The Defense Industry is Flush With Cash. Here's 1 Way to Invest.

George Washington once said, “To be prepared for war is one of the most effective means of preserving peace.” That still holds true today, with a hot war raging in Ukraine and escalating tensions in the Middle East and parts of Asia.

And these are just the headline-grabbing conflicts. The world is not a peaceful place - there are 110 armed conflicts underway currently, including seven in Europe, according to the Geneva Academy of International Humanitarian Law and Human Rights.

Global military expenditure grew 7% to $2.43 trillion in 2023, the steepest annual rise since 2009, according to a leading think-tank - the Stockholm International Peace Research Institute.

It's not surprising, then, that virtually all NATO members are increasing military spending. In fact, the proportion of spending going toward military equipment by NATO has more than doubled in the past decade.

In 2023, NATO member countries' spending totaled 55% of the world’s expenditure. Here in the U.S., in the year through September 2023, defense spending rose at its fastest pace since 2019 - at a nearly 5% rate.

This makes it obvious why the world’s largest aerospace and defense companies are set to rake in record levels of cash over the next three years.

According to an analysis by Vertical Research Partners for the Financial Times, the leading 15 global defense contractors are forecast to generate free cash flow of $52 billion in 2026 - almost double their combined cash flow at the end of 2021!

Let’s break down this forecast further.

“Boom” Times for Defense Contractors

Excluding the troubled Boeing (BA), the five top U.S. defense contractors alone are forecast to generate cash flow of $26 billion by the end of 2026. That’s more than double the amount in 2021.

There is a similarly positive (in terms of cash flow) story in Europe. Defense leaders there - including the U.K.’s BAE Systems (BAESY), Germany’s Rheinmetall (RNMBY), and Sweden’s Saab (SAABY) - have benefited greatly from new contracts for ammunition and missiles. These companies are forecast to see combined cash flow jump by more than 40%.

Rheinmetall has an interesting side story. Its CEO, Armin Papperger, was the subject of a Russian assassination attempt because of his strong support of the Ukraine war effort. Luckily, U.S. intelligence agencies got wind of this and warned German authorities.

The Euro Stoxx Aerospace and Defense index has roughly doubled since Russia invaded Ukraine in February 2022. That blows away the paltry 7% rise made by the broader Stoxx 600 benchmark in Europe.

Swelling sales, order books and profits justify much of that gain. Valuations for the likes of Rheinmetall and BAE have roughly doubled as a multiple of total enterprise value to EBIT (EV/EBIT), based on S&P Capital IQ data.

Geopolitical Reality

The reality is that a new era of global rearmament is gathering speed, and it will mean vast expenditures - as well as some tough decisions for Western governments' leaders.

Despite world defense spending reaching a record in excess of $2 trillion last year, NATO nations have only just begun to consider what 21st-century security will require with an aggressive Russia, a volatile Middle East, and the expansion of the Chinese military in the Pacific region.

Government officials focused on security say that military budgets may need to emulate Cold War spending of as high as 4% in order to keep the peace. That would equate to more than $10 trillion of additional defense spending commitments over the next decade, according to calculations by Bloomberg Economics.

Strong Cash Flows = Bigger Stock Buybacks

The spending surge by various militaries has already propelled order books for the large defense companies to near-record highs. It typically takes several years for new contracts to translate into higher sales, as defense companies book the majority of their sales once weapons are actually delivered.

Vertical Research notes that defense companies do not like to hold cash on their balance sheets. So, the companies have already increased their dividends and stock buybacks - and in fact, 2023 was the best year for buybacks by aerospace and defense companies in both the U.S. and Europe for the past five years, according to data from Bank of America. 

However, buyback levels still remain far below those of other sectors. This will translate to bigger stock buybacks to come.

Buy SHLD

In summary, since 2020, global defense spending has grown at a 4.2% annualized rate – up roughly 4 times from pre-pandemic levels. The best way to participate in this new era of high spending on weapons is through a broad-based exchange-traded fund (ETF).

My favorite is the Global X Defense Tech ETF (SHLD). It's a global defense ETF, so it has both the U.S. defense giants as well as those smaller, but faster-growing European defense firms.

Among the top 10 positions in its portfolio are: Lockheed Martin (LMT), RTX Corporation (RTX), Northrup Grumman (NOC), General Dynamics (GD), and the European firms like BAE Systems and Rheinmetall.

The ETF recently hit a record high and is up 31.5% year-to-date. There is much more upside to come. SHLD is a buy below $38.

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On the date of publication, Tony Daltorio had a position in: SHLD . All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.