The Iraq War is history. The war in Afghanistan is winding
down. And with the wind-down, a lot of investors may be thinking
that the defense industry is "history" too.
But here's the thing: History repeats itself. We're seeing
that in Iraq right now, as the ISIS spreads mayhem across the
Mideast. Meanwhile, to the north, Russia has proven itself newly
aggressive in Ukraine and Crimea, while to the east, a rising
China is flexing its muscles -- and pushing to impose its will on
In short, it's a dangerous world out there, Fools. So long as
it remains so, there will be a future for the defense industry.
Here's what you need to know to invest in it.
It's a dangerous world out there. You may need a 100,000-ton
Gerald R. Ford-class nuclear aircraft carrier to deal with it.
What is the defense industry?
A subsector of the aerospace and defense industry, the defense
industry in particular focuses on large-cap corporations (and in
many foreign countries, state-owned enterprises) whose primary
customers are nation-states, and whose primary products are
military hardware and services. Depending on the company, these
- Military aircraft (everything from F-16
unmanned aerial vehicles
(submarines, destroyers, aircraft carriers)
- Ground defense (
, APCs, and guns both big and small)
- Ammunition for all of the above (rockets, missiles,
bullets, cannon and howitzer rounds)
- Military satellites and also dual-use
(such as surveillance satellites, America's Global Positioning
Satellite constellations, and their European "Galileo" and
Russian "Glonass" counterparts)
- The rockets that put those satellites in orbit, and the
power those rockets
The complex electronics systems and software products that
permit all of the above to operate correctly, electronic warfare
systems such as radar -- and radar-jamming -- and software and
hardware components of both "cybersecurity" and "cyber warfare"
also fall under the category of defense products and
How big is the defense industry?
Defense is big business in the United States, with the defense
budget consuming approximately 20% of the federal budget in
recent years. Globally, the U.S. accounts for about 41% of
worldwide defense spending.
U.S. Department of Defense Fiscal Year 2014
(link opens a PDF)
But that still leaves nearly 60% of global defense spending to
account for. Consulting firm Deloitte estimates that the next
five biggest markets for defense products are China, France,
Japan, Russia, and the U.K. -- accounting for 23% of global
defense expenditures combined. The next 19% of global defense
dollars go to the militaries of Australia, Brazil, Canada,
Germany, India, Israel, Italy, Saudi Arabia, South Korea, and
Defense spending as a percentage of the global whole drops
steeply from there, but all-in, the global market for defense
products tops $1.72 trillion annually -- and makes up as much as
85% of the total value of the global aerospace and defense market
as a whole.
How does the defense industry work?
Excellent question. Clearly, defense is the proverbial
800-pound gorilla of the aerospace and defense market, accounting
for the vast majority of spending in its parent industry. So
understanding how this money gets spent is crucial for investors
The good news for investors is that defense spending is an
unusually "transparent" market, in which it's easy to track the
broad ebb and flow of revenues over time. This is because most
countries publish, and make easily available, information on
their planned defense budgets ahead of time -- often, years ahead
Data on U.S. defense spending, such as is laid out in the
table above, is just one example. You can find similar reports on
anticipated defense expenditures in "
" published by the Australian government, in public announcements
Russian Ministry of Defense
Japanese Prime Minister
. Even nominally communist
China publishes a defense budget
. (Although there's
quite a bit of disagreement
about how forthcoming China is in the information it
Once the budget is set, the governments in question typically
hold tenders, inviting bids from local and foreign defense
contractors, to provide the products and services they require. A
winning bid is accepted and, typically, the winner is
Caveat: One wrinkle that investors should be aware of is that
most major defense contracts awarded in the West these days may
name a single winner. But the firm that "wins" the contract and
is named the "principal contractor," rarely does all the work
itself. No sooner does a firm win a contract than it turns around
and parcels out much of the work to other defense contractors.
(Indeed, oftentimes defense companies bid as a "team" from the
The result is that no matter who wins a contract, as often as
not, "everyone" in the industry tends to benefit.
What drives the defense industry?
As with most industries, you can say that the defense industry
is driven by two primary factors: risk and opportunity. It's just
that the defense industry has its own peculiar take on the
definitions of these terms.
From a risk standpoint, the more dangerous the world, the more
nation-states perceive a need to spend money on defense. The
country that spends the single greatest percentage of its GDP on
its military, for example (10.3%), is one currently involved in
an on-again, off-again civil war: South Sudan. The next three top
spenders (again, as a percentage of GDP) all reside in the
turbulent Middle Eastern neighborhood: Oman, Saudi Arabia, and
But opportunity also plays a role. The United States, for
example, the single greatest spender on defense in absolute
dollar value, is protected by wide oceans to both east and west,
and has inoffensive neighbors to both north and south. Yet as one
of the world's wealthiest nations, the United States still spends
freely on defense -- enough to make it the No. 1 defense market
globally by a wide margin. Meanwhile, a surging economy and
valuable oil reserves combine with numerous, sometimes aggressive
neighbors to make China and Russia, respectively, the No. 2 and
No. 3 defense markets in the world.
Simply put, therefore, defense spending is likely to increase
both when nation states think they need to spend more on their
militaries -- and also just because they can.
Caveat: The wrinkle investors want to be aware of
is that defense spending by defense companies' host countries may
ebb and flow. But the companies are not limited to their host
countries' markets. As defense spending has trended down globally
in recent years (dropping 1.9% in 2011, then 1.3% in 2012,
followed by an estimated 2.5% decline in 2013 according to
Deloitte), defense companies are more and more often looking to
new markets abroad to shore up their revenue streams.
Where will they go to find the defense contracts that will
fill up their revenue streams? Turn to your nearest newspaper
headline to find out. Wherever conflict is, there will the
defense industry go to find new markets for its products.
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Try telling an Abrams main battle tank that the defense industry
is "history." Go ahead. Try. Photo: General Dynamics.
Defense Industry: Investing Essentials
originally appeared on Fool.com.
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