Defense Sector: Why War Does Not Always Equal Profit

We see Oct. 9, 2023′s sudden price increase in defense stocks as an overblown and simplistic reaction to the outbreak of war in Israel and Gaza. As we have pointed out before, in practice, the dots between military combat and defense contractor profits do not connect nearly as directly as they seem to in the investing public’s imagination. We will not alter our ratings or valuations of any defense contractors in light of this news, and we believe long-term development and resupply of missile defense technology are already sufficiently baked into our forecasts.

We hear two narratives used to justify snap purchases of defense contractors, and neither holds much water, in our view. First, there’s the idea that combat today leads to more future purchases of weapons manufactured by a given firm, making that company’s stock worth more. This ignores how long in advance militaries procure weapons, and how they’re subject to strategic and political constraints. Second, there’s the broader narrative that sudden fighting in a geopolitical hot spot increases instability and defense budgets, and thus defense contractor revenue. This is more logically sound, but after the U.S. defense strategy pivot to great-power rivalry in 2017 and Russia’s invasion of Ukraine in 2022, we don’t see incremental upside to global defense spending.

Live footage of Israel’s domestically developed short-range missile defense system (referred to as the “Iron Dome”) demonstrates capabilities most closely associated with RTX RTX and BAE Systems’ BAESF munitions portfolios, neither of which exceed 10% of company revenue. And as seen in Ukraine, when combat depletes munition stockpiles, they will be resupplied from allies’ existing stockpiles, with zero impact on the manufacturer that previously delivered them. Eventual orders for more of the weapons may come if current production rates won’t refill stockpiles in time, but adding capacity is expensive and time-consuming, and thus not a bullish outcome in our view.