The US defence sector has consistently underperformed the S&P 500 during the course of 2002, postin...
The US defence sector has consistently underperformed the S&P 500 during the course of 2002, posting a -19% return for the year to 22 November. This is more than 12% worse than the performance of the S&P 500 for the same period.
Head of global equities at M&G Aled Smith is overweight the sector, although he does not hold any of the large-cap companies bar United Technologies.
'Our core holding in the defence sector is L-3 Communications,' he says. 'The majority of its growth is coming from its intelligent warfare systems.'
Intelligent warfare is where all elements of a force are in communication with each other, such as missiles in flight being able to pinpoint their position relative to their own force's tanks and troops, he says. L-3 specialises in secure radio communications, which puts them at the forefront of this field, according to Smith.
L-3 Communications constitutes 2.3% of the M&G Global Leaders fund, he adds, with the other defence holding, United Technologies, making up 1.5%.
L-3 Communications is a mid-cap stock and does not feature in the aerospace and defence sector of the S&P 500.
This sector comprises nine companies, the largest being United Technologies, at just over 20%, followed by Boeing at 19% and Lockheed Martin at just under 16%.
However, looking at the performance of the nine companies in the sector for the year to 25 November, Rockwell Collins posted the best performance, with a 23% return. Only two other companies, Lockheed Martin and General Dynamics, managed positive returns for the same period.
Given the nature of the armaments industry, with one large customer, the US government, and the large contracts with long lead times, investors can have reasonable expectations of growth in defence companies, says Smith.
'Quite clearly, the defence sector has been a good performer with solid growth since 1996,' he says. 'Now there are new defence initiatives under Bush, defence spending is around $355bn and there is 16% year-on-year growth.'
What is currently worrying the sector, however, is the drop in public support for increases in defence spending.
As politicians' actions lag public sentiment, there is uncertainty over what will happen in two or three years time, says Smith.
'Earnings growth is still there but the price-to-earnings ratio drops,' he adds. 'The question becomes, which companies will get the growth and which have the good cashflow returns.'
Alison Sinclair, fund manager at Britannic Asset Management, agrees the defence sector has been a good performer but was seen as defensive at the start of this year.
'Defence stocks aren't performing as well and markets are now looking at cyclical stocks,' she adds.
Two bright spots for the industry, Sinclair says, are the possible war in Iraq and the fact the Republicans, traditionally more pro-defence than the Democrats, are in office. She holds Lockheed Martin and L-3 Communications and is overweight the sector against the S&P 500.
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