Defence stocks – essentially any business that provides products or services to armed forces or branches of law enforcement – have been pushed to the fore since the start of the war in Ukraine, having long been seen by many investors as pariahs, alongside other ‘sin’ sectors such as fossil fuels, tobacco or gambling. This is despite them fundamentally ticking all the boxes for a highly investable business model: long-term contracts, strongly counter-cyclical (public spending cuts rarely extend to the military), an end market that seems never to go out of fashion – conflict – and sovereign clients (almost all contracts are with government agencies) who always pay, although contract negotiations can be cumbersome. So, what is driving the change?
ESG volte face
In the world of environmental, social, and governance (ESG), pre-war, defence businesses were seen as doing substantial harm with their products and many were dealing with unpalatable regimes. Most funds with a focus on ESG would keep their distance and this led to poor total returns (usually despite high dividends) and low ratings. Almost in an instant, however, the Ukrainian war changes the dynamics. Many voices are calling for a revision of ESG standards to allow defence stocks to shed their pariah status and become a tolerated necessity that might even be seen as a social good. This is gaining traction and the sector is beginning to benefit from a double war dividend – faster growth and higher ratings. From an investment perspective, the sector has come in from the cold.