Companies in the defense industry have been in the spotlight since the start of the war in Ukraine.
The conflict highlighted the fact that many nations (especially in Europe) look under-prepared militarily for their new geopolitical reality. That is translating to a sector that seems to be embarking on a long winning streak, with expectations that global defense spending will increase and run at new, higher levels for the foreseeable future.
Estimates are that if all NATO members fulfilled their commitment to spend 2% of their GDP on defense, spending outside the U.S., China and Russia would rise by almost 8% before any additional war-induced spending.
But even before the Russian invasion, these companies ticked all the fundamental boxes for a highly investable business model: most of their contracts are long term, their business is strongly counter-cyclical (public spending cuts rarely extend to the military), there’s an end market that seems never to go out of fashion—conflict and armaments—and they have sovereign clients (most contracts are with government agencies) who always pay.
Global Defense Spending
Of course, most of the defense spending globally has and will continue to occur right here in the U.S. That is true even though the U.S. defense budget is close to 60-year low, at around 3.75% of GDP, which is high by NATO and other western economy standards.
In 2021, the nations of the world spent an estimated $2.1 trillion on defense. That’s about 2.5% of global GDP (it’s 2.1% without the USA).
The U.S. is the big gun in defense spending. The Pentagon’s annual budget is larger than that of the next nine nations’ spending (including other large countries, such as China, India, and Russia) combined.
The 2022 spending allocation on defense in the U.S. is around $750 billion. That is $2,275 for every man, woman, and child in the country. The global average is just $275 per person.
It is unsurprising then that the world’s largest defense contractors and suppliers are to be found in the U.S., meaning that these firms can be viewed as dependable proxies on U.S. defense spending.
The Defense Sector
I emphasize the word dependable.
This has been a steady and reliable sector for investors historically, with a total shareholder return over the last 15 years of more than 14% per year. For comparison the total shareholder return over the same period for the Dow Jones Industrials has averaged 4.9% and for the S&P 500, 10%.
Keep in mind, though, that the sector is not just a reflection of increased Pentagon spending. In the period after the Iraq War and the Obama administration presiding over a fairly steep decline in defense spending as a percentage of GDP, defense stocks actually rose in value.
Between 2011 and 2020, the amount spent on defense barely changed in nominal terms ($752 billion to $778 billion), but it dropped as a share of GDP from 4.8% to 3.7%. Yet, in that period, the index of defense stocks rose more than four-fold! This was thanks to the sector experiencing a major re-rating from Wall Street.
At the moment, among the largest U.S. defense companies, there is one company in particular that I favor.
The company is Northrup Grumman (NOC), which I prefer because of its involvement in the U.S. space program. More on that in a moment.
Northrup Grumman is best known for its aviation products, including the B2 stealth bomber, as well as its avionics and fighter radar systems.
The company has more often than not delivered positive earnings surprises to Wall Street in recent years, regardless of whether defense spending is rising or falling, or which political party occupies the White House.
The trend of positive surprises will continue. One main factor for that is Northup Grumman’s focus on international revenue diversification (now more than 15% of sales). The aforementioned ongoing geopolitical tensions globally should benefit sales and earnings going forward.
Looking ahead, Northrop Grumman will still do well because of military spending. It has won the Ground Based Strategic Deterrent program—the Air Force’s program to modernize the intercontinental ballistic missile system (ICBMs)—and the B-21 bomber program. Both of these program wins should drive top-line growth over the next few decades.
However, it is the company’s space business—where it has had more success than its peers—that caught my attention. The latest example of its success is its major involvement in the James Webb Telescope.
The resurgence of investment in space has become an important factor for Northrup Grumman, and it is actually helping the company to largely offset the sector-wide labor and materials shortages—supply chain woes—that have hit many defense stocks performance in 2022.
Another plus is that the space sector has rather large and fast-growing investment from private companies, such as Elon Musk’s SpaceX. That makes Northrup Grumman less reliant on government spending than others in the sector.
Northrup Grumman’s growing exposure to the space sector makes the company more of a play on continuing space investment than defense. That may be riskier, but it’s also potentially much more rewarding for its shareholders.
Northrup Grumman stock is a buy anywhere in the $455 to $485 range.