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Andrew Allentuck

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The best defence

Andrew Allentuck

 

WINNIPEG (GlobeinvestorGOLD)—Stock markets tend to flounder when there are risks of war or massive geopolitical instability. Major market averages tumbled as investors anticipated the worst outcomes of invasions of Iraq in 1991 and 2003. The catastrophe of Sept. 11, 2001 also devastated markets, yet defence spending as a component of the U.S. gross domestic product in the fourth quarter of 2001 rose 44 per cent from the previous quarter, the largest increase since the Korean conflict half a century ago.

Defensive investing usually means buying government bonds, where principal is certain to be returned at maturity, or buying gold as a play on international tensions and, perhaps, the weakness of currencies. But defence industry companies and defence portfolios do more than remain stable when there is war. They thrive when other industries are sinking as consumers reduce spending and interest rates begin to rise.

Investing in individual defence industry companies such as Northrup Grumman Corp., which makes fighter jets, or Alliant Techsystems Inc., the largest supplier of ammunition to U.S. forces, targets the portion of the capital market that deals with global instability. The sector is surprisingly small. Canada has only a vestigial defence industry. Even in the U.S., direct defence spending is less than 5 per cent of GDP, notes Carolyn Waxler, whose Stocking Up On Sin (Wiley, 2004), argues that stocks disdained by some investors for their ethical shortcomings tend to sell for lower multiples of earnings than do shares without that onus.

Investors who want to build a portfolio of defence stocks have to do some digging. There is no mutual fund sold in Canada that specializes in defence stocks, said Dan Hallett, President of Windsor, Ont.-based investment research company Dan Hallett & Associates Inc.

"There are 72 mutual funds in Canada with some defence stocks, but none has any substantial concentration in the industry," he explained.

Numerous mutual funds in the U.S., Canada, and other jurisdictions have holdings in defence industry companies, but seldom enough to qualify them as defence industry funds. Among exchange-traded funds, there's one portfolio with a heavy weighting of defence stocks, the iShares Dow Jones US Industrials. It has over 30 per cent of its top 10 holdings in General Electric Co., which makes jet engines; Boeing Co., which makes bombers and military helicopters, and United Technologies Corp., which makes jet engines. Add in the defence component of holdings of high technology companies such as Honeywell International Inc. and the fund clearly has a defence tilt, in spite of some dilution in non-defence, cyclical industrials. The fund's management expense ratio or MER is a relatively modest 0.60 per cent.

A U.S.-based portfolio, Vice Fund of Houston, Texas, holds 24-per-cent of assets in defence stocks including General Dynamics, United Technologies, Northrup Grumman and smaller companies such as United Defense Industries, which is in the business of refitting Bradley fighting vehicles and doing subcontracting work on warships.

Diluted with roughly equal weights of assets in alcoholic beverages, tobacco, and casinos, the fund has trounced the broad market. For 12 months ended June 30, 2004, the $14-million (U.S.) portfolio is up 33.4 per cent compared to the 17.9-per-cent gain of the S&P 500 Total Return Index in the same period. The fund has been in operation since August 30, 2002. Most of the defence stocks in the fund are old-line, heavy industrial companies that pay dividends in a range of 1 to 4 per cent, said Dan Ahrens, President of Mutuals.com, the fund's manager. By comparison, the average dividend yield of stocks in the S&P 500 index is 1.6 per cent.

The most tightly focused sector fund in the field is the $304-million (U.S.) Fidelity Select Defense & Aerospace Fund. Sold as a no-load, it has a modest 1.21-per-cent MER. For the 12 months ended June 29, 2004, the fund returned 36 per cent and over 10 years ended May 31, 2004, the fund has produced a 15.3-per-cent average annual return, better than the 11.3-per-cent average annual return of the S&P 500 Total Return Index in U.S. dollars in the same period.

Investing in defence stocks is a discipline distinct from buying other industries, Mr. Ahrens said. "This industry depends on long-term contracts. The average investor should not depend on the industry jumping through the roof just because there is some warfare. Characteristically, the companies are old-line industrial businesses that pay dividends in a range of two to four per cent per year," he added.

The ethical argument against investing in military products is questionable, he insisted. "It is not politically incorrect to invest in stocks of companies that keep your country safe." U.S.-based mutual funds can be purchased through investment accounts in the United States. Exchange-traded funds, however, trade like stocks and have no border issues.

How much should an investor who wants to hedge against international mayhem put into defence stocks? Derek Moran, a principal in the Kelowna, B.C. office of Vancouver-based financial planning firm Macdonald Shymko & Co., sees the problem as one of risk and insurance.

"The more you worry about the state of the world, the more you can invest in the sector. This is an insurance concept. But you don't want to get strung out in one sector. So I'd hold a typical allocation to 10 per cent of one's total portfolio, maybe up to 15-per-cent for the investor who is deeply apprehensive about world peace or the lack of it."

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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