraft that can stay at sea for 90 days without being resupplied.

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The episode is a stark illustration of the changing nature of defence and warfare: we are heading for a world in which conventional weapons and equipment are less effective and we need to rethink our approach to security. Keeping enemies at bay will be a far more complicated undertaking in future, involving a much wider range of technologies. This spells opportunity for long-term investors.

Surveying the landscape

When it comes to defending a country and its people, we typically envisage ships, fighter jets and soldiers operating somewhere overseas. But they can do little about Covid-19, which has been described by politicians as an enemy within and which has forced citizens to stay in their homes and sent economies reeling.

The army is usually thought of as a first line of defence, but today in the UK the National Health Service is the critical part of our national security infrastructure, while soldiers drive around delivering protective clothing.

Of course, Covid-19 is not an act of war. Nevertheless, one can’t help but ask “what if?” What if it had been not only a deliberate strike, but part of a sustained campaign? Could a state launch such an attack and would we be any the wiser? And what are we going to do next time?

For national security strategists, the implications of this unanticipated viral outbreak are unsettling. It will be feeding its way into thinking about what could threaten our security and what we need to do to stop it. And while it may not mean a sudden upturn in orders for big old naval destroyers, it heightens the sense of unknown risks and so will nevertheless boost sales of more appropriate and modern military equipment.

Projecting hard military power has its place, but so too does building adaptability and flexibility into operations, as well as investing in strong electronic surveillance and communications.

The character of war is changing

As the 18th-century Prussian army officer and leading military theorist Carl von Clausewitz argued, the nature of war doesn’t change, but its character does. And now the technological advances in society are driving rapid change in how we defend ourselves, with the incorporation of areas such as communications technology, artificial intelligence (AI), drones and robotics alongside conventional weaponry. With defence needs growing, supporting industries flourish too.

These trends confirm that we are very much still in the midst of the latest revolution in military affairs. They have occurred before. The arrival of railways in the 19th century, for instance, led to huge advances in troop and supply management and the invention of the breech-loading rifle transformed firepower and efficiency. This time the technology is built around communications, precision guidance, AI, robotics, drones and remote control.

A fast-moving sector

The possibilities are extensive and it is a hallmark of the defence sector that new concepts or techniques seem to move from speculation to reality in almost no time.

Once science fiction but now reality, for example, are biometric and sensing devices and even clothing and other wearable equipment that can understand and monitor the stresses and demands on the body though tracking heart rate and temperature.

In his 2006 book A Brief History of the Future, Jacques Attali, the French economist and former civil servant who was an adviser to President François Mitterrand, wrote about chemical, biological, bacteriological and nano-technological weaponry.

He believed that “Scientists will strive to increase their power, their miniaturisation and their accuracy. Chemical arms will be capable of seeking out and killing leaders without being detected; pandemics could be ready for unleashing at will; complex genetic arms may one day be directed specifically against certain ethnic groups”.

Technology for Attali was at the forefront of military superiority, with nano-robots undertaking surveillance and infiltrating physical bodies while animals could be cloned to become “living animal bombs”. He also wrote about big data centres and networked battle armour that could sense moods. None of these thoughts have been ditched; indeed, efforts to develop these ideas and trends have intensified.

Assessing future technologies

For investors, making sense of future wars is largely impossible. It is hopelessly difficult to second-guess decisions that haven’t yet been made and who knows what conditions future leaders and strategists will face? Fortunately, there is a wide array of professions working out what states and their militaries need to confront the future.

There are politicians, journalists, academics, think-tanks, engineers and even novelists in on the act. At the same time there are groups tracking technology shifts and uses and feeding these to defence company management. They may not be right about the future, but their ideas and views will be informing discussion and planning between government and the industry and this is ultimately what will drive sales.

It’s all a far cry from the protracted stand-off between the West and the Soviet Union. How military campaigns are conducted has changed significantly. Underpinning the peace between the superpowers during the Cold War was nuclear weaponry.

A large-scale war would have been unthinkably destructive. But the superpowers fought indirectly through “proxy” conflicts and long, grim civil wars have never disappeared, with dozens of conflicts enduring around the world.

The era of hybrid war

Key to understanding the defence arena today is recognising the shift to hybrid war, a term that embodies modern conflict. Many will go so far as to say that hybrid warfare has rendered many conventional approaches to defence obsolete.

Hybrid war is a blending of conventional military units with irregular personnel adopting strategies that aren’t necessarily military at all. There can be conventional fighting, but psychological warfare is common, while attacks are made on economies and politics using the media and businesses, for example. Cyberwarfare is another facet of hybrid war; it can disrupt societies by disabling state services.

A good example of hybrid war is Russian activity in Ukraine in early 2014, when it annexed Crimea. Russia was said to be using non-military personnel in Ukraine to inflame tensions and the link was not directly apparent. Russian lines of communication became much harder to gauge, which complicated the overall stand-off and sowed confusion among Ukrainians.

New areas of defence

There are some who argue that the US is currently in a hybrid war with China. According to this view, trade-war tensions, tariffs and even the geopolitical aftermath of Covid-19 are flashpoints, as well as the skirmishes between naval vessels in the South China Sea. The increasingly hybrid nature of war is what allows the incorporation into defence of activities such as cybersecurity and AI.

Cybersecurity is fast evolving and has caused extensive economic damage as perpetrators have attacked companies as well as government networks, and have extracted commercially sensitive and secret intelligence documents in addition to ransom money.

