As the world rearms, BAE Systems (LSE: BA) shares have reaped the rewards. So has fellow FTSE 100 defence stock Babcock International Group (LSE: BAB). But lately, they’ve gone into retreat. The stocks have slumped 14% and 20% respectively in the last three months. They’re now down 4% and 16% over the last year. What’s going on?
Rolls-Royce (LSE: RR) is a more complex beast. It has a Defence division, but that only generates around a quarter of its earnings. Roughly half comes from its Civil Aerospace arm, and the rest from its Power Systems division.
That’s helped the Rolls-Royce share price maintain its forward momentum. It’s up 22% in the last three months, and 50% over the last year.
The defence dip may shock many investors, who thought that given the state of the world, investing in weapon-makers was a one-way bet. So what caused it?
What just hit these top FTSE 100 stocks?
First, sentiment has been hit by rising hopes of some kind of peace deal in Iran. That conflict, along with the one in Ukraine, also suggests that warfare is changing. Cheaper kit like drones may now have the edge over more expensive hardware such as tanks, frigates and fighter jets. This could lead to a huge shift in demand.
Profit-taking has doubtless played a part. After a strong run, BAE systems and Babcock were trading on price-to-earnings (P/E) valuations of up to 28. Many investors may have decided a lot of good news was baked into the stocks.
Again, Rolls-Royce is slightly different. It’s P/E topped out at at a stratospheric 65. It has potentially huge new opportunity in small modular reactors, or mini-nukes, with government-interest growing worldwide. CEO Tufan Erginbilgic claims this has the ability to double Rolls-Royce’s market cap, although there’s plenty of cost and execution risk before we get there. Its Power Systems division is also benefiting from the artificial intelligence revolution, and the global spread of energy-hungry data centres. That may have offset and defence concerns.
Is this a defence sector buying opportunity?
The Rolls-Royce P/E has slipped but it’s still a gravity-defying 48. I’d suggest investors proceed with caution at these levels, although they might consider drip-feeding money in, or staying alert for any dips.
Despite the recent retreat, BAE Systems and Babcock aren’t exactly cheap. Their P/Es hover around 24. Both are successful, profitable companies, with healthy order books that give high earnings visibility for years ahead.
Both also have risks, of course, as they rely on government spending. And while the West is rearming, governments are strapped for cash. We’ve seen the political arguments play out in the UK lately.
Yet I think the recent dip may be an opportunity for long-term investors who feel they’ve missed out on the defence stock boom to consider Babcock and BAE Systems. I wouldn’t call it the perfect time, but if tempted, drip-feeding may be the best option.
Should you invest £5,000 in BAE Systems right now?
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Harvey Jones owns shares in BAE Systems and Rolls-Royce Holdings.
