Advisor cautions against defense stocks despite short-term alpha

Sector looks attractive now, but seasoned portfolio manager cautions against long-term decisions on momentary strength

Advisor cautions against defense stocks despite short-term alpha

The Monday after the Israel-Hamas war broke out Lockheed Martin stock gained around 9%. By early November it was up almost 12%. Given weak performance on broader markets it might seem that a period of warfare amidst a backdrop of global geopolitical tension is a golden opportunity for alpha-seeking investors. Military industrial stocks like Lockheed and Boeing could be viewed as an attractive play on global tension. One advisor, though, cautions against making a long-term decision based on short-term trends.

Francis Sabourin, director of wealth management and portfolio manager at Francis Sabourin Wealth Management of Richardson Wealth, explains that while the one-month returns of defense stocks like Lockheed might look tempting, their longer-term histories point to mixed performance. While Lockheed and the iShares US Aerospace & Defense ETF (taken as an aggregate of US defense stocks) outperformed the S&P 500 in October, they’ve underperformed that broad market index significantly on one-year and five-year bases. Sabourin believes that advisors attracted to this space should do their due diligence and ask where they actually plan to make returns on these holdings.

“Now we are asking questions about the future, and do we really think we will make a lot of money with these companies manufacturing military equipment?,” Sabourin asks. “I think there will be demand for armies to replenish their equipment, but what kind of profitability will we get out of that?”

Sabourin likens the current performance of defense stocks to the Canadian fertilizer company Nutrien. In the wake of Russia’s invasion of Ukraine last year Nutrien stock skyrocketed as the world predicted Ukrainian grain would be kept from international markets. Within a few months, a grain export deal was negotiated and Nutrien’s stock has fall to below it’s pre-war levels. On issues of geopolitical tension, there are so many uncertainties that picking winners and losers can prove incredibly difficult.

While war in the Middle East and an increase in global tension can be seen as tailwinds for these stocks, Sabourin notes that they face a wide range of headwinds too. These companies rely on long-term government contracts, which don’t necessarily allow for short-term adjustments to control higher costs. Their R&D focus is also very costly and comes without guarantees of success. They are also increasingly seen as pariahs by many institutional asset managers who are pursuing ESG or Socially Responsible Investing policies. Weapons companies are among the traditional set of “sin stocks” screened out by many asset managers. A lack of institutional investment could drag on valuations over the long-term.

Conflict, too, looks very different today than it did even ten years ago. While there has been an uptick in ‘shooting wars’ in recent years, conflict has also moved significantly to the digital realm. A global uncertainty play, therefore, might want to include more digital security companies than just an allocation to weapons manufacturers.

Sabourin says that advisors set on a weapons allocation may want to consider more broad-based ETFs with some added exposure to cybersecurity. However he argues that the current conflict premium may already be priced into these stocks and a slowdown in any major conflicts could mean their next major move is to the downside.

There are a wide range of other assets that act as a more traditional play during times of global uncertainty, too. Sabourin highlighted that both US dollars and gold bullion can offer portfolio diversification with positive exposure to global uncertainty. Military stocks, conversely, offer cyclical growth trends and the short-term boosts they get from an emerging conflict are extremely hard to predict because, generally, wars come as a relative surprise.

While advisors may see short-term opportunity in defense stocks emerging from this conflict, Sabourin remains adamant that they should not be making potentially risky long-term decisions based on a short-term trend that may have already run its course.

“The run up has been done, and when the war slows down some of the money in that sector will be disappointed,” Sabourin says. “It would be just like Nutrien, if you look at Nutrien’s performance it’s a perfect example. A big jump to the roof in the first month after the war in Ukraine started, and then after that it slowly went down until the share was below where it was before the war began.”