With a $750 billion national defense budget proposal for 2020, the US Defense Department is the primary customer for US defense companies. At De Angelis & Associates, we believe this unique business relationship offers compelling opportunities for investors in two ways. First, by providing investors a potential sense of security in a time of heightened geopolitical and economic uncertainty through dependable government revenue streams and significant barriers to entry. Second, by promoting innovation as the Department of Defense demands state-of-the-art technology and solutions to respond to the ever-evolving global geopolitical landscape.
Reason No. 1: A potential sense of security in uncertain times
Government contracts reduce the guesswork when it comes to how and when a company earns its revenue. The Department of Defense awards contracts with clear timelines, product/service expectations, and transparent pricing. This predictability makes US defense companies less susceptible to the macroeconomic backdrop, which is especially notable now as we face higher economic uncertainty in the tenth year of the current expansion. Importantly, the Under Secretary of Defense (Comptroller) forecasts continued growth in the national defense budget for several years (Figure 1).
We don’t yet know what final adjustments Congress may make to the $750 billion defense budget proposal; however, regardless of the final figure, many US defense companies still anticipate healthy growth as the Department of Defense has prioritized military modernization efforts (Figure 2), which include procurement, research, development, testing, and evaluation.
Figure 2: “Modernization” budget authority
The US defense industry also has significant barriers to entry considering many leaders in the space have strong and established brand reputation, regulatory expertise, proprietary technologies, extensive experience with government contracts, and very limited foreign competition (for US security reasons). Security clearances, specialized accounting rules, and substantial capital spending requirements also limit the number of incumbents. Since the government is particular about who does business with the military, its extensive procurement regulations and procedures can be daunting to navigate. These barriers can help protect the existing firms’ revenues and profits.
Reason No. 2: Innovation and state-of-the-art technology
Silicon Valley is not the only place to look for technological advancements. The Department of Defense’s mission of protecting the security of the United States requires cutting-edge technology to address the shifting geopolitical sphere. Geopolitical developments range from quickly growing Russian and Chinese military strength to further instability in the Middle East. As President Donald Trump put it, “as long as I am President, the servicemen and women who defend our nation will have the equipment, the resources, and the funding they need …”2 From unmanned aerial vehicles to Virginia-class nuclear submarines to enhanced cybersecurity, the Department of Defense contracts specifically with companies that can provide ultramodern solutions.
Predictable revenue from government contracts helps facilitate the development of these ultramodern solutions. Investment planning for research and development may be much easier when defense companies can accurately forecast their cash flows, a perk Silicon Valley does not have. Many US defense companies have active pipelines of both internal and government-funded research and development projects in various stages of commercial viability.
How can investors potentially capitalize on these opportunities?
It can be challenging to find focused exposure to the US defense industry as the vast majority of available investment vehicles target the broader aerospace and defense industry – including companies with little or no government revenue. Among companies that do have meaningful government revenue, determining which ones are the innovative leaders poised to potentially benefit from military modernization efforts is another challenge.
The Department of Defense is instrumental in shaping the defense industry and the investment opportunities within it. Predictable government revenues make defense companies less reliant upon broader economic growth, which may mean a greater sense of security during a slowdown or recession. At the same time, many defense amd aerospace companies are also world leaders in providing new technologies that change the way militaries operate. This combination of investment characteristics is available thanks to the strict business relationship between the Department of Defense and the whole US defense industry.
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Part of the article originally published by invesco.us.com
Credit: Invesco, DoD, DHS.
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