As one would expect, Russia’s war in Ukraine has fueled international growth for defense products as nations seek to protect their borders and those of NATO, as well as support allies. Security is now front and center of political discussions around the world, and governments have responded by allocating several hundred-billion dollars for equipment and supplies to combat this threat. Though some lawmakers argue about the cost, the majority understand supplying weapons and supplies to Ukrainian forces is a preferable option to putting U.S. and NATO troops directly in harm’s way.
In response to the increased attention to the sector and a fiscal 2024 proposed U.S. defense budget topping $842 billion (excluding any supplemental war-related spending and Ukrainian aid), investors have increased the amount of publicly traded defense stocks they hold in their portfolios.
The 54 U.S.-listed, publicly traded companies found in the SPADE Defense Index now have a total market capitalization of $1.25 trillion. Investment funds have seen their assets under management grow significantly in the past 18 months, with the Invesco Aerospace and Defense ETF (NYSE: PPA) tripling to nearly $2 billion.
During 2022, the aforementioned benchmark index gained 8.6%, outperforming the broader U.S. market by 28%. This rise was led by Allegheny Technologies (+87%), Maxar Technologies (+75%) and Northrop Grumman (+41%). Even with the broader U.S. market down nearly 20%, more than 4 in 10 defense stocks saw their share price increase by double digits in percentage.
Despite these gains in the stock market, total revenues of the firms found in this year’s Defense News Top 100 remained relatively flat at $534 billion. This apparent contradiction actually bodes well for the coming quarters and the next few years.
During much of 2022 and early 2023, many of the large prime systems manufacturers cited supply chain disruptions that led to an inability to increase production of weapons systems and equipment at the levels needed to supply Ukraine’s war effort and restock national assets. Although this has reduced anticipated deliveries in the near term and, thus, prevented firms recording revenues, a return to normal operations as these issues are overcome should lead to revenue boosts as more orders are fulfilled.
Still, there is a major challenge to the sector that could derail deliveries as 2023 progresses. Smaller, private defense subcontractors and suppliers are facing dire cash flow issues, as they have been impacted by the intersection of material and parts inflation, supply chain issues, and increased staffing costs. Faced with the need to renegotiate fixed-price contracts, some might consider walking away, which would put added pressure on prime contractors to meet delivery schedules.
Additionally, the Economic Price Adjustment-Labor and Material clause of the Federal Acquisition Regulation — meant to compensate for extraordinary inflation and supply costs via adjusted contracts — has been slow to come into play, as the paperwork from the large contractors and the necessary Pentagon approvals move slowly through the department’s procurement procedure.
For example, a chief executive of a small, 150-person firm described to me the challenges of procuring radiation-resistant capacitors and semiconductor chips. Small batch, specialized orders for space and defense missions are not prioritized before larger purchases placed by the automobile sector, this executive said.
Additionally, pricing for items such as capacitors are up 300%, lithium-dominant materials are up 400%, and the cost to maintain technical staff has increased by much more than the headline inflation rate — the latter being a symptom of the booming space sector as well as defense.
Larger firms, like those on the Defense News Top 100, have access to capital and likely can weather these cash flow issues. However, in the latter half of this year, it is very possible we will see a spike in mergers and acquisitions as larger firms take over the subcontractors and supply chain partners that they deem systemically important.
Despite these challenges, the performance of defense sector stocks is driven as a reaction to our perception of fear and stability. The activity in Ukraine is but one of a number of global and local threats from which companies operating in the sector benefit. The conclusion of hostilities in Ukraine will see Western nations focusing on restocking and reevaluating their needs for the future and determining how to counteract the enemies and threats that remain.
The Defense News Top 100 list contains 73 publicly traded companies that represent 79% of the list’s total revenues for 2022. Through June 30, 2023, the SPADE Defense Index has gained another 8.1% and is at a historic high.
Such performance is not atypical: Over the past 23 years, the sector outperformed in 17 of them, many times by double digits. In the coming quarters and years, we believe that the sector remains poised for continued growth.
Scott Sacknoff manages the SPADE Defense Index, a modified capitalization-weighted index made up of companies operating in the defense, homeland security and government space sectors.