FTSE 350: Build a defensive portfolio

The Treasury will likely welcome cost saving initiatives. The MoD currently faces a funding black hole of £7bn that could stretch to £15bn over the coming decade, according to the National Audit Office. A Strategic Defence and Security Review (SDSR), which last took place in 2015, is imminent. Defence giants like BAE Systems (BA.) and Babcock (BAB), which hold an array of government contracts, may be concerned over the future of these lucrative cash flows and repeat orders.

One industry observer is unpersuaded by the idea that Mr Cummings will succeed in slashing defence expenditure. Defence and aerospace analyst Howard Wheeldon argues that outsiders with grand ambitions for cuts can end up achieving the opposite outcome. “They come in with great ideas and great ambitions to save money, but actually they most often end up increasing the spend because of the delays and the trouble that they actually cause,” he observes. Babcock, which is building MoD’s aircraft carriers, isn’t vulnerable to threats on these vessels, he says. Rather, it could be exposed to the impact of base closures, which will likely be enacted in a bid to lower costs. The company is heavily involved in support services for the UK’s military bases.

There remains a litany of business contracts for defence companies in the air, and beyond. The Typhoon programme, which is partly-managed by BAE and carries components from Rolls-Royce (RR.), Meggitt (MGGT), Ultra Electronics (ULE) and Senior (SNR), will remain airborne for decades to come. Typhoon’s eventual successor, Tempest, is also being directed by BAE, and the initiative will offer more opportunities for these players. 

The rise in cyber risk and our dependence on communications will compel the MoD to beef up its space capability, Mr Wheeldon says. No astronaut has ever been into space without Cobham kit, but the company, which largely specialises in air-to-air refuelling, has been taken over by US private equity firm Advent International. QinetiQ (QQ.) operates in similar areas to Cobham, producing everything for Earth to satellite, from space security to avionics. BAE and Meggitt are also active in space, but to a lesser extent.

Global defence expenditure is booming and British players aren’t limited to UK government defence contracts. Defence is a rare kind of industry that is dominated by a few government buyers - the Five Eyes network, which is comprised of the UK, the US, Canada, Australia and New Zealand is fertile ground for defence work. In Korea, Babcock is investing heavily in support of the nation’s submarine programme.

But the sensitive nature of this business also limits ventures into emerging defence powers - the Gulf aside, it is very difficult for British defence companies to latch onto rising expenditure in nascent (or resurgent) nations like China and Russia, owing to national security requirements. Saudi Arabia, where BAE generates around 14 per cent of its turnover, has proven problematic owing to the regime’s involvement in the Yemen conflict, where it has employed Typhoon aircraft and faced accusations of war crimes. There is a temporary UK government block on new contracts that may be connected to the conflict, which could affect a pending Saudi Typhoon order. Germany has refused to participate in the contract. Investors would be wise to limit their exposure to contracts that are vulnerable to legislative and judicial changes. Moral risk is never far from defence.