As the name suggests, defence stocks were once considered by investors as defensive positions, often prized for their steady dividends even in slow growth environments.
However, rising geopolitical tensions and a surge in committed defence budgets has opened it up as a major theme for growth investors.
This is according to Sara Moreno (main picture), a portfolio manager at Jennison Associates, who manages emerging market stocks with a growth bias for the equity arm of PGIM.
Her investment approach favours companies seeking to address new markets or provide new services and products to customers by leveraging disruptive technologies.
These span sectors such as e-commerce, artificial intelligence (AI) and AI supply chain, biotechnology, luxury goods, online travel agencies and fintech.
Industrials is typically not a sector Jennison are overweight in, but they are now “because of defence,” said Moreno.
“It has become a growth sector, and we are now in a growth period for that sub sector,” she said, pointing to multiple defence positions in the emerging market equity strategy she manages.
Moreno said that it’s not just defence stocks that will benefit from the boost in spending, but also the infrastructure around the sector.
While some may be hesitant to build positions around a theme that had historically fallen outside the purview of growth-minded investors, Moreno says to generate alpha, one needs to be “flexible enough to go where growth pockets are opening”.
Not too late for defence stocks
But after a strong run of performance from defence stocks globally, is it too late for the defence opportunity? Not necessarily, according to Moreno.
“The way industrials and defence works, it’s about the backlog,” she explained. “So if the backlog continues to grow, that gives juice to the stock.”
“As pipelines get built-out and capex cycles form, that’s where you get more upside. So these airshows and NATO agreements give you a sense of the TAM [total addressable market] but then companies have to go out and win contracts.”
“As companies win orders and build out their backlog, you start to get visibility on earnings.”
She added: “The beauty of the sector is that something like a cargo plane or an engine for a jet fighter that comes with electronics around it are a highly profitable business, so a couple of these wins do a lot for your numbers.”
Once the backlog is built for these companies, Moreno said the earnings will come through, but she warned that if the backlog stops growing, investors may need to start cutting the position.
She emphasised that investors need to have strong sell discipline and make sure they’re “out before it rolls” because the windows for growth can close as abruptly as they open.
“We’re looking for specific types of companies but the critical thing is to remember to sell, because otherwise you round trip it,” she said. “But right now the backlog [for defence] is still growing.”
Current opportunities
South Korea has emerged as an area where defence as a theme is creating new opportunities for investors, according to Moreno.
She said certain Korean companies are offering solutions for US and European countries that need to ramp up their aerospace and defence spending.
“In Korea, there are aerospace and defence companies that are building the right products, but you’re not just buying the product, you’re buying the platform because everything’s interconnected: the electronics, all the chips, they’re very, very integrated,” she said.
Another area where Korean companies are seem to be beneficiaries is in shipbuilding, Moreno said.
“Everybody needs to upgrade their ships as the global fleet is in the midst of a renewal cycle. Add to this the greater defence needs of major countries. So where is the shipyard capacity? The U.S doesn’t have the capacity and Korea does.”
“China dominated and remains a dominant player in this space, but Nato countries are seeking alternatives. So, it’s Korea that will help with that, including addressing the associated power and transmission needs as well, and that’s also coming out of Korea.”
A different way to look at emerging markets
While many investors will look at emerging markets from a top-down approach, Moreno says a bottom-up approach can help find companies that “overwhelm” a poor macro backdrop.
One example of this can be seen in Brazilian aerospace stock Embraer, which is the third largest position in the PGIM Jennison Emerging Markets Equity Opportunities fund and up over 500% since 2023 despite a difficult economic and political backdrop in Brazil.
This is an example of a company which has done well because most of its revenue comes from US dollar denominated exports while its backlog has surged.
Moreno said: “Yes, it [macro] matters in the short term, but structural growth companies are addressing something beyond the macro.”
“We believe by taking the traditional EM model and putting it on its head, focussing on growth, have the earnings tell us where to look, and digging down to focus on companies that have a competitive, sustainable advantage, that underpins their structural growth, then put a concentrated portfolio of those companies together, we should be able to generate alpha over an economic cycle.”
The opportunity exists because in her view, the market often underestimates the duration and magnitude of growth that certain emerging market companies can provide.
She said: “Look at the fastest growing Chinese tech companies, people worried all the time about China’s slowing growth, but if you went with that top-down approach, you missed the entire ride of the leading companies whose growth factors was the offline to online penetration.”
“We think that the reason you ought to invest into emerging markets is because it is where the higher growth is, but the index doesn’t tell you that. It’s telling you the opposite,” she said.
“The top members of the index are the already maturing tech companies and a lot of financials, and a lot of legacy oil and materials – that’s not where the growth is.”
“By focusing on the growth components, we were invested in defence stocks two years ago because we were having the companies’ earnings potential guide us to where we need to be. Now we have moved from one position to multiple positions in defence because we realised there was something very unique and structural.”
