The companies and the defence sector are facing a long-term, structural, and strong trend. They are growing faster and more reliably than the market as a whole. Defence budgets are planned over cycles of more than ten years, which provides predictability in growth. Additionally, the companies and the sector offer risk diversification for a stock investor, also within the same asset class; stocks. This is unusual and valuable for stock investors. These perspectives are not often discussed.
Perhaps because the defence industry has previously been lumped together with controversial industries in a, in my opinion, completely incorrect way, but recently much has happened. During 2022 and 2023, we have witnessed a powerful change in the perception of the sector. Western defence is increasingly seen as a responsible investment. The President of the European Council, Charles Michel, takes the initiative for defence bonds to improve financing conditions for the defence sector. EU defence ministers jointly emphasise the importance of defence investments and that investors should stop excluding the sector on the grounds that it would not be sustainable and responsible. Now the media is also taking action. We see Affärsvärlden criticising the AP funds for choosing not to invest in British BAE Systems, which owns many of Sweden's critically important and historically successful defence companies. The clear change, with a more nuanced view of defence, is beneficial for the entire industry. This benefits the conditions for the defence industry to gain access to financing and investors.
What is behind the change?
We have a security policy threat right on the EU's border, something that has previously been underestimated and not sufficiently coordinated. Additionally, there is a globally increased geopolitical risk that greatly affects Europe. EU decision-makers are influenced by public opinion, which explicitly advocates investments for a credible defence. It is now also evident for Europe that the production rate of defence materiel cannot be scaled up quickly and easily. The EU and the USA have supported Ukraine in an impressively commendable way, even if the presence might have occurred earlier. The effect of the extensive support and the difficulties in increasing production is that we cannot even fill the gaps that the support to Ukraine exposes. Even American generals are sounding the alarm that the USA does not have the capacity to act in both Europe, the Middle East, and the Indo-Pacific region. Then we have procurement forms and regulations that extend the time between the realised need and the start of manufacturing. The regulations implemented within the EU for sustainability have high and important ambitions but have also made investors cautious about investing in the defence sector.
Did you know that the world's 100 largest defence companies had decreased revenue in 2022 compared to the previous year? (SIPRI 2023). It is an unequivocal risk indicator that it takes time to disburse defence budgets, start and complete production, and there is generally low readiness. Now, Financial Times recently reported that orders are pouring in at a pace that is unparalleled in modern times.
The prospects for the defence sector going forward
It is not the number of geopolitical events and pure conflicts that drive returns in the sector's companies. It is growth, profits, and profit growth and the development that affects it through defence budgets and investments over time. Strong returns in the sector are thus dependent on Western democracies meeting the large investment needs we face. That a credible rearmament occurs that allows us to feel safe and secure.
My assessment is that the EU and the West want to provide the best possible conditions for the defence sector going forward, and I believe this will influence investors to view the industry more positively, be comfortable from a sustainability perspective, and increase their investments in the defence industry.
A clearer EU provides a clearer playing field for investors and financiers.
Happy New Year!
Joakim Agerback
Portfolio Manager Finserve Global Security Fund I