"If you want to fight dragons, you have to become a dragon” – Friedrich Nietzsche
Nietzsche has been dead for 119 years, but he may well be describing the US reaction to the attacks on Aramco earlier this month. President Donald Trump declared last week that the US is “locked and loaded” to protect Saudi Arabia. Meanwhile, Secretary of State Mike Pompeo declared that Iran was responsible for the attacks (see here for our views on why an Iran war is unlikely).
In our view, the clear winners from the heightened tension in the GCC would include Western defence companies. There is now a dire need to strengthen Saudi’s air defence missile systems. This would be music to the ears of investors in US defence companies – Saudi Arabia accounts for a fifth of US arms sales since 2014.
Source: Tellimer Research
The leaders in the defence industry include Lockheed Martin Corp (LMT US), Boeing Company (BA US), Raytheon Company (RTN US), Northrop Grumman (NOC US) and General Dynamics (GD US). These five companies are direct suppliers to Saudi Arabia under the US$110bn arms deal that Trump signed with Saudi in 2017.
During George W. Bush’s "war on terror" in 2001 in the wake of the 9/11 attacks, these five defence giants prospered – they were beneficiaries of US defence largesse. Investing US$1 in these five 'defence diamonds' on 10 September 2001, would be worth US$8.30 today. To compare, US$1 invested in the S&P 500 is worth US$2.95 – investing in these stocks would have outperformed the S&P 500 by more than 410%.
The US defence budget has also more than doubled in real terms to US$695bn in 2018 from US$300bn in 2001. Defence spending peaked at US$700bn in 2011 (the elimination of Osama bin Laden led to a slash in the defence budget thereafter). Despite these budget cuts, the US is still by far the largest spender on defence. In 2001, its share in world defence spending was 35%. It is 43% now.
Defence stocks are excellent investments during strife. The industry has consistent earnings due to government contracts. Although cash flow can be uncertain as receivables can be high, revenue is usually reliable in a war-like situation. Furthermore, the collection risks in the industry are limited – the main customers are governments.
The sudden escalation in oil prices which followed the attacks on Saudi Aramco assets, has threatened several developing market companies. In contrast, the Dow Jones Defense & Aerospace Index has outperformed the Dow Jones Index by 16% ytd. But, the best is yet to come. Discerning investors should keep the 'defence diamonds' high on their watch list.