Second, demand could slow if the US, accounting for half of global defence spending, becomes more isolationist after the Bush presidency. Last March, the Department of Defense forecast an 8 per cent real fall in its budget to $463bn for the year to October 2007. But include the huge "supplemental" budgets used to fund Iraq and Afghanistan, and total spending could rise by up to 17 per cent year-on-year to $652bn, says the International Institute for Strategic Studies.
At a Pentagon dinner in 1993, US defence industry executives were warned to consolidate or die ahead of budget cuts. That “last supper”, as the event became known, seems a long way off now. Since September 11 2001, the FTSE global aerospace and defence industry index has returned almost 90 per cent in dollar terms, beating global equities' rise of about 60 per cent. From its traditional hefty discount to the market, the global sector now commands a 15 per cent premium on multiples of both earnings and book value.
Despite recent outperformance and earnings upgrades, investors should be getting nervous. First, profit levels are becoming punchy. Return on equity for the global sector has risen to 16 per cent, compared with an average since 1993 of 12 per cent. For the biggest stocks, such as Lockheed Martin and the UK's BAE Systems, return on equity is running at well over 20 per cent. Unlike the stock market as a whole, it is easy to see how high returns might normalise for the defence industry. Most contracts are supposed to be priced at a small premium to cost. Sooner or later, customers – usually companies' respective governments – may ask questions about value for money.
Second, demand could slow if the US, accounting for half of global defence spending, becomes more isolationist after the Bush presidency. Last March, the Department of Defense forecast an 8 per cent real fall in its budget to $463bn for the year to October 2007. But include the huge “supplemental” budgets used to fund Iraq and Afghanistan, and total spending could rise by up to 17 per cent year-on-year to $652bn, says the International Institute for Strategic Studies.
The lesson of Vietnam and Korea is that when wars end, spending falls sharply. Today, trophy projects such as the Joint Strike Fighter are hard to abandon. But the size of companies' secure order books should not be overstated. In December 2005, Lockheed, General Dynamics, Northrop Grumman and Raytheon had a combined backlog equal to 24 months of sales. Without a new US war, defence stocks look vulnerable.
