There's no shortage of geopolitical tensions in the world - and military actions to combat them - but the reality is that global real-term defence spending has fallen in each of the past three years. In response to austerity measures introduced by governments in the western world, many companies serving the sector have been hard at work restructuring their operations; including branching into niche growth markets or simply cutting costs to keep profit margins steady. Those initiatives, together with the added allure of share buybacks, have pushed valuations up from about 10 times forecast earnings in 2012 to around the 15 mark today.
Prospects could be about to get a whole lot better, too. That's the view of most bosses, who are growing increasingly assured that a turnaround in traditional defence spending is near. This optimism has been fuelled not just by a terrorist resurgence in the Middle East, a mounting refugee crisis in the Mediterranean and tensions in places including Ukraine and Asia, but also by a recent encouraging pledge from the US to unleash the shackles constraining the Pentagon's budgets.
Regardless of cuts enforced by the Budget Control Act of 2011, the US continues to be by far and away the world's biggest buyer of military hardware. A cap on spending there has been particularly damaging for Chemring (CHG). The manufacturer of flares and decoy technology generates about 60 per cent of revenues from the US Department of Defense and has resorted to cutting costs and focusing on niche specialist sectors as a means to get by. Others with weighty US exposure include Avon Rubber (AVON), BAE Systems (BA.), Cobham (COB), Meggitt (MGGT) and Ultra Electronics (ULE).
But despite the threat of further 'across-the-board' federal budget cuts, there is a growing consensus that military spending could be ticking back up. That positive sentiment was reinforced by President Barack Obama's surprising request in February to increase defence procurement and development spending by 13 per cent next year. As part of a $4 trillion (£2.5 trillion) 2016 fiscal budget shopping list presented to congress, the US President surprised many by asking for a base defence budget of $534bn, plus $51bn to fund wars in Syria, Iraq and Afghanistan.
Rising geopolitical tensions and cyber attacks are pressing priorities for a US government under pressure from Republican opposition, although questions are already being asked over whether the President's ambitious request for more funds will be granted. As the limit set by sequestration is just shy of $500bn, Barack Obama's latest appeal breaches the austerity fiscal policy by about 7 per cent. That perhaps explains why many believe it will be rejected by the Republican majority in both the House of Representatives and the Senate, although even a moderate increase will represent a major windfall for the sector.
Sentiment back in Blighty, on the other hand, is rather more tepid. As the sixth biggest military spender and home to some of the world's leading defence contractors, the UK is a critical market for the likes of BAE, Babcock (BAB), Cohort (CHRT), Qinetiq (QQ.), Rolls-Royce (RR.) and Ultra Electronics.
A Tory election win was largely celebrated in these circles, not only because of the party's pro-business rhetoric, the stability of a second term and important avoidance of a hung parliament, but also because its pledges for defence budgets were perceived to be the least menacing. Mr Cameron and his cronies vowed to maintain the current size of the army, bring into active service new aircraft carriers and build four new nuclear-missile-armed submarines. BAE, Babcock, Cohort, Rolls-Royce and Ultra Electronics are beneficiaries of these promises.
But despite being recognised as the most pro-defence mainstream political group, there's been plenty of scaremongering in the media of late that the Conservatives will actually push military spending below the 2 per cent of GDP threshold requested by Nato. As part of an ongoing austerity pact, non-ring-fenced areas such as defence are expected to be the worst hit - time will tell.
That means the UK could drop out of the four-nation club currently adhering to Nato spending requests, a group that surprisingly includes economic minnows such as Estonia and Greece. Taking the UK's place is likely to be Poland, which in response to perceived Russian aggression has raised its defence spending by 18 per cent to £6.6bn.
Poland isn't the only nation concerned by the Kremlin's efforts to make military modernisation a top national priority. Indeed, Russia's annexation of Crimea has spurred several other European governments into shelling out more to beef up their own armies, including a fearful Sweden, Germany and France.
But the moderate increases being hinted at in Europe are minuscule compared with what's going on in the East. At the beginning of the year, for example, Japan announced its biggest ever defence budget outlay to counter Chinese fighters intruding into its air space. The Chinese incursions were linked to ongoing territorial disputes over islands in and around the energy-rich East China Sea. According to reports, Shinzo Abe's government has responded to these long-running maritime disputes by snapping up high-tech military hardware, such as BAE's assault vehicles.
South Korea and Thailand, meanwhile, have also reacted to China flexing its muscles by increasing their defence budgets by 7 per cent. That came after Xi Jinping's government announced plans to increase China's military spending by 10 per cent in 2015, making it the second biggest in the world and significantly larger than its neighbours.
Tensions have been building in the Middle East, too. But then again, when haven't they been? Lower oil prices haven't stopped Saudi Arabia from vowing to boost its defence budget by 27 per cent over the next five years, in a move that leaves it on track to become the world's fifth-largest military spender by 2020. As regional conflicts worsen, the United Arab Emirates and Qatar are also keen to follow suit. Those trends have certainly spurred defence companies to look outside of their traditional markets, although, as Chemring recently reported in its half-year results, customers in the Middle East are not always as reliable as their Western counterparts.
Companies desperate to explore areas on the up will also be buoyed by the rapid growth of cyber security. This sector is expected to double in size by 2017, as the corporate world pledges to spend big to thwart a growing number of dangerous internet attacks. To highlight the severity, a government-commissioned survey from consultancy PwC recently found that 90 per cent of large organisations suffered a cyber attack at an average cost £1.46m - more than double that of the previous year. While bad news for the companies affected, the likes of BAE, Chemring, Cohort, Qinetiq and Ultra Electronics will be rubbing their hands. Other areas of interest include unmanned aerial vehicles, a market that's expected to grow to $11.6bn in the next decade as demand for cost-effective monitoring devices in agriculture, land management, energy and construction sectors swells.
IC VIEW: As economies improve and geopolitical tensions linger most believe the only way is up for the defence sector. We agree that defence budget cuts – bar perhaps the UK – have now bottomed out, but remain more attracted to those companies with increasing exposure to niche growth areas being bankrolled by big cash rich corporate giants, such as cyber security. Those liaising more with emerging regions and effectively cutting costs also deserve a special mention, as do companies better-placed to benefit from rocketing demand for aeroplane parts. Though ratings may look stretched, there’s still some value to be found in well-run companies that have been marked down - perhaps too severely - by the negative sentiment that’s dogged the sector.