Cyberattacks have also crippled services such as lighting or heating. They are another means of causing confusion and disruption in a country while destabilising and undermining governments.

The advent of artificial intelligence

AI and the associated “deep-learning” by machines and algorithmic processing are making themselves felt in several ways: mapping battle terrains, for example, or making algorithm-based decisions on the conduct of conflict. AI can be used to navigate and fly unmanned drones and undertake reconnaissance.

It can also be used to pilot missiles and, potentially, identify its own targets and decide whether or not to strike. This presence is only set to grow as computer storage and power expand and facilitate faster processing, which will make AI even more crucial. Drones, meanwhile, incorporate extremely well-engineered engines and sensors together with top-quality communications that allow an operator to strike targets remotely on the other side of the world without putting any citizens in danger.

Insurgent group leaders, along with terrorists or others posing direct threats to the US or its allies, are among potential targets. Unmanned vehicles can also play a part in eliminating explosive devices and various installations and are seen as a potential force on the battleground.

Burgeoning markets

The bottom line for investors in these important and growing areas of defence is that future prospects are strong. Take cybersecurity, which is a market that sits in and outside the defence industry. According to Cybersecurity Ventures, the sector was worth just $3.5bn in 2004, but should reach more than $170bn by 2022, reflecting a long-term compound annual growth rate of nearly 23%.

Swamping that is the almost 40% annual growth rate of the drone market fuelled in part by defence spending. Expansion in the military-robot market is likely to eclipse general robot market growth too, while spending on military space and satellite equipment and research is also climbing.

These favourable trends are supported by a generally upbeat outlook. US defence stocks have been a good area to invest in and the chances of further outperformance long term are good. Security concerns of governments around the world are fuelling more spending on modernising and innovating military hardware, and this is likely to continue over the next few years.

Worldwide spending is set to reach $2.1trn by 2023, according to research from Deloitte, the accountancy giant. The biggest contributor to this will continue to be the US, but countries such as China, Russia and India are all increasing their commitments to defence. Meanwhile, instability in the Middle East underpins regional spending there. And in Europe, countries are responding to pressure to increase their spending in support of Nato to over 2% of GDP. US military sales to overseas governments, meanwhile, remain strong.

The sector’s outperformers

How all this translates into share prices is not always clear-cut. Defence groups’ exposure to commercial, non-military markets varies greatly, so stocks are not solely influenced by defence considerations. In any case, there has been strong recent outperformance from Northrop Grumman, Lockheed Martin and Raytheon Technologies (which has just merged with United Technologies), while electronic components groups serving the industry, such as Teledyne and L3Harris Technologies, have also done well. Boeing has performed poorly amid trouble in its commercial arm after the grounding of its 737 MAX. We assess the most promising plays on the future of defence below.

The stocks to buy now

The defence sector can generate growth, but also provide investors with a hedge against uncertainty because it sells long-term, crucial security projects to deep-pocketed and committed governments.

One of the most attractive “pure-play” defence stocks is Lockheed Martin (NYSE: LMT), a big firm offering broad exposure to aircraft, including its potentially $1trn flagship F-35 Lightning II jets programme; maritime strike and sensor capability and drones. It’s also big in missile defence and hypersonics (weapons that can travel much faster than the speed of sound).

Lockheed is active in cyber-computing and AI and it will transport the first woman and next man to the moon. Much of what it does is critical to the security of the US and Nato. Recent earnings beat expectations. The stock has outperformed the market for years and during recent turbulence. This is likely to continue.

Consider also Raytheon Technologies (NYSE: RTX), the maker of the Tomahawk cruise missile. It’s a different proposition to Lockheed because a third of its sales are in commercial aviation – not great when no-one’s flying. But it could prove more lucrative, albeit riskier, than Lockheed if you take the view that in, say, two years’ time current events will be behind us and the world will be travelling again.

If you buy you’ll be holding a strong balance sheet and a highly regarded missile technology and drone business while you wait for the commercial aviation operations to rebound. Raytheon will report its first figures since its merger with United Technologies on 7 May.

Those seeking something smaller and more speculative – and who believe in the drone revolution – should research AeroVironment (Nasdaq: AVAV), a business focused on small, military drones. It’s an established Pentagon contractor. Leading products include Switchblade, Wasp and Puma.

The shares aren’t cheap and have easily outperformed the market so far this year, but there’s plenty of potential and more contracts to come. Patient investors could be well rewarded from current levels. Drones are a big growth area.

An alternative is Booz Allen Hamilton (Nasdaq: BAH). It’s a consultant to the US government with a heavy emphasis on defence and intelligence, which together comprise 70% of the group’s $7bn in annual sales. Clients include the United States Navy, Marine Corps, Army and Air Force. It’s also involved in the intelligence community, working with the US intelligence agencies as well as military intelligence. As defence needs change and become more technologically driven, Booz Allen looks extremely well placed to help America and its allies adapt to the challenges ahead and allocate growing defence budgets efficiently.

Finally, for investors who prefer funds, there are few options that concentrate solely on defence and they also tend to carry too much commercial aerospace exposure.

So consider instead an exchange-traded fund that should benefit from some of the technological trends underpinning growth in the defence sector: Lyxor’s Robotics and AI ETF (LSE: ROAI), which is priced in US dollars. It tracks the 150-stock Rise of the Robotics Index, takes a global view and has total expenses of 0.4% a year.

Writer and commentator Stephen Connolly has worked in banking and asset management for nearly 30 years (sc@plainmoney.co.uk)