On 2 January, the first trading day of 2019, the stock exchange that sets the tone for world markets – the US Dow Jones Industrial Average (DJIA) – fell 400 points before recovering to close with a modest gain of 18.36. On 3 January the DJIA was down 540 points by midday and closed down 660 points, a 2.83% decline.
The New Year kicked off here in Australia with the same pattern, as seen in the chart from MSN Money Australia.
Market experts the world over are warning investors to expect more of the same in the early days of the 2019 trading year – steep declines followed occasionally by moderate relief rallies. Fueling this volatile trading pattern is the universal bane of market investors everywhere – uncertainty.
With increasing frequency, the “R” word is creeping into commentaries seeking to bring a sense of certainty to the uncertain – recession.
We now have hard evidence of declines in two of the world’s largest economies. In China, the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) contracted for the first time since May of 2017, following from the November reading of 50.2 to 49.7 in December.
In the US, the Institute for Supply Management (ISM) PMI dropped to its lowest level since November of 2016, falling to 54.1 in December. While levels below 50 indicate contraction and above 50 expansion, the ISM PMI index fell from its November reading of 59.3. In addition, the ISM New Orders Index dropped to 51.1 in December, a steep drop from 62.1 the previous month.
The long-running bull market is flirting with bear market territory. Expert advice for worried investors ranges from going to cash, looking for recession-resistant high dividend payers, to seeking safety in defensive stocks.
However, investors who lived through the GFC know that few sectors escape a major market meltdown unscathed. While few are predicting a downturn the likes of what the GFC wrought, going on defense in some way seems the prudent thing to do.
There is strong evidence investing in established, high-performing defense contractors may provide the best available safe spot. The following chart tracks global military spending through 2017.
One would be hard pressed to find another business sector that rose in the immediate aftermath of the GFC. The situation in the world’s biggest defense spender shows the same pattern.
US defense spending declined following the fall of the Soviet Union, ramped up, and then fell again in 2011 due to a budget impasse between then President Obama and the US Congress leading to forced cuts to the US Defense budget. Under the Trump administration, spending on the military is rising again.
Looking for the best of breed defense contractors on the ASX begins with those with existing contracts and prospects with US defense contractors and the US military.
The Australian Government has adopted an ambitious goal of joining the top ten of global defence exporters, supported by financial assistance via the Defence Export Facility.
The Facility has arranged a loan for the Aussie company that stands head and shoulders above the pack – shipbuilder Austal Limited (ASB) – to build ships for the Republic of Trinidad and Tobago. Austal has multiple contracts with the US Navy and builds commercial vessels as well. There are a few other ASX players eying to make a mark in the US. The following table lists the prospects with share price and historical performance information.
While Austal builds both commercial and military vessels domestically and for multiple countries, more than 80% of its revenue comes from its business with the US Navy. Austal has provided somewhere in the neighborhood of 15% of the US Navy’s fleet and has multiple contracts in place through 2022.
As one might expect, the US Department of Defense (DOD) is selective about contractors for front-line defensive operations. Austal is the only foreign company the US Navy trusts to build ships for them. The company currently has two major contracts with the US Navy; one to build combat ships for close to shore use (Littoral Combat Ships or LCS); and the other to build ships for rapid deployment of troops and equipment – Expeditionary Fast Transport (EPF) vessels. The company has shipbuilding facilities here in Australia, in the Philippines, and in Mobile Alabama in the US.
Codan Limited (CDA) is a diversified provider of electronic products, from metal detection equipment to high frequency radio equipment to electronic tracking systems for mining operations.
The company derives most of its revenue from metal detection and tracking systems for mining applications, but the recent creation of a defence division to promote global military use of its high frequency and other radio systems and metal detection equipment for land mine detection bodes well for its future. The US military is already employing the company’s land mine detectors as well as the company’s radio communications equipment.
Electro Optic Systems Holdings (EOS) operates in two sectors – space and defence. The company’s world-class pedigree in both sectors is supported by a strategic alliance with one of the major US defense contractors operating here in Australia, Northrup Grumman (NYSE: NOC), dating back to 2006. Long reliant on its space tracking capabilities, EOS is emerging as a major supplier of remote-controlled weapons systems. With financing help from the Defence Export Agency the company landed a $410 million-dollar contract for its R400S-Mk2 remote weapons system, a product generating $600 million in revenues in its first year in the market.
The company has three other weapons systems in production and is aggressively pursuing the US market, with a new production facility and expanded marketing and product demonstration capabilities. On 24 September of 2018 the company issued a market update, reiterating its revenue guidance but doubling its profit forecast. This was welcome news to investors concerned with rising business development costs. The company’s balance sheet is strong enough to manage additional capital expenditures without the need to raise more funds. In addition, EOS announced the space sector would hit profitability in the second half of 2019.
XTEK Limited (XTE) provides a range of security products for military, police, and other government agency applications. The company’s focus on what we now call “homeland security” began in response to the 1978 Sydney Hilton Hotel Bombing at a meeting of Commonwealth Heads of State. Today XTEK has four business units – Lightweight Composites; Explosive Ordinance Disposal; Forensics; SUAS (Small unmanned aerial systems or drones); and Tactical and Protective Solutions.
As its name implies, XTEK is a technology driven company, with robotic scouting, search and detection systems, innovative firing systems, and image detectors. Currently the company’s military customer is the Australian Army, but the company has a foothold with the US military for its composite technology product line with its XTclave™ technology. XTclave™ is used to create lightweight combat helmets and body armour and is currently in testing for use with US Terrorism Combat operations, following an initial purchase contract. The company also has a full motion video mapping software application, XTatlas™, for use with both piloted aircraft and SUAS drones.
There are three other micro-cap stocks worth mentioning for those with higher risk tolerance.
Quickstep Holdings (QHL) specialises in carbon fire composite materials. The company’s future seemed bright when the F-35 Lightning II Joint Strike Program, led by the US contractor Northrup Grumman, opted to use Quickstep composite materials in constructing the aircraft, a 20-year project with estimated revenue to Quickstep of $700 million.
The primary customer for the F-35 was the US, with projected purchases of 2,443 aircraft. Joining the program were the United Kingdom, Italy, the Netherlands, Canada, Turkey, Australia, Norway, Denmark, Japan, Israel and South Korea with anticipated purchases of 3,100 aircraft by 2035.
Speculation about cost overruns and production delays soured the mood for investors, and the speculation turned into fact. Quickstep has delivered its component parts – doors, panels, and fuselage parts – and the program appears to be back on track, although some problems persist.
Titomic Limited (TTT) is an additive manufacturing, or 3D printing company, with an innovative technology using titanium and kinetic fusion cold spray. The technology can be used for parts replacement in military applications with the benefit of the superior strength and light weight of titanium.
Cybersecurity company Whitehawk Limited (WHK) serves the SME (small to medium enterprise) marketplace with an online cybersecurity clearing house where client companies can find solutions to meet their cybersecurity needs. The company has applied for a patent for its machine learning algorithm and artificial intelligence platform.
The company is in its infancy on the ASX, listing on 31 January of 2018. In December the share price got a much-needed boost on the announcement it had secured its first defence industry client. The contract is with an unidentified US top 12 defence industrial base company for supply chain risk management. Whitehawk will provide its 360 Cyber Risk Framework, enabling the client to manage security risk from an initial 50 companies in its supply chain. This could be a significant breakthrough for this highly speculative company, as suppliers to defence contractors are a primary source of security risk.
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Published by Paul Taylor, Portfolio Manager Fidelity Australian Equities Fund, Fidelity