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A corner of the UK market is enjoying its best year in at least two decades, yet investors are in no rush to price in further good news. A strategic review of the country’s defence requirements estimated that the government needs to spend a further £68bn to ready Britain for a war. The response was lukewarm. Local aerospace and defence stocks rose about 2 per cent this week.
This implies some scepticism that Westminster will — or can — find the eye-popping funds the report called for. The sum is more than three times the size of the financial “black hole” the Labour government says it inherited from its predecessor. And while the review outlines a need for drones, autonomous vehicles and AI, as well as nuclear warheads, fighter jets and submarines, politicians have no obligation to follow its advice.
Yet UK defence stocks are, by and large, a relatively attractive bunch. True, the eight included in the FTSE All-Share index, led by BAE Systems, Rolls-Royce, Babcock and Chemring, have gained a combined £53bn in market capitalisation this year, or 55 per cent. It is also true that the rally this year has left most of the sector sporting above average valuations. BAE trades on 20 times forecast earnings versus about 12 over the past two decades.
The growth profile for UK defence stocks has brightened, though. Prime Minister Sir Keir Starmer may have avoided calls to set a clear target this week. But it is clear that Europe’s governments will in fact be spending more on defence, helping provide longer-term clarity to earnings as projects are agreed. Nato meets later this month and members are expected to commit to raising their outlay to 3.5 per cent of GDP, with more to go on related areas such as infrastructure and cyber security.
Meanwhile, even after their furious charge, UK defence stocks continue to look relatively cheap compared with some of their European counterparts. Even setting aside Germany’s Rheinmetall, which is shooting for the stars thanks to a new €500bn government funding plan, the likes of Leonardo, Thales and Safran trade between 27 and 30 times this year’s earnings.
BAE, Babcock and Chemring are at 20 or below. Projected earnings growth is a little lower than that of their European rivals, but defence contracts make for lumpy financial models at the best of times. The UK’s spending promises — or hopes — fall far short of Germany’s. But they are likely to pick up from here. Defence stocks should too.
