The battle of the defence stocks

Hand flipping wooden cubes for change wording" Panic " to " Calm".

Edwin Starr’s song War rings true today more than ever when we see the devastation caused to the people of Ukraine. The war has created much turmoil in financial markets too via extended supply chain issues, commodities shortages, and further uncertainty. Defence stocks have been one of the few bright spots in the Footsie so far this year and such stocks should benefit from revised government defence budgets and any geopolitical uncertainty.

BAE is shining

BAE Systems (LSE: BA.) has enjoyed significant share price appreciation due to the uncertain geopolitical backdrop, and this could continue. So far, £104bn of defence spending increases have been announced by seven European countries. BAE is already benefiting from this, with contract wins from the German government. Military equipment such as fighter jets and naval ships made up about half of the group’s sales as of December 2021.

The company is attractive to me both as an income and growth investor. It currently has a 3.4% dividend yield and the continued development of its cyber intelligence units should boost higher margins.

The shares are more expensive than their longer-term average, currently at 15x forward price-to-earnings (against an average of 11x). But I think they could get more expensive as rising tensions between China and Taiwan could be reflected in the price of defence stocks such as this. Regardless of that, general commitment from governments to increase defence spending should benefit BAE and so the company has scope to grow into its valuation. This is a stock I may add to my portfolio soon.

Avon is underperforming

Another large defence player in the UK is Avon Protection. Unfortunately, I can’t be so optimistic about this stock. The shares have fallen 61% over the last 12 months. This downtrend doesn’t appear to be ending any time soon either. The company confirmed plans to wind down its body armour business in December after Avon products failed US Army tests. Alongside this, it was announced that its CEO will leave at the end of this year.

Streamlining operations may lead to a turnaround for the stock longer term, but there’s too much uncertainty today for me to invest. Also, the stock is too speculative for my liking, given the high valuation at 40x earnings.

Software is the new defence

Two other companies I’ve been monitoring are Chemring and Palantir. Chemring supplies the defence industry through its Sensors and Information (S&I), and Countermeasure and Energetics products. The company saw a 27% increase in underlying profit for its S&I business over the past six months and should benefit from the government defence spending mentioned above. Chemring’s steady profits and reasonable valuation mean this could be a quality stock to hold in my portfolio for years.

Meanwhile, a high-growth play in this area is Palantir, an AI data analytics company that makes a digital clone of a business, aiming to improve its efficiency and digital security. It has won several US Government defence contracts and is currently bidding for a £360m contract to control the UK’s NHS IT infrastructure. It seems it has what Warren Buffett would describe as a ‘moat’ around its business because once a company adds Palantir’s clone to its digital infrastructure, it becomes hard to change provider. This could be a great long-term purchase for my portfolio.

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Peter McMullan does not own shares in any of the companies mentioned. The Motley Fool UK has recommended Avon Protection. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.