Investing in the US Military Industrial Complex

Following the Great Financial Crisis and the pandemic, we have seen a collapse of globalization and a return to protectionism. Global supply lines came under extreme pressure in 2020 when world governments effectively shut down economies for 18 months. As a direct result of a weak US foreign policy under the Obama and Biden administrations, culminating in the disastrous US-led withdrawal from Afghanistan, sovereign nations have looked to shoring up their own defence capabilities.

Following the Russian invasion of Crimea and Ukraine, members of NATO have increased both their contributions to NATO and their own defence budgets. With China continuing its expansionist local and global initiatives, the US, Japan, and other countries in the region have increased their defence spending and procurement, led by South Korea and Taiwan.

As I write, the winds of war are blowing hard again in the Middle East following a terrorist attack by Hamas from Gaza on Israel. Iran, the main sponsor of terrorism in the region, is active in spreading conflict to achieve its global ambitions through use of its proxies: Hamas in Gaza, Hezbollah in Lebanon, and Islamic Jihad backed by Syria and Hezbollah. Whether Iran is drawn into direct conflict with the US or Israel remains to be seen.

Against this backdrop, investors may again be interested to invest in the military sector, which the US government and US companies dominate. However, what appears to be an obvious path to investment success is not clear-cut. In this sector, budgets and political decisions tend to be made years in advance, and funds take time to become available. Political gridlock in Washington and in-fighting amongst EU nations often affect production and delivery of military goods and services. Defence companies also have complex supply chains, including a need for many semiconductors and other advanced technologies. COVID-19 disrupted supply chains, which led to delivery delays and revenue below forecasts. The producers of military goods and service have one thing in common: one buyer, the US government. Fortunately, the federal government has deep pockets and a long history of paying its bills. This stability gives defence companies and investors some predictability when it comes to managing cash and projecting growth.

Will conflict move defence stocks?

Returns on defence capital have been reasonable over the past decade. with its wars and insurrections. However, these returns have not out- performed investing in a broad index of US stocks that include aerospace and defence stocks.

All the four largest defence firms by capitalization are represented in the Vanguard Total Stock Market Index, which we hold in our all-weather investment strategy. This index holds large, mid and small investment companies. Against the Vanguard Total Market Index ETF of +8.67%, the iShares Aerospace and Defence Index ETF posts a performance year to date of -3.55%. During the last decade, the iShares ETF Index of Aerospace and Defence stocks return on capital was +9.91% against the Vanguard Total Stock Market Index ETF of +11.23%.

Defence stocks, like many industrials, tend to be more plodding than high- flying technology or biotech stocks. Defence stocks are best suited for income-oriented investors seeking steady growth and rising dividends rather than immense valuation increases.

Jeremy Blatch TEP
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