Profit from the world’s defence spending

Many governments are cash-strapped. Yet one part of state spending around the world keeps stubbornly rising: defence.

Take 2008 – the latest year for which overall figures are available. Global military spending grew by 4% to a record $1,464bn, says the Stockholm International Peace Research Institute (SIPRI). That capped a 45% rise since 1999 and equalled 2.4% of global GDP. In comparison, global sales of consumer electronics are around $700m annually. Sure, defence budgets in Britain, for instance, have been under threat for years. But although the UK is the world’s third-largest weapons buyer (equal with France), it accounts for just 4.5% of total global military spending. The fastest defence expenditure growth (174%) between 1999 and 2008 was in eastern Europe, largely (87%) coming from the Russian Federation, according to SIPRI.

In countries where cash isn’t constrained, arms buying is set to soar. In 2008, oil and gas-rich Algeria upped its weapons spend by 18% in real terms to $5.2bn, the highest level in Africa. With Islamic insurgency increasing, further such growth is a shoe in. The same goes for the Middle East, where defence expenditure is expected to surpass $100bn by 2014, says a report this month by Frost & Sullivan. “The financial muscle of countries like Saudi Arabia, the UAE and Israel is enabling the Middle East to keep spending a huge chunk of GDP on defence,” says the firm’s Gautam Ganapathy. “Although Middle East countries have fewer active troops compared to Western nations, the ratio of their defence spending to GDP is highest in the world.”

Yet in total spending terms, the US is the major determinant of global military spending. George W Bush’s presidency saw armed forces’ expenditure rising to its highest in real terms since World War II. It reached 41.5% of 2008’s world total, mostly due to Iraq and Afghanistan. The current US defence budget is $700bn and is set to rise, despite huge US deficits. “Emerging details about the fiscal 2011 defence budget confirm what US defence executives have been expecting,” says Reuters this week. “Defence Secretary Robert Gates is delivering on his promise to secure modest but steady growth.”

That helps to explain how, by 2013, global defence spending will have climbed by another 22% or so, according to Datamonitor’s Global Industry Guide.

India is a classic case of how the global arms industry is going gangbusters. The country faces external disputes with Pakistan and China and internal security issues. No surprise then that India has grown defence spending by 7% annually. At $30bn in 2008 it was already the world’s tenth-largest military spender.

Traditionally, India has bought arms from Russia and its indigenous suppliers. But the November 2008 Mumbai attacks revealed glaring holes in national security. The first comprehensive report on India’s military capabilities, just published by KPMG and the Confederation of Indian Industry, concluded that at least half the country’s defence kit is now obsolete and needs urgent upgrading. So equipment supply is being opened up internationally.

“India’s market is attracting attention from the large European and US defence contractors,” says Matthew Potter at BNET UK. “The focus to date has been on new air and naval assets, but eventually new ground equipment will be needed. This will create demand that US and European tank and artillery manufacturers will be fighting to fill.” We look at one UK stock already raiding the world’s war chests below.

The best bet in the sector

Britain is the world’s second biggest weapons exporter, with international arms sales totalling £4.2bn. And one firm is largely responsible: BAE Systems (LSE: BA/).

BAE Systems builds everything from tanks  to aircraft carriers and fighter planes for customers in more than 100 countries. It’s the world’s second-largest global defence business and the biggest in Europe (based on 2008’s £18.5bn turnover).

In America, it’s the sixth-largest equipment supplier, and the leading non-US supplier to the Pentagon. And not only is BAE in pole position to participate in defence projects worldwide, it’s exploring civilian avenues too, according The Guardian. The British police, for example, are planning to start using unmanned spy drones.

BAE now boasts a forward order book of almost four times its market value of £12.5bn. The balance sheet is sound, with net debt negligible. Yet the shares have recently suffered on fears of a bigger-than-expected cut back on the UK defence budget, and the long-running allegations of bribery to generate sales. But with these factored into the stock price, at 351p BAE looks cheap on a current p/e of 8.5. The forward dividend yield is 4.7%.

PS. (Updated on 8th Feb 2010): Since this article was written, BAE has agreed to pay nearly £300m to settle bribery allegations in the UK and US prior to 2002. The defence contractor further said that no one responsible for the matters under investigation still works for it. What’s the bottom line? This sounds like a large payout, but it was less than the market had feared. Further, the deal won’t stop BAE bidding for government contracts on both sides of the Atlantic. So one major uncertainty overhanging the company is taken out. And while UK defence cuts are still likely, investors aren’t too worried. Last week BAE outperformed the market by 2%.

  • James Hutchison

    It’s not a comforting notion, but periods of serious economic instabilty have historicaly resulted in conflict. This may simply manifest itself as civil rioting due to high enemployment with economic & social instability, such as occured in Brixton in 1981.

    Economic problems can also form an environment for international war such as happened with the high unemployment & inflation in 1930’s Germany. Defence stocks could clearly perform well if the current international economic instability becomes more ugly. However, there is a moral issue from seeking to profit this way.

  • Jim

    Agree with James Hutchison on the moral issue.

    Then again, I ask myself what influence I could have in how political and economic problems develop. Send emails to my MP?

    I feel that the way events happen in the world of politics is rather beyond what I, as an individual could do anything about. No matter how much I like or dislike what goes on I still have to drink and eat and if investing in enterprises that develop defensive stocks helps that then so be it.

    Ultimately its what happens in the world of politics that dictates how these defensive stocks are used.