Putting the Defense Sector Under the Microscope

Subscribers to Chart of the Week received this commentary on Sunday, February 4.

Later this month, Feb 24. will mark the two-year anniversary of Russia’s invasion of Ukraine. And next Wednesday marks four months since the Oct. 7 attack on Israel by Hamas. There’s nothing to celebrate about these two dates, unless some progress toward a ceasefire is made toward each conflict in the coming days and weeks. In the weeks after Russia first attacked Ukraine back in 2022, I wondered out loud what it could mean for defense stocks. With two years of sample size, plus a new known unknown entering the fray in the last three months, it was time for a check in with the sector, to see whether the guilt of investing in geopolitical conflict outweighed the gains of a shrewd investing observation.

The iShares U.S. Aerospace & Defense ETF (ITA) has added 18.3% since February 24, 2022. This included valleys in September 2022 around $91, and peaks around $126 in late December. A solid gain, but via the chart below, not some steady linear line that reaps off death and destruction. The VanEck Semiconductor ETF (SMH), for context, added 37.5% over that same timeframe.

Sector stalwart Lockheed Martin Corp (NYSE:LMT) has added only 8.2% over the roughly two-year window. Fellow heavyweights Northrop Grumman Corp (NYSE:NOC), General Dynamics Corp (NYSE:GD), and Textron Inc (NYSE:TXT) have added 12.7%, 21.4%, and 23.2%, respectively. Again, solid returns, but are they worth it knowing you are investing in bloodshed? That’s in the eye of the trader.

Consider the charts of these four names all overlayed into one picture. LMT, NOC, and GD enjoyed outsized gains for most of 2022, before returning to rangebound action for most of 2023. TXT took the opposite route, laying low until late 2023 and eventually pacing the sector by its Jan. 26 record high $86.65.

 

In late January, all four defense stocks reported fourth-quarter earnings. LMT and NOC suffered post-earnings bear gaps of 4.2% and 6.3%, respectively, as the companies were beset by cash flow and sales figures that disappointed. GD and TXT, however, gapped 4.7% and 7.8% higher, respectively, after their quarterly reports topped analyst estimates.

Seasonality could bring a short-term boost. Per data from Schaeffer's Senior Quantitative Analyst Rocky White, four defense stocks landed on the table of best-performing February stocks on the S&P 500 Index (SPX) in the last 10 years. NOC and LMT average respective February returns of 4.3% and 3.1%, with positive returns 90% and 80% of the time. If you are curious whether the outsized monthly returns were a direct result of new conflict, note the outsized gains from February 2022 and October 2023. Yet at the same time, Senior Market Strategist Chris Prybal reminded me of the length of time it takes for these defense contractors to fulfill and deliver orders. They’re unable to produce their widgets in a quick enough manner to see a direct impact.

This is all a drawn out way of saying that there’s more to defense stocks than geopolitical conflict. There are notable gains to be wrought immediately after news of conflict breaks that seems more sentiment driven than fundamentals driven, with nearly all of those returns leveling out over various timeframes. Whether that complicates or articulates the moral dilemma when investing in these stocks is again in the eye of the trader.